The smooth functioning of the financial system is critically dependent on a sophisticated and evolving infrastructure comprising of payment, clearing, trading, information, settlement, messaging and legal systems which is often taken for granted. However, glitches and gaps in this ‘invisible’ part of the market have the capacity to seriously disrupt the financial system as was highlighted yet again through the problems caused by the lack of proper settlement in the Credit Default Swap market in the current crisis.
More often than not both financial institutions failures as well as financial system wobbles are driven by bad housekeeping which has become ever more important as the financial system has become more complex and inter-connected. Especially because such ‘back office’ systems are hidden from sight, governments and regulators need to be proactive in ensuring that such systems do not lag behind market innovations and are resilient.
- Develop robust clearing and settlement systems for all financial instruments: Many new financial instruments including OTC derivatives such as Credit Default Swaps do not have well-developed settlement and clearing systems which increases counterparty risk and compromises both financial stability and market integrity. It is urgent that such systems which provide a centralized and closely supervised mechanism to monitor and settle trades in financial instruments be developed preferably at a pan EU or global level.
- Increase the standardization of products and proportion of on exchange trades: While there is a role for customized products, too many of the products traded and sold have been designed with a view to increase profit margins and for regulatory arbitrage. These reduce transparency in the financial system and increase systemic risk. There is a need for regulators to ensure that such products are rolled back and replaced by more standardized products most of which should be traded on closely supervised exchanges.
- Drive the development of robust support systems: In addition to these, regulators need to closely supervise legal systems, back office systems, information systems and payment systems and use their statutory powers to ensure that the development of these systems keeps pace with financial market developments. They also need to subject these systems to regular stress tests to ensure that they are robust, efficient and resilient.
Regulators were alerted to the critical importance of market infrastructure when the mid-day collapse of Hersatt, a mid-sized German bank nearly triggered a systemic collapse. This spurred the development of the Continuous linked settlement bank (CLS), a settlement system for foreign exchange transactions which has come out with flying colours in the current crisis and also helped improve market information as well as reduce transaction costs.
Likewise, instituting the suggested regulatory changes will not only contribute to increased market stability but also improve market transparency, reduce costs and make crisis induced stabilizing regulatory interventions easier to carry out.
Sony Kapoor
Managing Director, Re-Define