counter terrorist financing policies time for a rethink 37877

October 2011Issue 14.8

EU ................................................ 1 Vincent O’Sullivan, PwC FS Regulatory Centre of Excellence and Stephen Kinsella, Lecturer, Department of Economics, University of Limerick, Ireland review the need for EU banks to recapitalise in light of the continuing pressure of the sovereign debt crisis.

INTERNATIONAL ......................... 4James F McCollum, Partner, James F McCollum and Assoc. Ltd, Canada, is the invited Rapporteur for the 2011 Banking Law Symposium, at the OECD, Paris. A brief summary is provided of the key policy conclusions relating to crisis management and the use of government guarantees during the recent !nancial crisis.

UK ...................................................... 7Prof. George Walker, FRI executive editor, provides an overview of the role of the UK Prudential Regulation Authority.

UK .................................................... 11Marco Merlino and Dr Nicholas Ryder, Commercial Law Research Unit, Department of Law, Faculty of Business and Law, University of the West of England, Bristol provide a reassessment of the !nancing policies underpinning the current counter terrorism policies.

EU .................................................... 13Frederik Dømler, Researcher, University of Warwick, provides a detailed and critical analysis of the proposed European reforms of the credit default swap market.

Recapitalising European banksIntroductionEuropean banks face a !200bn capital shortfall amid continuing sovereign stress in the eurozone, according to the International Monetary Fund (IMF)1. In its biannual global "nancial stability report, the IMF does not quantify how much additional capital European banks need to withstand future losses – calling for credible stress tests to identify this "gure – but its calculations do illustrate the gravity of the situation facing the already fragile banking sector.

Christine Lagarde2, Managing Director of the IMF, called for ‘decisive action’ to mitigate the real risks of contagion and a full blown liquidity crisis given their shortfall. Primarily, EU banks need ‘urgent’, ‘substantial’ recapitalisation, according to the former French Minister of Finance, to bu#er banks’ balance sheets and enable them to withstand the risks of sovereign default and weak growth in the global economy, possibly even using further public funds. Of the !200bn, the IMF estimates that European banks have lost around !40bn through their exposures in Greek sovereign debt, !20bn each due to Irish and Portuguese national debt, and the remaining !120bn attributable to banks exposure to sovereign debt in Belgium, Spain and Italy. Banks have also been a#ected by sovereign risks on the liability side of their balance sheet as implicit government guarantees have been eroded, the value of government bonds used as collateral has fallen, margin calls have risen, and bank ratings downgrades have followed cuts to sovereign ratings.

European o$cials initially questioned the "gures underpinning the IMF’s calculations, particularly around the use of the Bank for International Settlement’s data on sovereign debt exposures. However, the downgrading of several large European banks, the problems at Dexia Group, together with concerns over liquidity, has forced Brussels to rethink its strategy. The latter is a good re%ection of how market sentiment is evolving. In September 2011, European banks were facing di$culties in tapping wholesale funding markets. The press3 reported that some major "nancial institutions in Europe were completely cut-o# from dollar funding markets, as US institutions pull back capital in response to the region’s debt crisis. In response, the European Central Bank4 (ECB) announced on 13 September that it had allotted $575m in a regular seven-day liquidity providing operation at a "xed rate of 1.1%; it also indicated that it will be lending an undisclosed amount of dollars directly to two euro-area banks on 15 September. Apart from dollars lent to a troubled Greek bank in August 2011; this was "rst time the ECB has pumped dollars into its eurozone banking system for over six months. Furthermore, in a coordinated action, "ve international central banks agreed on 15 September to inject billions of dollars into Europe’s troubled banking system in an e#ort to avert a global credit crunch. Markets are re%ecting heightened concerns; with the premium European banks pay to borrow in dollars through the swaps market is close to the highest level since the 2008 crisis, according to data compiled by Bloomberg5.

Compulsory recapitalisation of European banksIn light of volatile market conditions, European o$cials are coming around slowly to the IMF’s position and addressing the need for signi"cant capital

Financial Regulation International . October 2011 . Issue 14.8

injection in many European countries. This is re%ected by recent proposals propagated by the President of the European Commission (EC), José Manuel Barroso, whereby systemically important banks may be forced to temporarily raise additional capital with restrictions on dividends and bonus payments on an interim basis. As part of its road map to stability and growth6, the EC called for ‘signi"cantly’ higher capital reserves to help banks replenish their balance sheets to withstand market turmoil amid the eurozone’s sovereign debt crisis. The coordinated bank recapitalisation strategy would cover all potentially systemic banks in the EU, equating to around 90 "rms. According to the proposals, all sovereign debt exposures should be taken into account to ensure full transparency on asset quality. For Greek sovereign debt, President Barroso suggested that some form of private sector haircut was required, although he gave no indication of the appropriate level.

While falling short on speci"cs, various sources have indicated a 9% Core Tier 1 (CT1) capital ratio to risk-weighted assets will be adopted by the European Banking Authority (EBA) when/if it assesses exposure to sovereign debt, if the road map is adopted at the EU summit later this month. Such a requirement would put considerable strain on banks and could place them at a competitive disadvantage against their international peers given that the Basel III ratio of CT1 is only 7%. It would also be a considerable shift in the EC’s previous position which suggested setting Basel III capital requirements as the maximum standards across the EU, in line with initial Franco-German proposals. The rumoured CT1 level is also considerably higher than the 5% set by the EBA during its stress test exercise in July 2011.

While the Basel III capital requirements will not fully apply until 2015 to allow banks to comply with requirements gradually, the general consensus is that European banks will be given only six to eight months to bring their capital reserves in line with the new requirements. In practical terms, national supervisors should establish these requirements using their existing supervisory powers in the form of additional bu#ers which prevent the distribution of dividends or bonuses pending the recapitalisation, according the EC’s proposals.

Getting stressed over stress testsThe proposals put forward by the EC would represent a much bigger recapitalisation of European banks than was envisaged in last summer’s stress tests, as some form of sovereign debt write-down is anticipated. While the criteria for the stress test was toughened this year with negative projections of GDP growth (0.5% contraction) and equity prices (15% contraction), markets considered that the lack of a requirement to build scenarios on the possibility of a sovereign debt default undermined the credibility of the test.

Speaking at the European Systemic Risk Board (ESRB) second ordinary meeting on 22 June 20117, EBA Chairman Andrea Enria refuted this claim stating that sovereign debt risk exposures were adequately addressed in the 2011 stress test. For exposures in the trading book, stress test participants

must apply mark-to-market under current regulations. The EBA has also updated the parameters associated with this exercise in line with market movements in those countries most adversely a#ected by the "nancial crisis. In the loan book, banks are required to calculate the credit risk of sovereign exposures by estimating probabilities of potential losses of sovereign default as part of the exercise. To address the possibility of some banks underestimating sovereign risks, the EBA has provided additional guidance which sets the %oor on the sovereign risk weights – based on publicly available information such as external rating – which banks are required to map to their own internal risk-rating scales.

Clearly, this micro-prudential exercise – designed as an ongoing supervisory tool – cannot divorce itself from the severe macro-prudential risk in the system, and market reactions. Speci"cally, including the possibility of sovereign debt restructuring, or even a sovereign default in prescribed stress test scenarios, however, could have sent a message to the markets which would have made the current delicate e#orts to stabilise the Greek situation more di$cult. Reliance on banks to e#ectively quantify private and sovereign risk proved spectacularly unjusti"ed in some cases.

Recognising this, Andrea Enria admitted that its July stress test exercise, which Dexia passed, did not completely quell negative market sentiment given the situation in Greece8. While, the EBA has denied imminent plans for a new round of stress tests, it did not rule it out completely in the near future. It is most likely that it will remodel sovereign write-downs using historical data in its July stress test, to assess the impact of pricing their sovereign debt at the going rate.

Will recapitalisation result in restructuring?To raise additional capital to bu#er against sovereign debt write-downs, banks may be forced to jettison non-core business operations and scale-back or deleverage elsewhere. Such restructuring scenarios are already been being discussed at BNP Paribas and Société Générale. For example, Société Générale plans to free up !4bn in capital through asset disposals by 2013 to increase CT1 capital9. This strategy may be adopted by other European banks as they face a number of challenges in raising capital through private sources.

Firstly, management may hesitate to raise capital through a rights issue given the depressed nature of their stock – the average European bank’s equity is trading at only about 60% of its book value. The debt market is volatile and we have seen some large players unwilling to roll-over dollar denominated debt to European banks in recent months. While investors will return to this market as they search for higher yields when market conditions stabilise, European banks, as it currently stands, already have signi"cant short-term funding re"nancing needs. According to analysts, European banks must roll-over around !1.7trn of senior debt of more than a year’s maturity over the course of the next three years, which could leave little room to raise additional capital.

While banks’ retrenchment strategy may be the only viable option for meeting the new requirements through private means, there is a concern that this will reduce

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lending in the real economy and dampen any meaningful economic recovery. The situation highlights the complexity of the interdependence between banks and public revenues. A strong banking system helps stimulate private investment in the economy which in turn generates taxable revenues. European "rms rely on banks for as much as 80% of their funding compared with only 30% for US "rms10. Similarly, if governments restore the long-term sustainability of their public "nances, the risk premium on banks’ exposures to sovereign debt will be reduced, bringing down the need for additional capital at banks.

It is very likely that national governments will step-in and provide some form of temporary support if their systemic banks are unable to raise capital at sustainable rates. The EC has signalled that stricter rules on state aid for banks – which were originally planned to expire in 2010 – will now not be introduced until at least the end of 2011. Prolonging the exemptions given to governments to support their banking system is necessary given continued tensions in funding markets, doing otherwise would not be ‘safe’ according to Commissioner Almunia11.

The French government, for its part, stands ready to inject capital into its beleaguered banks, if necessary12. If national support is not available, though, recapitalisation may be funded by a loan from the eurozone bail-in mechanism – the European Financial Stability Facility. In this regard, the EC’s road map outlines that public interventions must strictly follow state aid rules for bank support to ensure the level playing "eld in the single market. A recent EC sta# working paper13 on state aid concluded that the temporary framework for state aid during the "nancial crisis worked properly, and plans to extend it to the end of 2011 were justi"ed. However, when the crisis is "nally over, the provision of state aid should return to the objective of less and better targeted aid. The working paper, notably, did not discuss how future state aid practices will be work with and complement the anticipated regulatory framework for recovery and resolution planning.

In e#ect, a stressed situation envisaged in the recovery and resolution scenarios is already upon us. Similarly, if state aid is given, nationalised or quasi-nationalised banks will be required to signi"cantly restructure their operations and hive o# any pro"table business units to repay public support. Some investment banks already predict that the disposal of fund management and private equity arms of European institutions this year may buoy the weak mergers and acquisition markets. Irish banks are considerably further along this process than their peers elsewhere in Europe. In 2010, Bank of Ireland was forced to sell its asset management and life assurance businesses and a building society to comply with state aid rules. Similarly, Allied Irish Banks had to sell pro"table international arms in Poland and the US before passing EU state aid rules.

A case for tighter fiscal integrationOverall, risks to global "nancial stability have increased markedly in the last six months signalling a partial reversal

in progress in the health of the "nancial system since 2008. The failure to stem contagion risks and credibly address sovereign and banking system concerns has led to a wide-scale pullback in risky assets, stoked fears of recession, and sent investors rushing towards safe investments such as in gold and Swiss francs. The eurozone sovereign crisis is not only infecting European and US banks, and their respective economies, but now is spilling over to emerging markets. Low interest rates could lead to excesses as the search for yield exacerbates credit cycles (and possibly leading to credit bubbles) especially in emerging markets.

Against a backdrop of the indecision and division between member states on how to solve the sovereign debt crisis, the road map presented by the EC is timely and might help frame negotiations when heads of states meet at the forthcoming EU summit on 23 October. It also places the EC at the heart of discussions around crisis management in Europe which recently have been increasingly framed by bilateral meetings between the French and German governments. The EC is keen to show that it has an important role to play in coordinating actions across the Union. Delivering agreement on its road map would be a major win for the EC and the entire European project.

However, it is clear that bank weaknesses will not be addressed through restructuring alone. Previous e#orts to address the sovereign debt crises were labelled ‘reactive’ and ‘piecemeal’ by the EC President José Manuel Barroso14, indicating that more decisive and coordinated action is now needed to end the ‘vicious circle’ of concerns over the sustainability of sovereign debt, the fragility of the European banking system and overall economic growth prospects. Moreover, the IMF in its stability report, is calling on European policymakers to speed-up their actions to address longstanding "nancial weaknesses both in their economies and banking systems, believing that markets are now ‘losing patience’ with the patchwork attempts to repair and reform the EU "nancial system. Therefore, the road map also calls for immediate action in addressing Greece’s "scal problems; enhancing current backstops, frontloading stimulus policies, and adopting more integrated economic governance.

More generally, the IMF believes there are some ‘serious %aws’ in the current architecture of the eurozone which threaten the viability of the entire project. European regulators and authorities need to recommit to a common vision of the eurozone with tighter "scal and regulatory integration, which is built on solid foundations – including, for example, the creation of a single rule book for regulation in the EU which the European Supervisory Authorities are trying to propagate. Furthermore, Jean-Claude Trichet15, President of the ECB, called for a ‘deeper and authoritative’ role for the EU over "scal policy when "nances in member states ‘go harmfully astray’. He suggested it was necessary to "nd a new balance between ‘the independence of countries and the interdependence of their actions’ in a common currency bloc. In this regard, he proposed a ‘new concept’ for the eurozone that

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envisioned cases of ‘compulsory’ intervention from EU leaders and the ECB in ‘major "scal spending items and elements essential for the country’s competitiveness.’ To coordinate this function, he %oated the idea of establishing a European "nance ministry whose powers to intervene in national economic policy would be ‘well over and above the reinforced surveillance that is presently envisaged’.

Since the introduction of the single currency in 1999, "scal policy of countries has remained largely under the responsibility of national countries according the principle of subsidiarity – a presumption in favour of national sovereignty. However, national policy was supposed to be formulated in the context of the provisions of the stability and growth pact which imposed tight constraints on "scal policy, particularly about budget de"cits. However, following the launch of the euro, an increasing number of countries found it di$cult to comply with the limits set by the Pact (including Germany and France). Since 2003, more than 30 excessive de"cit procedures have been undertaken, with the EU reprimanding member states and pressuring them to tighten up their "nances, or at least promise to do so. The EU, however, has never imposed a "nancial sanction against any member state for violating the de"cit limit, given the political sensitivities in implementing such measures. The lack of enforcement of the stability and growth pact gave countries, like Greece, discretion to run up high levels of debt during the last decade. The EU had apparatus before to clamp down on excessive sovereign debt and failed to do so, adding more power will not necessarily change this.

Vincent O’Sullivan, PwC FS Regulatory Centre of Excellence. Stephen Kinsella, Lecturer, Department of Economics, University of Limerick, Ireland.

Endnotes1. IMF, Global Financial Stability Report (September 2011)

www.imf.org/external/pubs/ft/gfsr/index.htm2. Christine Lagarde, Global risks are rising, but there is a

path to recovery: Remarks at Jackson Hole (August 2011) www.imf.org/external/np/speeches/2011/ 082711.htm.

3. Wall Street Journal, Central Banks Pour Dollars Into Europe, http://online.wsj.com/article/SB10001424053111904060604576572442555810356.html.

4. European Central Bank, ECB announces additional US dollar liquidity-providing operations over year-end (September 2011) www.ecb.int/press/pr/date/2011/html/pr110915.en.html.

5. Bloomberg, ECB Will Lend Dollars to Two Euro-Region Banks as Market Funding Tightens (September 2011) http://mobile.bloomberg.com/news/2011-09-14/ecb-lends -dollars-to-two-banks-in-the-euro-area-as-credit-markets-tighten.html.

6. European Commission, A roadmap to stability and growth (October 2011) http://ec.europa.eu/commission_2010- 2014/president/news/speeches-statements/pdf/20111012 communication_roadmap_en.pdf.

7. European Systemic Risk Board, Introductory Statement by Andrea Enria, (June 2011) www.esrb.europa.eu/news/pr/2011/html/sp110502_1.en.html.

8. Reuters, EU works on banks, Obama urges swift action (October 2011) www.reuters.com/article/2011/10/06/us-eurozone-idUSTRE7953D520111006.

9. Société Générale, Accelerating the transformation (September 2011) http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9MTA2Nzg3fENoaWxkSUQ9LTF8VHlwZT0z&t=1.

10. Financial Times, EU banks could shrink to hit capital rules (October 2011) www.ft.com/cms/s/0/f2e62f82-f4f2-11e0-9023-00144feab49a.html#axzz1b9RzMwVY.

11. Joaquín Almunia, Stoking growth in Europe: a time for bold decisions (September 2011), http://ec.europa.eu/commission_2010-2014/almunia/headlines/speeches/index _ en.htm.

12. Financial Times, France ready to give banks public capital (October 2011) www.ft.com/cms/s/0/93029b2e-f4e7-11e0-ba2d-00144feab49a.html#axzz1b9RzMwVY.

13. European Commission, The e#ects of temporary state aid rules adopted in the context of the "nancial and economic crisis (October 2011) http://ec.europa.eu/competition/publications/reports/temporary_stateaid_rules_en.html.

14. José Manuel Barroso, Speech by President Barroso: A Roadmap to Stability and Growth (October 2011) http://europa.eu/rapid/pressReleasesAction.do?reference=SPEECH/11/657&format=HTML&aged=0&language=EN&guiLanguage=en.

15. Jean-Claude Trichet, Building Europe, building institution (June 2011) www.ecb.int/press/key/date/2011/html/sp11 0602.en.html.

The 2011 Banking Law Symposium entitled Crisis Management and the Use of Government Guarantees was held on 3 and 4 October 2011 in the conference facilities of the Organisation for Economic Cooperation and Development (OECD) in Paris.

The participants discussed recent and prospective measures (both national and international) as well as further

changes needed to contain and prevent "nancial crises. Inter alia, they focused on:

to the newly established European Financial Stabilisation Fund;

light of the recent experience in several countries;

Summary of the OECD Banking Law Symposium on Crisis Management and the use of Government Guarantees

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Check out previous issues at www.i-law.com/financialcrime

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associated with government guarantees and the linkage between guarantees and European sovereign debt issues;

for "nancial sector competition; and

The Symposium was organised by John Raymond LaBrosse, Rodrigo Olivares-Caminal and Dalvinder Singh with the assistance from Sebastian Schich from the Secretariat of the Committee on Financial Markets (CMF) of the OECD. The event was part of the OECD’s 50th anniversary special symposium and took place just prior to the meeting of the CMF, and served as an input to it. This very timely symposium, in light of very recent European "nancial developments, was part of the OECD’s ongoing work on the fallout of the global "nancial crisis and major "nancial sector issues, of which the role of government guarantees is a signi"cant component.

Keynote speakers included Christine Cumming, First Vice President, Federal Reserve Bank of New York, Charles AE Goodhart, Professor Emeritus, London School of Economics, Már Gu&mundsson, Governor, Central Bank of Iceland and Charles Enoch, Deputy Director, Monetary and Capital Markets Department of the International Monetary Fund. Additionally, some 20 presentations were made by academics, as well as private and public "nancial sector specialists.

When problems began to appear in the US sub-prime mortgage-backed securities market in 2007, it was largely felt that, despite some strains, the banking system, or the "nancial system more generally, could absorb them within a relatively short time frame and that the world would go on as before. Underlying this was the experience of other "nancial shocks during the past 25 years or so, when "nancial safety nets, despite some country speci"c exceptions, proved equal to the task.

As it has turned out, a problem, which was initially thought to be largely con"ned to sub-prime mortgage lending and its bearing on US banks, quickly revealed other fragilities and that systemic risks in the "nancial system more broadly had been building up for some time. As the situation evolved, the various problems began to feed on each other, resulting in a virulent global "nancial crisis. As Doug Arner emphasised, one type of "nancial crisis can quickly morph into another, with 2008-09 clearly being a case in point. It seems fair to say – with the bene"t of hindsight, to be sure – that there was a lack of understanding of accumulating systemic risks, both by the private sector as well as by the authorities, and that safety nets in most cases were inadequate and/or incomplete and risked being overwhelmed. Financial innovation, globalisation and the introduction of the euro all had implications for risk containment that were not fully recognised.

The symposium, however, is a clear example of the international community’s commitment to forging enhanced, well thought-out mechanisms for containing

systemic risks in the context of a highly interconnected global "nancial framework with ongoing "nancial innovation.

While use of government guarantees was a central theme, the symposium also analysed the roles played by prudential regulators, central banks, deposit insurers and treasuries in dealing with the crisis. These included traditional measures such as the central banks’ lender of last resort role (including its lack of availability), some extraordinary measures, such as recapitalisation, asset purchase and guarantee schemes, as well as more inclusive guarantees on the liability and asset sides of bank balance sheets. Even by traditional standards a number of countries had a less than complete "nancial safety net and deposit insurance had to be quickly introduced and or substantially strengthened. Under the circumstances, and the need to act quickly, mistakes – often very expensive ones – were made at public, ie taxpayers’, expense, and they will shoulder a burden for many years. This is clearly and convincingly documented in David Mayes’ paper, with reference to New Zealand’s deposit guarantees and Ireland’s comprehensive bank liability guarantees. A central message is that in the midst of a global "nancial crisis it is not the best time to start to think about creating a safety net, and that guarantors should have some idea of potential exposure beforehand. Insu$cient "nancial institution supervision coupled with blanket guarantees can jeopardise the "nancial viability of the state.

It would be hard to imagine a more di$cult situation than that in which Iceland found itself. The Governor of the Central Bank of Iceland, Mar Guömundsson, noted that bank liabilities were some 10 times GDP, approximately half of which were denominated in foreign currencies, and that the traditional lender of last resort function of the safety net was not available to support non-Icelandic currency activities of its banks. Under the circumstances the sovereign could not provide a credible guarantee. An important factor, which allowed bank risk to accumulate, was the European passport for "rms, which permitted "rms licensed in one country to operate in other member states. The passport was focused on competition issues, but there was a lack of attention to the "nancial consequences of it, particularly for a member country using a di#erent currency. The authorities had little choice on how to proceed. Rather than making a good bank/bad bank split, a split was made along currency lines. The domestic side became fully functional, with bank liabilities at 1.7 times GDP, while the the foreign currency side went into receivership and is currently in a workout. A positive side of this was that the credit standing of the sovereign was not impaired and the risk of a sovereign default and/or an unbearable burden on Icelandic citizens was averted.

Several presenters focused on important macro-prudential issues, suggesting that the traditional three-tier safety net – central bank (lender of last resort), bank deposit insurance, and regulator-supervisor (micro-prudential) – was incomplete and called for the creation of additional players or a net that was more widely focused and covered


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non-traditional players in the shadow system of "nancial %ows. A number of proposals were put forward and discussed. Charles Goodhart, with reference to the evolving UK situation, called for the creation of a macro-prudential authority and argued that systemically important "nancial institutions (SIFIs) should be at the centre of "nancial regulation, since this is where the greatest threats to the system are located. He provided suggestions regarding its powers and scope and where it might be most appropriately located, at least in the UK.

Among the suggestions for additional players were a guarantor of last resort or a tiered guarantor system, bank recovery and resolution funds (BRRFs – Nieto and Garcia), an investor of last resort (Manns) and a resolution apparatus (several participants). Maria Nieto noted that the functionality of BRRFs was predicated on an e#ective resolution regime and would not work if the sovereign itself was in "nancial di$culties. Je#rey Manns stressed that while the US bailout program served to stabilise markets, it had little deterrent e#ect, created a moral hazard and did not provide a framework for the future. Having a framework in place would help take politics out of the equation and having more strings attached and potential taxpayer bene"ts would make assistance more publicly acceptable. He advocated the creation of a Federal Government Investment Agency which would share in bene"ts as assisted "rms recovered and would imply that all stakeholders would take a haircut. Perceptions of unfairness regarding the recent program has resulted in strong public resistance to further bailouts and unfortunately can complicate and/or limit US policy responses down the line. John Raymond LaBrosse and Dalvinder Singh outlined how the relative roles and importance of the various safety net players and stakeholders changed as the "nancial crisis evolved.

It was noted that micro- and macro-prudential regulation can, at times, be at odds with each other. The best regulatory framework for individual components of the system, may not be the most appropriate from the perspective of the overall system. Rosa Lastra picked up on this theme, as did some other participants, also noting that prudential regulation is dealing with a moving target, so that ongoing adjustments may be necessary. With reference to Hyman Minsky’s work, some three decades ago, Charles Goodhart made the point that an extended period of macroeconomic stability can lead investors and institutions to take on more risk than the underlying state of a#airs warrants – since in a tranquil state of the world there is a tendency to under-estimate risk. This can be magni"ed if interest rates are low and expected to remain so for some time.

While not traditionally thought of as part of the safety net per se, several presenters underlined the critical importance of a well-designed resolution mechanism for troubled "nancial institutions. The lack of such was an important feature of the di$culties and limited options the authorities, particularly in European countries, faced in handling the

crisis. It was underlined that a well-designed resolution system can improve the e$ciency of the safety net, assist in containing a moral hazard, can be especially important in dealing with failing multinational "nancial "rms and has the potential to be helpful in coming to grips with too big to fail (TBTF) and SIFI issues. A comment was made that a mechanism for untangling and resolving cross-border institutions would have helped limit the damage resulting from the Lehman failure.

Recent G20 summits have called for the development of e#ective mechanisms for resolving SIFIs and an end to TBTF safety net hostage-taking. Eva Hüpkes outlined key aspects of the Financial Stability Board’s (FSB) work and recommendations in this regard. She noted that the FSB’s proposals involve the creation of convergent regimes, incentives for cooperation and strike a balance among home and host country interests and global "nancial objectives. Recovery and resolution plans at a minimum for all global SIFIs, private sector funding and information sharing are critical features. She noted, however, that some commentators felt that the draft recommendations do not go far enough. The FSB will submit its "nal proposals to next month’s (November) G20 Summit.

Charles Enoch provided a detailed update on the European 2010 Directive. He noted that considerable progress was being made to improve safety nets, but that there are outstanding issues. He remarked that there are areas where there is ‘too much Europe’, or excessive harmonisaton, and areas where there is ‘too little Europe’ or insu$cient harmonisaton. A maximum for capital requirements is an example of the former, for this could prevent a country from addressing some of its prudential concerns. Having deposit insurance at the national level in the context of large pan-European banks is an example of the latter. He remarked that having a national deposit insurer for domestic banks and a European level insurer for pan-European banks could o#er a path forward. Like a number of other participants, he stressed that developing mechanisms for resolving the failure of cross-border "nancial institutions remains a critically important issue for Europe and the world more generally.

Turning to the sovereign debt crisis, the symposium also focused on the facilities put in place by the IMF and the European Union to deal with in the aftermath of the banking crisis. The banking and sovereign debt crisis are closely interlinked, since European banks holdings of sovereign debt are substantial and a sovereign default could threaten the viability of some banks and reignite the banking crisis. Rodrigo Olivares-Caminal provided an account of the European Financial Stabilisation Mechanism (EFSM), and the potential European Stability Mechanism (ESM). Funding, burden sharing, conditionality, use of guarantees, and monitoring and reporting mechanisms were touched on. The use of guarantees involves a two-tiered moral hazard issue – involving both the recipient country and "nancial institutions acquiring and holding its debt. He noted that



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the rationale for an ESM was not quite clear since it seemed to replicate some of the functions of the IMF and could operate in a similar manner insofar as country-lending programs are concerned. Rosa Lastra noted that an important issue in monetary and economic unions is that there is a strong M, but a weak E or "scal capability to back up the monetary or "nancial features.

The use of guarantees, where they worked well and where they precipitated other problems, cropped up throughout the Symposium. How best to contain the associated moral hazard and limit associated taxpayer exposure were reoccurring elements. As Christine Cumming and others pointed out, guarantees have been an important element in preserving liquidity and restoring market functionality and avoiding worst case scenarios. Christine Cumming went on to note that despite their associated problems (particularly moral hazard, the cost of putting in place control mechanisms and taxpayer exposure), it would be di$cult to manage "nancial crises without them and that other forms of intervention were likely to be more intrusive and perhaps more costly. She noted that implicit or assumed guarantees did not work well; when it became clear to participants that assumed guarantees were not justi"ed panic ensued. The sad outcome for implicit guarantees in some European countries reinforces this view.

Christine Cumming remarked that guarantees, insurance and options are similar conceptually; this is important because modern "nance theory provides some guidance on guarantee valuation and, by extension, risk monitoring. She went on to describe the key features and experience of o$cial intervention in "nancial institutions and markets during 2008-09 and comment on the afore-mentioned proposals of the FSB to address resolving cross-border SIFIs and TBTF institutions.

Fabio Panetta focused on the e#ectiveness and costs of government guarantees on bank bonds. These were largely e#ective in stabilising market conditions and have since been discontinued. Market conditions have recently deteriorated, however, so the question of guarantees is being raised again. Among other issues to be considered are credibility, as well as the potential implications for sovereign "nances, given current sovereign debt problems (ie they worked last time, but will they again?). He was also

concerned about the market distorting e#ects of guarantees. This last point was discussed by Sebastian Schich and Arturo Estrella, and backed up by their detailed empirical research. The evidence presented is consistent with Fabio Panetta’s preliminary results, and as well as with a priori notions. That is to say, the market value of a sovereign guarantee is a positive function of the credit rating of the sovereign. This suggests that to avoid competitive distortions the strength of the sovereign should be taken into account in guarantee pricing. It also has implications for the moral hazard issue, since a guarantee by a strong sovereign to a weak institution would be an invitation to it.

Lee Buchheit and Mitu Gulati made insightful comments on the treatment of guarantees and other contingent liabilities in sovereign debt restructurings. It was noted that there were three options with respect to constructing a government balance sheet, none of them very attractive: leave them out, treat them as a full liability item or o#er bene"ciaries the option of calling them at their current net present value or taking a haircut after a restructuring. Option 1 can be misleading, option 2 can encourage claims, while option 3 is an admission that you are likely to default. It was noted that we are no longer in a world where contingent liabilities are small, so this issue has more immediacy than in the past. How to put in place mechanisms so that guarantees can be better handled in restructurings in the future remains an important issue.

In summary, the sessions analysed how governments, central banks, regulators and deposit insurance agencies worked together to contain the global "nancial crisis. Additionally, they focused on e#orts to overcome ongoing obstacles, as well as the most important proposals to improve safety nets, both at the national level and internationally. The development of resolution mechanisms for the failure of a large multinational "nancial institution remains a critical issue for the international community.

It seems fair to say that the Symposium was unique, timely and useful. Hopefully, it will contribute to improving understanding of the nature of the global "nancial crisis, the crisis process and how best to develop mechanisms to avert future crises or check them at an early stage.

JF McCollum, Partner, James F McCollum and Assoc Ltd. Canada.

The Bank of England and the FSA issued a joint paper on the supervisory approach to be adopted by the Prudential Regulatory Authority (PRA) in May 20111. A separate paper on the supervision of insurance companies was to be released later in May 2011 with a further paper on the Financial Conduct Authority (FCA) in June 20112. The Bank and FSA had arranged a launch Conference for the PRA on 19 May 2011.

Hector Sants, FSA Chief Executive and PRA Chief Executive Designate, described the PRA’s purpose as being ‘fundamentally di#erent from that of previous regulatory regimes’ and that it would ‘lead to a signi"cantly di#erent model of supervision to that which was in use pre-2007’3. Hector Sants highlighted four speci"c points. The purpose of the PRA was to focus on the stability of the system overall but through the mechanism of individual "rm

Prudential Regulation Authority


8

supervision. The PRA would reduce the risk of individual "rm failure with any failure occurring in an orderly manner. Baseline supervision would ensure that regulators complemented and promoted market disciplines and not substitute them with responsibility for managing the "rm remaining with its management, board and shareholders. The PRA should not be accountable for all "rm failures with failure being a necessary part of any healthy, innovative market system.

Hector Sants identi"ed three further key sets of tools including rules and regulations (principally dealing with capital, liquidity, leverage and governance), resolution plans and supervisory oversight of management actions and strategies. In designing the new approach, the authorities had ‘taken into account the lessons from both periods of supervision’ under the Bank of England and FSA. Hector Sants summarised these in terms of inadequate capital and liquidity standards and a supervisory ‘presumption’ that supervisors should not question senior management judgement and market discipline. Rather than act in a ‘reactive’ manner, the new approach would be ‘outcomes’ and ‘judgement-based’, focusing on business models, capital and funding strategies with ‘close intensive engagement’. Sants stated that supervisory sta# would have to have ‘optimal experience and technical ability’ although he accepted the ‘economic reality’ that compensation levels would be ‘multiples less’ than within regulated "rms4. Sants also referred to the need to ensure e#ective accountability, international contribution and domestic inter-agency coordination.

Andrew Bailey, FSA Director of UK Banks and Building Societies and PRA Deputy Chief Executive Designate, referred to the PRA’s single objective which would allow it to ‘focus fully on promoting the safety and soundness of the "rms it regulates’ under a ‘so-called twin peaks model of future "nancial regulation in the UK’5. He added that, ‘The PRA’s regulatory philosophy will be based on the premise that "nancial "rms should be subject to the disciplines of the market, with regulation and supervision addressing residual market failures’ with "rms being allowed to close ‘in an orderly manner with minimal impact on the "nancial system’ through a combination of prudential policy, supervision and resolution. Bailey referred to the PRA’s new risk assessment framework and ‘forward-looking’ and ‘judgement-based’ approach to supervision. The PRA would create a ‘high-level framework containing minimum standards expected of "rms’ and incorporate FPC recommendations to ensure consistency between micro- and macro-prudential policy.

The PRA would form an essential part of the new regulatory regime as it would principally be responsible for supervising "rms holding £11trn in assets which was nine times UK GDP and with UK banks alone holding "ve times UK GDP. The PRA would regulate 157 UK incorporated banks, 48 building societies, 652 credit unions and 162 branches of overseas banks from the European

Economic Area (EEA) and globally. Around 2,000 "rms would be subject to PRA oversight.

Financial crisisThe lessons from previous crises were summarised in the joint May paper6. The principal regulatory failure was stated to be inadequate Basel capital and liquidity standards with weak domestic FSA supervision. Supervision had focused on ensuring that there were credible systems and controls in place with intervention being limited to technical regulatory breaches. There had also been a lack of necessary resolution tools with deposit protection being insu$cient to ensure depositor con"dence.

The reference to the crisis having been caused by defective Basel standards may have been overly simplistic. Many authorities, including in the UK, had the ability to impose higher target ratios in addition to the minimum 8% Basel I requirement with the use of higher levels being expressly provided for under Pillar 2 of Basel II. Everyone understood that the Committee had been unable to agree international liquidity standards and that this remained to be governed by local measures. The crisis would not have been prevented even if all of the major banks held considerably higher levels of capital against the unexpected collapse in wholesale markets including, in particular, the structured "nance sector.

Supervisory approach has since been strengthened through the FSA’s ‘Supervisory Enhancement Programme’ (SEP) which was adopted following its investigation into the oversight failures at Northern Rock. Bank resolution has been substantially improved through the extensive new tools available under the Special Resolution Regime (SRR) set up under the Banking Act 2009 and the FSA’s separate work on requiring "rms to prepare comprehensive pre-crisis internal Restructuring and Recovery Programmes (RRPs).

New approachThe PRA supervisory paper deals with underlying supervisory principles, scope, risk assessment framework, supervision, policymaking and "rm authorisation and individual approval. The new approach was being developed by the Prudential Business Unit which was set up within the FSA on 4 April 2011 in cooperation with the Bank of England.

1. PRA principlesThe single objective of the PRA would be to promote the safety and soundness of regulated "rms and in so doing minimising any adverse e#ects of "rm failure on the UK "nancial system. The PRA would not be required to ensure that no authorised "rm fails which would remain the responsibility of "rm management, boards and shareholders (para 3). PRA supervision would be targeted at "rms’ resilience (capital, liquidity and leverage), interventions and resolution (para 4). All "rms would be subject to a baseline level of supervisory oversight which would reduce



9

the probability of failure or that a "rm failed in an orderly manner (para 6). The PRA would work closely with the Financial Policy Committee (FPC) within the Bank to combine individual and larger system’s oversight (para 7). Supervision would be risk based, targeted at the principal risks, be forward-looking and require corrective action at an early stage to reduce the probability of disorderly failure (para 12).

Supervisory sta# would be required to form judgements on current and future risks to a "rm’s safety and soundness with major judgements requiring the involvement of senior and experienced individuals. The process was referred to as ‘rigorous and well-documented’ (para 15). Arrangements would be adopted to ensure cooperation between the PRA and the FCA; PRA and Financial Services Compensation Scheme (FSCS) and other parts of the Bank involved with macro-prudential analysis, market intelligence, infrastructure oversight and with the Special Resolution Unit (SRU) (para 16). The new policy would attempt to learn from the lessons of previous regulatory failures as well as be properly coordinated with international and EU regulatory developments and ensure proper public accountability (paras 17 and 18).

2. PRA scopeThe PRA would be responsible for the regulation of "rms holding £9trn in assets and EEA "rms with £2trn in assets (para 22). The UK market was nevertheless highly concentrated with 85% of personal current accounts being provided by the "ve largest "rms (para 23). Financial services contributed 10% of UK GDP and banking 5% of UK GDP.

The PRA would also be responsible for the supervision of other "rms that could present a signi"cant risk to the stability of the "nancial system or to one or more PRA supervised entities within the same group. It was expected that this would include investment "rms authorised to deal in investments as principal on their own account subject to additional designation criteria having regard to the size of the "rm, substitutability of services, complexity and interconnectedness. Other shadow banking activities may also be brought within the scope of supervision with the FPC monitoring the new ‘regulatory perimeter’.

3. PRA risk assessment frameworkThe PRA would focus its resources on "rms that generated the greatest risk to the stability of the UK "nancial system. A provisional risk assessment framework had been produced based on ‘gross risk’ and ‘safety and soundness’ with an assessment of potential impact and ‘risk context’ (external and business risks) with regard to gross risk and risk mitigation factors in connection with safety and soundness, including operational (risk management and controls and management and governance), "nancial (liquidity and capital) and structural mitigation (resolvability).

This would assess the impact of "rm failure on the stability of the system and on whether orderly resolution was feasible and credible (para 27). The channels though which a "rm might a#ect the stability of the system would be assessed having regard to impairment of the system to carry out its functions. The PRA would take into account loss of access to payment services (paras 28-31).

In considering risk context, the PRA would assess how the external macroeconomic and business context may a#ect the execution of a "rm’s business model under di#erent scenarios. The PRA would then assess factors that may mitigate the adverse impact of a "rm on the stability of the system including resolvability, "nancial strength (liquidity and capital) and risk management and governance (paras 32-36).

4. PRA supervisionThe PRA’s approach to supervisory assessment was again described as being based on ‘forward-looking judgements’ with ‘supervisory interventions’ being clearly directed at reducing the major risk to the stability of the system (para 37). All "rms would be subject to a baseline level of supervisory reporting with the PRA’s approach being more intensive where "rms posed a greater risk to the system (paras 38 and 40). Supervisory assessment would be focused on business risks, "nancial strength, risk management and governance and resolvability (paras 46-64). The PRA would work closely with auditors and internal "nance, risk and compliance functions within "rms and use available external data (paras 65-74). The PRA would identify where further corrective action was required by "rms (para 75) and use its statutory powers to secure necessary and remedial action on an ex ante basis (para 80).

The PRA would create a new ‘Proactive Intervention Framework’ (PIF) to support the early identi"cation of risks and actions in preparation for failure or resolution7. This would be based on "ve stages of low risk to viability of "rm, with no additional supervisory action being required, and moderate, material, imminent risks to the viability of the "rm (stages 2, 3 and 4) with speci"ed recovery and resolution actions and "nal resolution and winding up (stage 5). All "rms would be placed within the PIF as appropriate, although necessary adjustments would have to be made for dealing with EEA "rms due to the limited powers available to the PRA.

5. PRA policyPrudential policies would set out the high-level framework and expectations against which "rms were to be assessed with prudential rules establishing minimum standards and prudential policy supporting judgement-based supervision (para 91). Policies and rules should be clear in intent, robust and support timely intervention (para 92) with "rms being required to comply with ‘the spirit as well as the letter of its rules’ (para 93). The PRA would continue to use cost and bene"t analysis (para 105) and be responsible


10

for ensuring that remuneration policies and practices were properly risk aligned (para 107).

5. PRA authorisation and approvalThe PRA would deal with applications for authorisation (para 110) with an assessment of resolvability being ‘embedded’ in the authorisation process (para 113). Authorisation would be determined on a ‘whole "rm’ basis (para 112) with the FCA having to consent on the grant of relevant permission (para 114). The PRA would determine the approval of individuals carrying on signi"cant in%uence functions in cooperation with the FCA. It was expected that this would include around 5,000 individuals within the 2,000 "rms regulated by the PRA covering approximately 12,500 roles (para 118).

Financial Conduct AuthorityThe strategic objective of the FCA will be to protect and enhance con"dence in the UK "nancial system with three operational objectives of securing an appropriate degree of consumer protection, promoting e$ciency and choice in the market for "nancial services and protecting and enhancing "nancial system integrity. The FCA’s regulatory approach is summarised in terms of preventative action, tackling problems rather than symptoms, di#erentiation, securing fair and safe markets, engaging with retail consumers and ensuring credible deterrence in addition to proper transparency and disclosure as well as accountability8. The FCA will have new powers of product intervention although the FSA has already issued substantial new guidelines in this regard. It will be able to withdraw or amend misleading "nancial promotions and publish information on the issues of warning notices although these are connected with technical powers rather than any new regulatory approach as such (para 1.9). The FCA will be expected to make more ‘judgemental trade-o#s’ between di#erent objectives (para 1.14) of all this is already re%ected in the FSA’s new post-crisis supervisory response, especially in such areas as product regulation.

PRA supervisory commentIt is questionable whether the May and June statements provided any additional substantive guidance on the nature and operation of the PRA and FCA beyond that already provided in the earlier Treasury consultation documents in July 2010 and February 2011. The apparent purpose would appear to be simply an attempt to clarify supervisory approach issues in advance of the publication of the draft Financial Services Bill placed before Parliament in June 2011. The core message was that the PRA and FCA would adopt a more judgement- and intervention-based approach to supervision. Supervisory judgement was nevertheless implied in the FSA’s original principles based approach to supervision and ‘More Principles Based Regulatory’ (MPBR) policy with enhanced intervention already being secured under the FSA’s post-Northern Rock ‘Supervisory Enhancement Programme’ (SEP).

The new system will also still be risk-based and secure "rm authorisation and individual approval with the earlier dual authorisation and permission regimes being retained. A new risk assessment framework is nevertheless adopted, based on the risk to "nancial stability. It is unclear to what extent this will supplement or replace the earlier FSA ARROW and ARROW II frameworks. The term "nancial stability is also not de"ned with the May 2011 paper only referring to "nancial stability as described in Bank of England Annual Reports. The paper does refer to the adoption of a new ‘Proactive Intervention Framework’ (PIF) based on risks to "rm viability and requiring early corrective action similar but still not as intensive as in the US with agency ‘prompt corrective action’.

The main distinction between the earlier and new approaches would appear to be based on the extent to which the agencies will re-assess internal management decisions although the extent of this intervention remains unclear from the papers. It is accepted that "rms are responsible for their own stability with the PRA principally relying on market discipline to promote prudent conduct9. The PRA will examine business models in terms of sustainability and vulnerability (para 47) and conduct forward stress testing (para 54). It will also attempt to take into account a "rm’s ‘culture’ (para 59) which re%ects earlier FSA statements on ethical culture10. The precise level of supervisory intervention in individual internal decision-taking remains unclear. Theoretical and operational di$culties also continue, having regard both to the desirability and feasibility of supervisory sta# in being able to challenge all signi"cant internal management judgements in large complex "nancial groups.

The most signi"cant omission is possibly in clarifying the extent to which the PRA will carry over or rewrite existing FSA regulatory principles, rules and guidance. The most signi"cant transitional and the continuing compliance costs that will arise will be for "rms attempting to ensure that they properly implement all of the new regulatory provisions adopted by both agencies. It would have been of considerable assistance to attempt to provide some clari"cation on this issue. It is possible, in practice, that little substantive regulatory change will result from the changes announced even with two new rulebooks. While this may be the most desirable outcome, it calls into question the need for the larger institutional reforms underway.

These are still important and useful documents in setting out the operational policies that will guide the PRA and FCA in practice. It must still be stressed that much of this has already been re%ected in the FSA’s own internal supervisory and regulatory reforms adopted in response to the "nancial crisis and identi"ed in such key papers as Lord Adair Turner’s ‘A Regulatory Response to the Global Banking Crisis’ (March 2009). The larger institutional reforms currently under development in the UK, and especially with the establishment of the FPC, PRA and FCA, are signi"cant and may be of substantial value in creating



11

a new central bank-based macro-prudential model which will assist in preventing future crisis and instability. The most e#ective elements of the earlier FSMA regime should nevertheless be retained and incorporated into the new system, including speci"cally the integrated supervision and regulation of major "nancial "rms and "nancial risks on a common basis and under a common set of rules.

Institutional reform of itself will not make the "nancial system any more stable. The new model has to rely on a large degree of ‘regulatory delegation’ of non-systemic function to the FCA to allow the bank to focus on its management of monetary policy, the regulation of major UK "nancial "rms and payment systems and on macro-prudential policy. The bank would otherwise have been administratively and operationally over burdened. It remains to be seen how e#ectively all of the new compromises and challenges, that this institutional separation of function necessarily creates, will be resolved in practice.

GA Walker, Centre For Commercial Law Studies, London.

Endnote1. Bank of England and FSA, Prudential Regulation

Authority – Our Approach to Banking Supervision (May 2011).

2. FSA, Financial Conduct Authority Approach Document (June 2011).

3. Speech by Hector Sants, FSA PRA Banking Conference, The Queen Elizabeth II Conference Centre, London 19 May 2011.

4. The PRA would be ‘imaginative in its employment o#ering and seek to reach out to a diverse and di#erent pool of individuals than are traditionally attracted to the City and indeed the regulators of the past’ with Sants hoping optimistically that a ‘greater acceptance of the purpose and challenge of regulation by society as a whole would help address this key issue of ensuring the PRA has the right quality of individuals’. Ibid.

5. Andrew Bailey, ‘The supervisory approach of the Prudential Regulation Authority’, The Queen Elizabeth II Conference Centre, London 19 May 2011. Other commentators have questioned whether the new approach is strictly ‘twin peaks’ rather than ‘tri-peaks’ or a multiple peaks model.

6. Bank of England and FSA, Prudential Regulation Authority (n1), Box 1, p5.

7. Box 5, pp18-19.8. FSA, Financial Conduct Authority Approach Document

(n2) Chapter 4.9. Box 3, p11.10. See, for example, Hector Sants, ‘Should regulators judge

culture?’ (17 June 2010); and Hector Sants, ‘Culture and Ethics in Behaviour and Judgements’ (4 October 2010). See also FSA, An Ethical Culture to Financial Regulation (2002).

IntroductionIt is ten years since the terrorist attacks in the US led to the instigation of the "nancial war on terror by President George Bush. The events of 11 September 2001 propelled counter-terrorist "nancing to the summit of the international community’s "nancial crime agenda. Traditionally terrorist have relied on two di#erent source of funding including state and private sponsored. Nevertheless, state funding has declined in the last twenty years, as there are fewer states willing to risk exposure to severe international sanctions. Therefore, terrorists actively seek to vary their funding activities and in many cases have become self-su$cient. More recently, sources of "nancing terrorism derive from both legal and illegal sources. This was clearly illustrated by the terrorist attacks in London in July 2005. One of the main targets of the "nancial war on terror was the alternative or non-remittance underground banking systems, which included for example the Hawala system. However, there was no evidence that these systems were used to fund either the attacks of 11 September 2001 or those in London in 2005. However, it is important to point out that these systems are susceptible to abuse by money launderers and organised criminals as they are

cost-e#ective, quick, reliable, and represent a ‘safe’ means of transferring funds.

Counter terrorist financing policiesThe UK has a long history of tackling terrorism, and the legislative measures can be traced back over twenty years. The UK has attempted to disrupt terrorist "nancing via two methods, the use of suspicious activity reports, or SARs, and by freezing the assets of known or suspected terrorists.Each will be dealt with in turn. Terrorists use reverse money laundering techniques and their funds initially circulate as clean money does, via the same methods as used by business and the public. Therefore, it makes sense to target terrorist "nancing via "nancial intelligence gleaned from a SAR, which is a piece of information which alerts law enforcement agencies, via the Serious Organised Crime Agency, that certain "nancial transactions are in some way suspicious and might indicate terrorist "nancing. When an individual or organisation from the regulated sector knows or suspects that an o#ence has been committed under the Terrorism Act 2000 (ss15-19), they are legally required to complete a SAR. However, this requirement does not include charities and this may create issues as terrorists often use such a source to

Counter terrorist financing policies – time for a rethink?


12

fund their attacks1. SARs have become an integral part of the UK’s counter-terrorist "nancing policy and may also be used to prevent further terrorist activity, through being linked to ongoing enquiries and regularly adding valuable new information. An example of this was the 154 SARs linked to the investigation of the liquid bomb plot in 2008. It has been suggested that the ‘practical use of data about transactions is after an attack, when there might be some chance of tracing links in the networks that sustain terrorist movements2.’ On the other hand, their use can be criticised. For example, due to the large volume of SARs submitted to SOCA every year, it is very di$cult to ‘separate the wheat from the cha# ’3. Furthermore, the e#ectiveness of the reporting obligations under the Terrorism Act 2000 must be queried, due to the extensive sources of funding options available to terrorists. One way of enhancing the SAR regime can be through the ‘Know Your Customer’, or KYC requirements. Indeed, Professor Mike Levi has argued that these requirements are at the ‘the core of the countering terrorist "nancing process’4. Another mechanism employed in the UK to prevent terrorist from accessing their "nances is freezing their assets. This process is managed by HM Treasury who may freeze terrorist assets through various legal avenues, although in practice they will exercise this power under the Terrorism Order 2006 in accordance with Resolution 1373 and under the Al-Qaida and Taliban Order 20065 (AQO) in accordance with UN Resolution 1267. The popularity of freezing assets was demonstrated before the terrorist attacks in 2001: approximately £90m of Taliban assets had been frozen. Since the terrorist attacks, an additional £10m has been frozen. More recently, the amounts blocked in 2009 totalled just under £20m. Based on the "gures it may be argued that the e#ectiveness of asset freezing is relatively low and as a disruptive strategy its e#ectiveness must be questioned. Nevertheless, the importance of freezing assets cannot be underestimated because it remains an important weapon in the war on terrorist "nances. The ability to freeze the assets of suspected terrorists has been questioned in the courts. Freezing a terrorist’s assets may deprive them of all their resources and this arguably ‘creates a practical consequence of preventing movement and travel’6. On the other hand, it may be argued that ‘without access to funds or other economic resources the e#ect on both suspected terrorists and their families can be devastating.’7 This was an issue raised in A v HM Treasury8. The Supreme Court’s judgment was signi"cant for two reasons. Firstly, through art 4 of the Terrorism Order 2006, it was held that the Treasury had exceeded their powers by introducing the ‘reasonable suspicion test,’ which went ‘beyond the requirements’ of resolution 1373. The test was held to be an ‘Attempt to adversely a#ect the basic rights of the citizen without the clear authority of Parliament’.9 Secondly, art3(1)(b) of the AQO, was held ultra vires s1 of the 1946 Act as ‘a designated person under a freezing order has no means of subjecting his designation to judicial review, and is denied an e#ective

remedy’10. In response to the Supreme Court’s decision the Treasury implemented the Terrorist Asset-Freezing (Temporary Provisions) Act 201011. The latter deems all of the impugned Orders in Council under the 1946 Act to have been validly adopted and thus retains in force all directions made under those orders. Therefore, under these provisions freezing terrorist assets is lawful.

ConclusionsCounter-terrorist "nancing initiatives have had some success in ending planned terrorist operations. However, it is arguably impossible to trace all terrorist funds, and ultimately prevent terrorist atrocities from occurring. Terrorist attacks require disturbingly small sums as they move through the "nancial system, and tracing these funds is challenging, especially before the event. Interception of funds is counter-productive because it deters terrorist groups from drawing money from paramilitary activities into political activity. Where credit card fraud can generate su$cient cash to contribute toward the terrorist attacks of 11 September 2001, the di$culties of incapacitating those terror groups by "nancial means cannot be overstated. Therefore, it may be argued that e#ective strategy against terrorist "nance in the UK will require more than legislation. It may be argued that disruption is the best initiative against terrorist property, as if it succeeds it will inevitably prevent terrorist attacks from occurring. Disrupting terrorist property involves counter-terrorist "nancing regimes such as SARs and the freezing of terrorist assets however, these strategies alone cannot succeed in the "nancial battle against terrorism. On the other hand, if these mechanisms can prevent even one terrorist attack, such as the ‘liquid bomb plot’, then it’s worth it. Furthermore, it is clear that freezing assets may involve a host of human rights issues which must be balanced against preventing a terrorist attack from occurring. In light of the vast array of sources, and the low-cost methods to fund a single terrorist attack, it is arguably impossible to trace and prevent funds being used for terrorism.

Marco Merlino and Dr Nicholas Ryder, Commercial Law Research Unit, Department of Law, Faculty of Business and Law, University of the West of England, Bristol.

Endnotes1. Sproat P. ‘Counter terrorist "nance in the UK: a Quantitative

and Qualitative commentary based on open-source materials’ (2010) Journal of Money Laundering Control 13(4), p328.

2. Anon, ‘The lost trail-e#orts to combat the "nancing of terrorism are costly and ine#ective,’ The Economist, 22 October 2005, available at www.economist.com.

3. Donohue L. Anti-terrorism "nance in the United Kingdom and the United States, (2006) 27 Mich.J.Int’l L 303, p307

4. Levi M. ‘Combating the "nancing of terrorism: a history and control of threat "nance’ (2010) British Journal of Criminology 50(4), 50, p651.

5. Made Under UN Act 1946 s1(1).



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IntroductionCredit default swaps (CDSs) have developed considerably since their inception in 1991. Together with collateralised debt obligations (CDOs), they are considered the most important instrument intransforming global credit markets, experiencing popularity like few other "nancial instruments, growing in notional amount outstanding from US$632bn H1 2001 US$, to US$8.4trn in H2 2004 to more than US$62trn at its peak in H2 20071. This tremendous growth combined with the fact that failures of large CDS market players, including two well-known investments banks Lehman Brothers (bankrupt), Bear Stearns (bought by JP Morgan Chase) and the paramount worldwide insurance company AIG (bailed out by the Federal Reserve and Department of Treasury)2, could easily lead to hasty and injudicious conclusions that CDSs are toxic products which should be prohibited or heavily regulated. If the G20’s recent momentum in the political debate surrounding OTC derivatives – and the CDS market is mirrored in the "nal legislation in Europe and the US, CDSs would in the best case be curtailed and in the worst case eliminated.

Against this background, this paper critically evaluates two questions within an European framework. First in order for regulators to justify an overhaul of the CDS market, it seems inevitable to understand what role CDSs played and then establish regulation accordingly.

Therefore, what role did CDSs play during the crisis and to what extent are the regulatory measures proposed by the European Commission proportionate?

It is argued that the Commission’s reaction is in many respects disproportionate as CDSs merely re%ected the underpriced risk in the mortgage market, although acknowledged problems of opaqueness and concentration in the interconnected CDSs market ampli"ed the crisis. Despite this discrepancy, it could be imagined that the reform potentially would have market-improving bene"ts.

Therefore, to what extent is the European reform of the CDS market advantageous?

By evaluating the European Market Infrastructure Regulation (EMIR), the Market in Financial Instruments Directive (MiFID) and the Capital Requirements Directive (CRD) it is concluded that the reform in many respects is detrimental to the CDS market and "nancial stability. These three reform initiatives neatly re%ect the G20 commitment:

All standardised OTC derivative contracts should be: ‘(1) traded on exchanges or electronic platforms, where appropriate; (2) cleared through central counterparties by end-2012 at the latest; (3) OTC derivatives should be reported to trade repositories; and (4) non-centrally cleared contracts should be subject to higher capital requirements.’3 Although other angles would be of interest these four components are considered as the main changes to the CDS market and will thus constitute the main elements of this evaluation.

A more comprehensive paper on the European reform of CDS should also include an evaluation of the new proposal regulating short-selling and certain aspect of credit default swap4.Although less controversial than the restrictions on short selling of CDSs an analysis of the consequence of the Market Abuse Directive’s extended reach covering OTC derivatives and CDSs would also be of interest. Yet, for present purposes this falls out with the remit of the current study.

The answers to the questions raised are answered within the following structure: the "rst section sets the scene with an introduction to CDSs and their role during the "nancial turmoil of 2008. The second section presents the European CDS reform and show how G20’s commitment to change the OTC market, including CDSs, is re%ected in the EMIR, MiFID and CRD. The third section critically evaluates, the extent to which, the four main components of regulatory change are advantageous by elucidating the adverse e#ect for the CDS market, "nancial stability and ultimately society. Finally a conclusion sums up the "ndings and suggest areas of further research.

Credit default swaps and its role during the financial turmoil of 2008What is a credit default swap?A CDS contract simply transfers the default risk of a single or a basket of reference entities from the protection buyer to the protection seller (the ‘writer’). The protection buyer pays a recurring (swap) premium (ie an ‘insurance fee’) to the protection seller during the life of the contract. If a credit event occurs to the reference entity ("nancial, non-"nancial companies or governments), the protection seller compensates the protection buyer corresponding to its loss. If no defaults occur and the contract expires, the insurance premium would constitute a sunk cost to the protection

The reform of European credit default swap market

6. Per Sedley LJ Court of Appeal ([2008] EWCA at 1257. Ahmed and Ors v HM Treasury [2010] 2 WLR 378 (SP), p406.8. Ibid.9. Ibid, p407.

10 Middleton B. ‘Freezing Terrorist Assets’ (2010) J Crim L, 74, 209, p210.

11 Six days after the orders were quashed; B Middleton ‘Freezing Terrorist Assets’ (2010) 74 J Crim L 209, p213.


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buyer. The CDS therefore resemble an ‘insurance policy’, insuring the protection buyer in return for periodic payments to the insurer (protection seller).

The popularity and tremendous growth of CDSs since their inception in 1991 is arguably due to the separation of the asset with which the risk is associated and the actual management of the credit risk, contrary to traditional credit risk management tools as insurance, letters of credit, guarantees and loan participation, where it is necessary to hold ownership of the underlying asset (similarly, where one cannot insure a house without ownership). Secondly, this distillation of credit risk allow it to be traded to third parties who can better bear the risk, but do not want the other risk exposures, contrary to other credit insurance instruments.

However, on the downside, whether the protection buyer aims to protect itself as it holds a stake in the reference entity; diversify its portfolio risk; or simply speculate, the protection buyer takes on another risk: the credit risk that the counterparty, defaults. Therefore, in 97% of credit derivatives (ie credit default swap contracts) some form of a collateral arrangement is established to mitigate this counterparty credit risk.

What is the size of the CDS market?The notional market value grew with an impressive rate from only US$5trn in H2 2004 to its peak of US$60trn 2007 (compared to world GDP in 2007 of US$55.8trn), although with a subsequent decline to US$29.9trn in H2 2010. Prima facie, it seems that the CDS market has declined after the crisis – and some might even argue as a consequences of the crisis. However, that is not the case. The CDS market has actually expanded after the crisis and would have reached an estimated amount of US$80trn in 2009 if trade compression had not been undertaken by triReduce who has eliminating US$ 66trn of notional amount thus far. This technique replaces multiple trades between two parties with a single or a few trades which resembling the same credit exposure within each party’s tolerances level.

Although the notional amount has been reduced, it remains an inaccurate measure for the parties’ actual counterparty exposure, as it constitutes the gross nominal value of deals, which are not settled. A more appropriate measure for the real risk exposure is the gross market value, as it resembles the replacement costs of all open contracts at mark-to-market prices. Thus, if one party is in a gross negative market value position of all deals and the contract were to be settled immediately, this value would represent liabilities to its counterparties and vice versa. This amount constitutes only 5.5% (or US$1.67trn) of the notional value. An even more precise measure is the current credit exposure and liability value as it also takes into account the legally enforceable bilateral netting e#ect and would therefore constitute an even lower exposure. This value therefore represents the claim that if the contract were settled immediately, it would represent a fairly good estimate for

the actual amount changing hands. Unfortunately these data sets for CDS are not developed.

Who are the main actors?As a consequence of banks’ multiple roles as protection buyer, seller – and intermediary their position in the CDS market is signi"cant. Among the 26 largest CDS players, "ve banks constitute 88% of the notional amount bought and sold. Arguably the collapse of large (although not the largest) derivatives dealers as Bear Stearns, Merrill Lynch and Lehman Brothers contributed to this concentration. Furthermore, the concentration of risk is magni"ed by the interconnectedness: 40% of the reference entities cited are companies within the "nancial sector and seven CDS dealers are among the top 10 most cited reference entities. Hence the risk of ‘double default’, ie a company being a large counterparty and CDS reference entity, is obviously enhanced intensifying the risk concentration potentially undermining CDSs’ risk diversi"cations e#ects.

What role did CDSs play in the financial turmoil of 2008?The story of CDSs in the crisis is ambiguous. On the one hand, CDSs provided crucial information as the market started to collapse and investors who discovered this could hedge their risks and curtailed losses, arguably particularly important as credit rating agencies’ credibility deteriorated. On the other hand, the combination of a concentrated and interconnected market with an inherently opaque nature, the CDS market made it di$cult to assess the vulnerability of counterparties (eg Lehman Brothers) causing panic and regulators’ passivity in the build-up.

However, focusing exclusively on CDSs as an individual product it remained relatively stable and worked well handling large settlements organised (agreed by senior regulators in both the UK and the US), as the example of Lehman proves. Although rumours circulated that US$400bn could have been referenced to Lehman, the notional amount reported by the Depository Trust Clearing Corporation was US$72bn and the actual amount changing hands only US$5.2bn as the many entities were both buyers and sellers of protection on Lehman (recall the concentrated market structure). In order to put this number in perspective, consider Lehman’s bond debt of US$150bn, which suggests that derivatives, including CDSs, were not the cause of Lehman’s fall (and neither Bear Stearns’ rescue).

Rather, appreciating the underlying mortgage market and its relation to monoline insurers such as AIG and its CDS business is key to understanding the cause of the crisis. Generally, the major dealers worked with balanced book, so for each trade an o#setting trade were in place diversifying risk exposure. Importantly, this was not the case for the insurance company AIG, who mainly operated as a protection seller. And a huge one: AIG’s net notional amount of protection sold (US$493bn) was double the size of all other dealers’ aggregate positions. AIG could



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build up this position as its subsidiary AIG Financial Products (AIGFP) sold CDS protection that were neither regulated as insurance contracts nor as a bank (which would have required them to hold capital against potential CDS payouts); could attract counterparties due to its AAA rating which allowed AIG (the parent) to guarantee AIGFP’s (the subsidiary) obligations and therefore neither had to post collateral (until a certain point) and thus achieve cheaper fees for counterparties; and because commercial bank counterparties could achieve regulatory relief on their trading books under Basel 1 upon the purchase of CDSs (on CDOs) from monoline insurers.

Importantly, all this would have mattered less if the underlying mortgage-backed securities were priced accurately. AIG protected US$61.4bn (ca. 1/3 of all other dealers, aggregate protection sold) with CDSs on CDOs containing signi"cant amounts of mortgage-backed securities (including the risky sub-prime mortgages). Furthermore, an even larger exposure to the mortgage market was evident outside AIGFP’s CDS portfolio and therefore is ‘… AIG’s collapse best understood as resulting not simply from its mortgage-related CDS exposure, but rather from its companywide mortgage-related security exposure, of which the CDSs on multi-sector CDOs were only a part’. Therefore, CDSs written on corporate loans and non-securitised prime mortgages and some other higher quality diversi"ed assets did neither trigger rating downgrades nor collateral requirements. Rather it was mainly AIG’s companywide exposure to mortgage-backed securities external to the CDS portfolio, which caused the downgrade, and therefore collateral requirements and ultimately federal assistance.

The European regulatory reform of CDSThe world’s political elite of G20 decided in April 2009 (London Summit) that standardisation and resilience of credit derivatives should be encouraged particularly through CCPs5 and later in September 2009 (Pittsburgh Summit) four framework conditions regulating the OTC derivatives market were presented:

‘All standardized OTC derivative contracts should be: (1) traded on exchanges or electronic platforms, where appropriate; (2) cleared through central counterparties by end-2012 at the latest; (3) OTC derivatives should be reported to trade repositories; and (4) Non-centrally cleared contracts should be subject to higher capital requirements.’6

The "rst element which instructs OTC derivatives on exchanges is dealt with in what will become the second

version of the Markets in Financial Instruments Directive (MiFID); clearing through CCPs and trade repository registration is contained in the new piece of legislation, the European Market Infrastructure Regulation (EMIR); and the enhanced capital requirement is dealt with in the updated version of the Capital Requirements Directive (CRD). Although none of these initiatives have yet been implemented, the following three sections present each piece of legislation at its current stage7. Figure 1 provides an overview of the regulatory measures to accommodate G20’s objectives.

European Market Infrastructure Regulation Importantly, the Commissions’ recent regulatory proposals – on OTC derivatives, central counterparties and trade repositories (EMIR) – which is based on two prior communications8, generally suggests enhanced counterparty risk mitigation through the use of CCPs and improved transparency through trade repositories.

Central CounterpartiesRegulatory agencies authorising clearing eligible CDS products on CCPsIn accordance with the G20’s commitment that all standardised OTC derivatives should be cleared through CCPs, the Commission proposes a bottom-up and a top-down approach. The former a#ords the CCP the discretion to decide whether they wish to clear a certain contract. This is approved by the competent national authority, which in turn informs the European Securities and Market Authority (ESMA). ESMA subsequently decide, based on certain criteria, if such a contract should be required to be cleared throughout the European Union. The more controversial top-down approach provides the ESMA in collaboration with the European Systemic Risk Board the power to authorise, which contracts should be subject to a clearing obligation9.

This strong regulatory control of the scope of contracts to be cleared is according to the Commission inevitable, as this responsibility cannot solely be left to the industry itself10. For example, nine major CDS traders, on the Commission’s request, signed a letter on 11 March 2009, with ISDA as intermediary, committing them to clear all eligible CDS contracts with a European reference entity or indices through a European CCP by 31 July 200911. However, on 3 July 2009 the Commission admited that it needs other measures to reach the ambitious goals of clearing all eligible CDS contracts through CCPs in late 201212.

Figure 1. OTC derivative reform in Europe

European Market Infrastruction Regulation

Capital Requirements Directive IV Markets in Financial Instruments Directive II

relative to centrally cleared derivatives


CCP Benefits Although a comprehensive cost/bene"t analysis by the Commission of the increased use of CCPs is absent, it must be assumed that the intentions which incentivise more CCP clearing is to reduce systemic risk. If systemic risk, which can be de"ned in various ways, is thought of as an ‘initial spark and a proceeding chain reaction’, would the CCP’s role mainly be to sti%e the chain reaction of the initial spark (ie default of a clearing member) whilst it could be envisioned that capital regulation and prudential supervision would diminish the chance of the ‘initial spark’ occurring. The CCP would function like an insurance company, ie if one of its members triggers a default the CCP would guarantee that member’s counterparties contracts and thus disincentivise any extreme actions by counterparties. Contrary to the concentrated CDS market in which one default might cause a counterparty to default triggering a destructive domino e#ect, the CCP would disperse the losses on all the CCP members (like insurance losses are shared among policyholders) if the default were su$ciently severe13.

Mitigating risk concentration in CCPsThe Commission acknowledge the increased systemic importance of CCPs as the earlier bilateral trades will become increasingly centrally cleared. Therefore, new organisational, conduct of business rules and prudential requirements are contained in the proposal. In addition the CCP will be subject to authorisation conditions and procedures, which include capital and liquidity requirements, risk assessment of the CCP before authorisation and annual evaluation of the CCP by the national competent authority.

Similarly, CCP interoperability (ie that a CCP establishes a connection to another CCP that allow members of both CCPs to trade with each other) also becomes an issue as non-interoperability would only allow trades to be executed among members of the same CCP. The risk associated with the option of interoperability will be managed by implementing risk management procedures governing the interlinked CCPs’ relationship and pre-approval of the interoperability agreement between the CCPs.

Trade repositoriesAs for CCPs, similar authorisation approval and general standards of operation is established for European trade repositories securing reliable and transparent data. The main function of the trade repository would be to collect information on trades to the public and regulators in order to detect potential excessive risk positions in due time. According to the Commission this would enable ESMA to detect similar excessive risk positions as those undertaken by Lehman, Bear Stearns and AIG.

The Commission has de facto established a new market for trade repositories, as it will become mandatory to report trades to a trade repository located in the European Union no later than the day after the execution of the

contract. The global leading US-based trade repository, the Depository Trust & Clearing Corporation, who trace 97% of all credit derivatives trades established its new subsidiary, DTCC Derivatives Repository Ltd, in London in August 2010, resembling the exact same CDS information as it’s DTCC’s New York based trade repository, the Warehouse Trust Company LLC. Although, this kind of trade repositories established in third countries can be recognised in Europe under certain conditions, the establishment of DTCC’s subsidiary in Europe could be interpreted as a sign of mistrust in the transatlantic cooperation, practically making this provision super%uous.

The two "nancial infrastructure companies, Bolsas y Mercados Españoles and Clearstream, established REGIS-TR in July 2010, who initiated operation of interest derivatives in December 2010, with the ambition of storing all OTC derivatives contracts, including CDS, by Q3 2012. Therefore REGIS-TR will be a new competitor to TRI-optima who had stored interest derivatives information since January 2010 and DTCC’s trade repository on CDSs.

Capital Requirements Directive The part of CRD IV that concerns OTC derivatives and thus CDSs suggests two important capital requirement changes: for bespoke bilateral trades and trades which are carried out through a central clearinghouse.

Increased capital requirements for OTC traded derivativesThe Commission’s proposal amending the treatment of counterparty credit risk would both signi"cantly enhance the capital requirement according to KPMG: ‘The BCBS has estimated that the new rules will increase the regulatory capital requirements against trading book risks by three to four times from current levels and against counterparty credit risk by six to eight times’14; and improve general risk management measures (eg wrong way risk and credit value adjustment) and procedures vis-à-vis derivative counterparties as these allegedly proved insu$cient during the crisis.

Uncertainty on CCPs risk weightWith regards to the capital exposure to CCPs, the Commission recently commenced a new round of consultation, as it had to take into account the most recent update of Basel III. Very interestingly, the Basel Committee altered how risky they viewed the use of CCPs. In the "rst proposal in December 2009, CCPs were evaluated as risk-free with a 0% risk weight (if complying with CPSS/IOSCO recommendations for CCPs), to a 1-3% in 2010 and in the latest proposal a 2% risk-weight acknowledging that CCPs are not risk free.

Although the exact capital requirements attached to CCPs or bespoke bilateral products are not yet determined, the Commission evidently encourage a greater CCP use, incentivised through CRD4, which suggests a larger

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discrepancy in capital requirements between OTC and CCP cleared CDSs.

Markets in Financial Instruments Directive MiFID II, which is currently being developed by the Commission after a public consultation document of December 2010 and a deadline for responses on 2 February 2011, will amend the "rst MiFID from 2007 mainly in light of the shortcomings it was exposed to during the crisis. It will therefore increase its scope to not only cover equity markets, but also non-equity markets as OTC derivatives including CDSs.

The main change to OTC derivatives is that clearing eligible and su$ciently liquid derivatives should be traded on regulated markets, ie Multilateral Trading Facilities (MTF) or Organised Trading Facilities (OTF) with the objective of increasing the transparency of OTC trades and thus stability by avoiding excessive credit exposures. Furthermore, CCP clearing is usually associated with exchange trading accommodating the objectives of EMIR. After ESMA has established standards for which derivatives that is clearing eligibility by June 2012 at latest, they will within this group of clearing eligible derivatives determine which should be mandated onto exchanges based on a not yet clari"ed liquidity measure, although potentially based on frequency and size of transaction.

StandardisationIn producing the MiIFID proposal, the Commission will take into account the comments from the Committee of European Securities Regulators (CESR). Importantly CESR suggest that an increased standardisation, ie legal, process and product uniformity, of OTC derivatives contracts are the prerequisite for transferring OTC trades to exchanges. Targets for standardisation within the three parameters will be set, and if not achieved, mandatory regulatory intervention by ESMA is suggested. The same idea of mandatory regulatory intervention is applied for exchange trading. That is, if certain targets, to be set by ESMA, which should be ‘su$ciently ambitious in order to e#ectively encourage increased platform trading’15 are not reached, regulatory intervention from ESMA should be adopted.

EvaluationAlthough as argued above CDSs merely re%ected the under-priced risk in the mortgage market during the crises, the regulation of OTC derivatives and CDSs has become a highly politicised topic mirrored in a vast amount of regulatory proposals at international level, mainly Basel III16, and regional level in Europe and the US17. This section looks to critically evaluate, challenge and elucidate the adverse e#ects of the four main components of the game-changing European CDS reform.

European market infrastructure regulationClearinghousesAlthough a large part of AIG’s CDS position could not have been traded through a CCP due to its customised nature speci"c to CDOs18 CCPs are suggested as the quick "x for OTC derivatives and particularly CDSs19 re%ected in EMIR and Dodd-Frank20. The industry’s anticipation of this move from OTC to CCP CDS clearing has increased the notional CDS amount cleared from virtually nothing in the beginning of 2010 to US$3.2trn in end-June 2010 (10.5%) and over US$7trn in 2011.

Despite this industry change, it is intriguing that neither of the two major jurisdictions where CDSs are mainly traded has actually agreed to any speci"c rules on which products should be cleared and which can remain as OTC products after two years of planning and various consultations. The problem is that regulators try to implement regulation ordered from its political masters, which is complicated and might not even provide with the actual bene"ts of "nancial stability and abolishment of systemic risk that it intends to do. The critic of the proposal can be separated in a general critique of CCPs and a particular concern of mandating CDSs on CCPs.

A general critic of CCPsRisk homogeneity increase risk contained in CCPsA clearing member would initially bene"t from decreased cost of monitoring its counterparties, as it only needs to concentrate on the creditworthiness of the clearinghouse. The homogeneity between the clearing-members is re%ected in the sharing of cost from default by one of the CCP members compared to a bilateral market where it is only the counterparty to the speci"c transaction which su#ers; and the fact that each clearing member post the same collateral despite creditworthiness (to a certain point). This decoupling of creditworthiness and collateral would incentivise institutions of a below-average creditworthiness to join the CCP (and vice versa), enabling them to accumulate larger exposures than what would have been possible in a bilateral market. That is, the CCP structure could disincentivise good quality institutions from employing CCPs, which thus increases the inherent risk contained in the CCP. Similarly, although ESMA’s suggestions to the speci"c characteristics of CDSs which must be cleared remain uncertain, it could be envisioned that trades with less creditworthy counterparties would be deposited in a CCP (as the CCP assumes the counterparty risk) and other trades with more "nancially sound counterparties would therefore remain traded bilaterally OTC21.

Disregarding how the details of the reform transpire, the intentions seems to be that the majority of OTC products will be cleared centrally by the end 2012 if no further delays occur. Naturally, this regulatory intervention establishes

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a new market for CCPs and new entrants to the market. Initially this would suggest a market where competition between clearinghouses can %ourish to the bene"t of clearing members, who would realise lower margin requirements. However, important negative consequences would follow from this. First, as dealers are free to choose services from any CCP the competition on margins might cause a decrease of margins to such a low level that members are not insulated from losses, ultimately jeopardising the CCP’s survival – a competition that is currently evident and intensifying. This situation is analogous to the credit rating agencies’ competition for market shares resulting in over-optimistic ratings22. Although CCPs are expected to mitigate the risk of defaulting with tight risk management procedures failures are not inevitable and have occurred in the past.

Secondly, despite of the CCP risk management procedures could a situation similar to a ‘bank run’ also be envisioned. That is, if one of its members defaults causing concerns about the CCP’s "nancial standing and therefore a potential raise of margins, the CCP could be exposed to a ‘CCP run’23. This would suggest that clearing members would want to gather in larger and more solvent CCPs.

Third, Du$e and Zhu establish a theoretical model, which provides evidence that increasing the number of CCPs from one (ie obviously also decreasing the number of CCP members in each CCP) will decrease the ‘netting e#ect’ and therefore increase the exposure to counterparty default and/or increased collateral as a consequence24. Hence fewer CCPs, which can ‘cross clear’ multiple products, eg CDS and interest rate swaps jointly are recommended as the economic bene"ts of bilateral clearing, which allow for cross clearing of multiply products, otherwise would exceeds the bene"ts of CCP clearing25.

This suggests that multilateral netting e#ects will encourage a natural monopoly due to the inherent scale and scope e$ciencies and therefore could raise antitrust concerns26. This occurred for the "rst time on 29 April 2011 when the Commission initiated investigations of abusive monopolistic behaviour of the clearinghouse ICE and nine CDS dealers accusing them of agreeing on preferential fees and pro"t sharing arrangements27 in violation of art 101. However, such agreement is, according to Pirrong, inevitable due to the inherent economics of scale advantages for the CCP and bene"ts for clearing members to gather in the same CCP as this enable the CCP to comprehend each counterparty’s risk better, rather than if dealers are dispersed in several CCPs28.

Despite the fact that market forces will diverge towards a natural oligopoly or monopoly which is more e$cient in normal times29, such institutions will create signi"cant systemic risk and moral hazard problems in excess of a single large clearing member’s default30, particularly considering that a large proportion of the OTC derivatives are increasingly cleared centrally as a consequence of the

new regulation. Although numerous CCPs might develop in the CDS market should concerns of contagion e#ects be noticed as the proposal encourage interoperability of CCPs. This allows CCP members from di#erent CCPs to trade with each other as CCPs with this set-up are linked to each other. Thus if one CCP get its model wrong or charge too low margins (which is arguable more likely in a competitive market) would it a#ect other CCPs, its members and ultimately the market in general31. Therefore, a real risk exists that the old problem of a too concentrated – and interconnected – CDS market will be replaced by a new one: concentration of risk in an interconnected and too-big-to-fail CCP regime.

derivatives dealers Although multilateral netting improves overall welfare for derivatives dealers, the redistribution of wealth to its derivatives counterparties would only improve e$ciency ‘if derivatives counterparties incur a higher cost than other creditors to bear default risk’32. The reasoning is that the CCP’s multilateral netting mechanism reduces the collateral posted and the replacement cost to the bene"t of derivatives counterparties at the expense of the derivatives dealer’s creditors. In the absence of multilateral netting the derivatives counterparty would not have a claim on the (non-netted) positive/‘in-the-money’ positions. Creditors would, however, as this constitutes an asset to the "rm33. This suggest that CCP netting would not be preferable to the defaulting part’s creditors as their claims are devaluated relative to the derivatives counterparty.

Supranational v National CCP authorisation and supervisionThe ESMA is determined to play a crucial role as CCP authoriser and supervisor, although it would be the country in which the CCP resides that would bear the burden if a CCP should default34. In the "nal proposal the commission partly comply with this idea, although ESMA will remain important in the authorisation process to ensure harmonised treatment of CCPs as these operate cross-border and arbitrage across national authorities could give advantages to certain CCPs, who are more carelessly regulated. Therefore, due to the increased signi"cance of CCPs it will be increasingly important that a balance is struck between harmonised CCP requirements dictated by the EU, and the autonomy of national supervision, as it would be the individual member state that would assist the CCP in case of default.

Challenges of clearing CDSs through a CCP

bilateral CDS trading Pirrong asks the question, why has the industry itself not established CDS clearinghouses earlier if the bene"ts to the clearing of these products for CDS traders are so

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evident? The contention is that economic costs of clearing CDSs centrally exceed the bene"ts of trading CDSs OTC as a consequence of asymmetrical information between the insured (clearing member) and insurer (CCP)35. Furthermore compared to other OTC products, CDSs are ironically the asset class that contain the characteristics that make them the hardest to centrally clear, although it allegedly is the products which regulators most want to trade through a CCP36. Two-thirds of ‘eligible’ CDSs are expected to be CCP-cleared according to the IMF37 and according to the Turner Review 50-75% of all standardised CDS contracts can be CCP-cleared38. Please note that a clear de"nition or consensus of what constitutes an ‘eligible’ or ‘standardised’ CDS contract is not yet established which arguably confuses and complicates matters and make speci"c estimates (such as 2/3 or 50-75%) inadequate.

First of all, it is important to understand that the product complexity of CDSs makes them hard to centrally clear. Compared to interest rate swaps, CDSs are volatile39, asymmetric in exposure pro"le, contain wrong-way risk (ie strong correlation between counterparty and the credit quality of the reference entity)40 which is magni"ed by the concentrated market structure41, contain jump-to-default risk (ie a credit event which trigger a sudden rise in the mark-to-market CDS premium in which the collateral is to low leaving the protection buyer uncovered if the counterpart defaults), and di$culties in o#setting CDS trades (particular for single-names)42.

For these reasons dealers’ models of assessing the risk and value of CDSs are ‘rocket science quantitative models’. The accuracy of these models reduces their market risk, counterparty risk and ultimately provides a trading pro"t – obviously conditional on its accuracy. On the contrary, CDS CCPs would not be incentivised to develop the same sophisticated models as they neither trade to earn a pro"t nor aim to manage market risk (only counterparty risk). And hypothetically if the models were to be improved this bene"t would ultimately rebound to CCP members. However, this does not suggest that dealers’ models are perfect, but rather that they are superior for complex products relative to CCPs’ models. Needless to say, this discrepancy does not exist for standardised CDS products, as the risk is less costly evaluated43.

Secondly, many CDSs trade infrequently and therefore it is di$cult to determine the actual market price. Therefore, dealers must rely on ‘mark-to-models’ to determine margins (based on price) and due to dealers’ modelling expertise and superior market information can counterparties themselves assess price and thereby collateral levels with a higher accuracy.

Third, usually CCPs determine margins based on product risk and not the creditworthiness (ie balance sheet risk) of the clearing member in order to avoid discriminating against clearing members. This is problematic considering that Lehman, Bear Stearns and AIG su#ered not from product risk of CDSs, but under-priced risk originating in the

mortgage market, which would indeed constitute balance sheet risk. Bilateral traded CDSs do include such balance sheet risk in the determination. Even if CCPs were to include balance sheet risk in the assessment they would probably not be able to assess this risk as accurate as the dealers themselves due to the dealer institutions’ opaque and information-intensive balance sheets.

increase risk The sections above explain why neither CCPs in general nor CCP CDS clearing are a ‘silver bullet’. However, regulators remain determined that CCPs and CDS CCPs should play a greater part in clearing in order to eliminate the opacity of the market and establish more transparency. Although CDSs have experienced enhanced standardisation (particularly the ISDA BIG Bang Protocol, Small Bang Protocol in 2009 standardising mainly operational, trading and the legal framework) required for more central clearing, this standardisation comes at a cost: the protection buyer’s inability to customise contracts and hedge risk. Noteworthy, the OTC market was developed as the buy side demanded derivatives contracts that could be tailored beyond what regulated exchanges could o#er44. It is therefore essential for the survival of the OTC market, including CDSs, what ESMA determines as the threshold requirements for what a ‘standardised’ CDS constitutes in mid-2012. Prohibitive requirements would essentially eliminate the possibility to tailor contracts and hedge risk and ultimately jeopardise the existence of the OTC CDS market.

Furthermore, to the extent that ESMA actually will demand stringent standardisation requirements of CDSs this would inevitably lead to higher basis risk, ie more risk being unmanaged as no CDS can be tailored to the requests, which thus makes it more expensive to hedge risks for end-users45. With regards to CDSs, in the worst case scenario this could constrain parties from dispersing risk by hedging against industries, companies or sovereigns, thus concentrating risk in certain segments with the cost of higher volatility.

Trade Repositories This paper argues that although the CDS product in isolation functioned well during the crisis, related problems of transparency should be emphasised as the opaque nature of the OTC market concealed trades causing problems of detection CDS positions, which therefore ampli"ed panic (eg Lehman). The market very much acknowledges this and initiated a process of reporting CDSs to the DTCC’s TIW trade repository, which today virtually report all existing CDSs globally. Furthermore, third country trade repositories’s trade compression has cut US$66trn of notional CDS amount, which inevitably also makes the market far more transparent and comprehensible.

It can therefore be questioned how an additional European CDS trade repository, as eg REGIS-TR would

19


20

add value. Contrary, CDS dealers would under the new regulatory framework be obliged to report to new European registered repositories, which would only duplicate the information TIW holds causing at least two unintended consequences: "rst, increased operational cost for CDS participants of reporting to more than one trade repository and, secondly, leave supervisors with a fragmented and unclear overview of the CDS market and thereby defeat the fundamental purpose of detecting systemic risk positions.

Although third country trade repositories can be recognised in Europe under EMIR and CFTC’s Gary Gensler assured European regulators information access46, DTCC’s establishment of its duplicated CDS trade repository in Europe seems like a lack of con"dence in this transatlantic cooperation.

Capital Requirements Directive

Concerns have been raised that the new capital requirements, ie Basel III and CRD IV, for OTC derivatives could establish a disproportionately large discrepancy between OTC and CCP-cleared/exchange-traded derivatives47not aligned with the actual risk inherent in each contract form48. This discrepancy would inevitable incentives an exaggerated use of CCPs as OTC derivatives could become prohibitively expensive to trade. This would position OTC CDS derivatives in a vacuum as the characteristics of CDSs make them di$cult to CCP clear. An alternative scenario is that the requirements would not be prohibitive but ‘only’ constrain hedging with the consequence of increased cost for end-users and ultimately the wider economy49. This is particularly problematic as CDS provide crucial information on the creditworthiness of various "nancial, non-"nancial and sovereign entities.

Does a common CCP risk-weight fit all?Another important key concern is the uncertainty surrounding the 2% capital requirement for exposures to CCPs altered from 0%50. which spurred the Commission to initiate its own consultation, as the rationale for the 2% had been challenged. However, a 2% risk-weight for all CCPs in the "rst place is most likely not an appropriate measure as CCPs structures and risk pro"les inevitably will diverge. A "xed threshold would arguably favour CCPs with a lower than 2% risk threshold and vice versa. Therefore, rather than trying to achieve a common rigid risk-weight for all CCPs, harmonised standards should be embraced as these would allow for CCPs to contain di#erent risk-weights according to risk pro"le.

Markets in Financial Instruments DirectiveAt "rst, the Commission’s proposal to ‘transfer’ more OTC traded CDSs to exchanges seems reasonable considering general bene"ts of exchanges: increased pre-trade price transparency which should reduce the chance of obtaining an inaccurate prices; e$cient post-trade processing; and reduced

operational cost. Furthermore, exchanges usually have CCP clearing entities attached (although not compulsory) that clear products, which in addition would accommodate EMIR’s objective of more CCP clearing (although as argued above CCP clearing is not exclusively advantageous). Despite these characteristics and the uncertainty of the "nal requirements for what kinds of CDS products would be forced on exchanges, the proposal has been confronted with critique from both academics and the industry.

The 'financial innovation spiral' compromised If the "nal standards set by the ESMA meet the Committee of European Securities Regulators (CESR, ESMA’s predecessor) targets of an ‘su$ciently ambitious’ thresholds which would ‘e#ectively encourage increased platform trading’ this could interfere with the ‘natural’ symbiotic relationship between OTC and exchange-traded products which predict that customised products evolve into standardised o#-exchange products and "nally onto exchanges (‘commoditisation’) which in turn again spurs innovation in the OTC market (‘"nancial innovation spiral’). This would therefore predict that forcing these products (which are not su$ciently commoditised) on exchanges would limit the OTC market’s inherent bene"ts of customisation of contracts and innovation. A rather obscure outcome could be that participants would be incentivised to increase the complexity of the product in order to exclude them from the (not yet developed) category of a standardised CDS and thereby avoid exchange trading.

Are CDSs suited for exchange trading?Exchange trading requires a su$cient liquidity and trade frequency in order to establish accurate price formation, low trading cost, resilience, anonymity etc51. And importantly liquidity attracts more trading and thereby even more liquidity and vice versa52. So could CDSs qualify for such an exchange arrangement?

Although CDSs have become more standardised, eg sharing standard settlement and maturity dates (since 2004) and standardised "xed coupons (since 2009) the trade infrequency of the single-name CDS cannot coexist with exchange trading without di$culties. Some CDS indices (mainly "ve-year maturity), which are also the product that can be cleared, would arguably be able to become exchange traded due to its liquidity and frequency in trading. However, the diverse nature of single-name CDSs, which constitute 60% of the total market, cannot accommodate exchange trading as they vary in liquidity and trade infrequently. That is, for all (non-"ve-year maturity) single-name CDSs hedging would in practice be impossible, as the maturity cannot "t with the underlying hedge. Furthermore, if the hedge was attempted anyway for an infrequent traded CDS product this would obviously impact the market price signi"cantly and e#ectively undermine the bene"t of the hedge.

The market price impact would also compromise anonymity. Envision an institution that wishes to hedge a certain credit risk on a reference entity, which is also the institution’s client in another respect, this would jeopardise their relationship contrary to the privately negotiated OTC market in which the reference entity is not aware of the transaction between the buyer and seller.

Regulatory inconsistency: short-sell ban of naked sovereign CDSsIt appears problematic and inconsistent that the most frequently traded product (sovereign CDSs) and therefore the product that is best suited for exchange trading, is the very same product that is restricted by the new proposal regulation short-selling and certain aspect of Credit Default Swaps53 as it make them less liquid and traded less frequently. This regulation proposes a harmonisation for short-selling as a response to member countries’ divergent approach to the restriction of short-selling of eg naked CDSs on sovereign debt to avoid increased borrowing cost for indebted countries (eg PIIGS countries)54. Although the Commission’s proposal would only give the competent national authority in coordination with ESMA the power to restrict naked CDS positions in exceptional situations55, the European Parliament in response to the Commission’s proposal suggested even stricter requirements for uncovered CDSs56, which could make the sovereign CDS market illiquid and jeopardise the possibility of hedging risk on sovereigns, although evidence of naked CDSs’ on sovereigns negative externalities cannot be established. Sovereign CDSs would most likely not a#ect governments’ ability to lend as the net exposure to sovereign CDS contracts account for only 0.5% of total government debt, which caused the IMF to suggest that a ban ‘would be ine#ective’ and also ‘di$cult to enforce’.

Price transparency Although exchange trading obviously provides transparency of prices, this would not be of much help if the majority of CDSs, as argued above, does not "t into this exchange framework. Secondly both pre- and post-price transparency are arguably su$cient. In regards to pre-trade price transparency various sources provide this data: eg parsing service and commercial vendors (Bloomberg, Markit and CMA/QuoteVision/DataVision); multiple dealer prices provided to clients; and CCPs (to the extent cleared through CCPs). Regarding post-trade eg DTCC TIW provides information on virtually all CDSs to the market and regulators. In the UK CDS volumes are also reported to the FSA and other providers of end-of-day prices are also present57. It should therefore be questioned how much a formalised regulatory CDS framework for pre- and post-trade transparency will add besides rigidity.

ConclusionIn answering the "rst question this paper raises, the European Commission’s regulatory proposals at its current

stage appear disproportionate to the role CDSs played during the "nancial turmoil. Although Lehman Brothers, Bear Stearns and AIG all engaged in CDSs, none of them failed as a consequence of the nature of this very product. The two former investment banks operated with merely balance books and collateral arrangements. This is re%ected in ‘only’ US$5.2bn actually changing hands and not US$400bn as "rst suggested. The opacity of the OTC market arguably coverted this to Lehman’s counterparties thus amplifying panic in the web of concentrated CDS dealers.

On the other hand, AIG’s subsidiary AIGFP did not operate with a balance book, but rather with a net notional amount of protection sold, double the size of all protection sold, possibly due to its special regulatory treatment attractive for both AIG and its counterparties. A part of this large CDS position was referenced on CDOs, which in turn contained mortgage-backed securities (including the risky sub-prime category). Notably an even larger exposure to the mortgage market was evident outside the CDS portfolio. Therefore, AIG’s CDS positions merely re%ected AIGFP’s underpriced risk of the mortgage market in the US, which was also the cause of its collateral calls and thus collapse.

Importantly, it should be acknowledged that the CDS market worked well handling large organised settlements. Arguably, CDSs also provided crucial information on creditworthiness, which is particularly important considering the lack of credible ratings by credit rating agencies. Moreover, the price information CDS provides is also increasingly used in other markets, such as loan, credit and equity markets59.

In light of this, the Commission’s overhaul of the European CDS market appears exaggerated, particularly considering that the troubled CDS dealers were based, supervised and regulated in the US. Therefore, a reform agenda should rather start by detecting the actual scope and scale of the problems in Europe and subsequently establish new regulation accordingly, rather than assuming similar solutions to potentially di#erent problems.

Despite the lack of evidence of CDSs’ detrimental role during the crisis, the international political momentum of the G20 dictates reform of OTC derivatives – and in particular CDSs: an agenda that is neatly re%ected in new initiatives, the European Market Infrastructure Regulation, and the updates of the Capital Requirements Directive and the Market in Financial Instruments Directive.

The European Market Infrastructure Regulation proposes a greater use of clearinghouses as a quick "x to enhanced transparency, stability and systemic risk problems – a proposal which was challenged from two angles. First, from a general perspective, suggesting that: (1) clearinghouses treat all members as one homogeneous group posting the same collateral despite of divergent creditworthiness which would incentivise institutions of below-average creditworthiness to join and thus increase risk contained in clearinghouses, which in turn would disincentivise above-average institutions to join, detrimental to the

21


objective of reducing systemic risk; (2) clearinghouses would have to strike a "ne balance between a competitive and a monopolistic market. The market would naturally converge towards the latter due to signi"cant scope and scale bene"ts (eg more e$cient netting and the CCP’s overview of all participants in that segment) and therefore constitute a signi"cant systemic risk. The contagious e#ects of a CCP failing are inevitably diminished in a competitive market (encouraged by the commission) although this market would be ine$cient and could cause smaller individual CCPs to fail due to "erce competition on margins. A multiple-CCP market, with interoperability between CCPs, although years into the future for CDSs, would also enhance risk contagious e#ects which calls for considered risk management procedures; and (3) although multilateral netting enhances overall welfare, it should be noted that CCPs merely transfer wealth from the dealer institution’s creditors to its derivatives counterparties, as the counterparties incur reduced replacement costs and collateral postings at the expense of the CDS dealer’s creditors. In the absence of netting the defaulting institutions’ (non-derivatives counterparty) creditors could claim the non-o#set ‘in-the-money’ positions: a claim that the derivatives counterparties would hold ownership of in a CCP netting environment.

Secondly, from a speci"c CDS perspective it was suggested that: (1) the product complexity of CDSs make them hard to CCP clear and that CCPs would not have the same incentives to develop as sophisticated models as current bilateral counterparties; (2) this is magni"ed by the fact that a large proportion of CDSs trade infrequently requiring sophisticated ‘mark-to-models’; and (3) CCPs’ neglect balance sheet risk, as eg mortgage related exposures in the 2007-08 build-up, whilst bilateral traded CDSs also include balance sheet risk in the assessment of collateral requirements (although arguably based on wrong assumptions in the case of AIGFP who severely mispriced mortgage risk). Despite these arguments, mandatory CCP clearing of certain CDSs (to be determined by ESMA) would curtail the inherent and original purpose of the CDS-market: hedging credit risk which would therefore increase basis risk and in the worst case force CCPs to clear products they are not equipped to manage.

The encouragement of enhanced transparency through trade repositories should be welcomed considering the challenges and panic caused from not being able to detect CDS positions during the crisis. However, multiple CDS trade repositories is neither bene"cial to the market nor regulators as this would possibly fragment data and lead to higher operational costs for dealers. Rather a transatlantic cooperation should work towards one single global CDS trade repository.

The Capital Requirements Directive accommodates EMIR’s objective of more CCP clearing. The capital requirements dictate a large discrepancy between OTC and CCP-cleared products, which could incentivise an exaggerated use of CCPs, particularly detrimental for

CDSs, which are hard to clear in the "rst place. This could position some CDSs in a disastrous vacuum: too expensive to bilateral trade (resulting from the CRD) and too complex to CCP clear (resulting from the EMIR). This in turn curtails credit risk hedging possibilities and increases the cost for end-users and ultimately society. Secondly, regulators should establish clarity of why CCPs are attached with a 2% risk-weight and explain how all CCPs can bear the same risk-weight despite di#erent risk pro"les, which arguably allow CCPs to bene"t from risk pro"le in excess of the rigid threshold of 2%. Rather a framework of conditions should encourage prudential risk pro"les (eg harmonised minimum standards) as CCPs could possibly constitute the next systemic too-big- and too-interconnected-to-fail entities.

Finally, the MiFID, complementing the objectives of both CRD and EMIR, suggests more exchange trading of CDSs to accommodate objectives of enhanced transparency. T his proposal can be criticised in that: (1) the mandating of OTC-traded CDS on exchanges would curtail natural innovation and customisation in the OTC market and in the worst case encourage market counterparties to develop even more complex and opaque products in order to avoid status of ‘exchange tradable’ (the same argument could possible apply to CCPs), which comes at a higher cost in the new CRD4 framework; (2) a large proportion of the CDS market (eg single names that constitute 60%) does not accommodate exchange trading, which require liquid and frequent trading. This is magni"ed, as many CDS trades require anonymity in order not to jeopardise business relations that cannot be achieved on a transparent exchange; (3) EU regulation on short-selling of CDSs could potentially make one of the most suitable exchange products, sovereign CDSs, illiquid and non-quali"ed for exchange trading if naked CDS trades are curtailed, although evidence of its detrimental e#ects are absent; and "nally (4) the price transparency exchanges o#er are available from a variety of other providers, questioning what a formal regulated CDS exchange would add besides regulatory rigidity.

The delay of EMIR and MiFID59 indicates the di$culties regulators face in striking the balance between what their political masters at G20 have determined to be the quick "x and what is actually possible, e$cient and desired by the industry in a multifaceted CDS market. If European regulators neglect the shortcomings of the issues discussed in this paper, the CDS reform could prove detrimental for both market participants and the wider economy, neither achieving the objectives of "nancial stability nor reduced systemic risk.

With a short-term focus, further research should consider the possible regulatory arbitrage between the US Dodd-Frank Act and the equivalent European proposals discussed herein, as it seems inevitable that some parts will be inconsistent when regulatory intervention change each market structure’s DNA so radically. In a longer-term perspective an analysis of the reforms in the EU and the US should be compared to the initiatives, or lack of initiatives,

22

in the Asian "nancial centres that have arguably not subscribed to the same regulatory overhaul60 which could diminish the European and American monopoly power of the derivatives market61. Further study should also address the question of whether the potential curtailment of the CDS market would provide an incentive for the use of other credit insurance products, new innovative (‘regulator-neglected’) products or an increased use of new platforms as ‘dark pools’ and their potential consequences.

Frederik Dømler, Researcher, University of Warwick.The author !rst and foremost wishes to acknowledge the valuable comments of Mark Connolley, Partner, Neural Insight Limited, Christopher Jones, Risk Management Director, LCH.Clearnet, Richard Metcalfe, Head of Policy, International Swaps and Derivatives Association, and Mark Austen, Chief Operating O"cer and Christian Krohn, Managing Director from the Association for Financial Markets in Europe.

Endnotes1. ISDA Market Survey, ‘Notional Amount outstanding at

year-end, all surveyed contracts, 1987-present’. 2. United States Government Accountability O$ce, ‘Troubled

Asset Relief Program – Status of Government Assistance Provided to AIG’ (09-975, GAO 2009), see highlights.

3. G20, ‘Leaders’ Statement The Pittsburgh Summit 24-25 September 2009’, preamble 13, p9.

4. Commission, ‘Proposal for a Regulation of the European Parliament and of the Council on Short Selling and certain aspects of Credit Default Swaps’ COM (2010) 482 "nal.

5. G20, ‘Declaration on strengthening the "nancial system, London 2 April 2009’ p3.

6. G20, ‘Leaders’ Statement The Pittsburgh Summit, 24-25 September 2009’, preamble 13, p9.

7. Please note that the current stage is up until 5 July 2011. All developments beyond this point are considered beyond the scope of this paper.

8. Commission, ‘Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee, the Committee of the Regions and the European Central Bank – Ensuring e$cient, safe and sound derivatives markets: Future policy actions’ COM (2009) 563 "nal; Commission, ‘Communication from the Commission – Ensuring e$cient, safe and sound derivatives markets’ COM(2009) 332 "nal.

9. Commission, ‘Proposal for a regulation of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories’ COM (2010) 484 "nal p6.

10. Ibid, p7.11. ISDA, ‘Clearing of CDS in European clearing house (Letter

of commitment)’ (2009). 12. Commission, ‘Commission sta# working paper

accompanying the Commission Communication ensuring, e$cient, safe and sound derivatives markets (EMIR working paper)’ Working Document (2009), p42.

13. Gregory J, Counterparty Credit Risk: The New Challenge for Global Financial Markets (John Wiley & Sons 2010) 370-71 and p374-75.

14. Williams G et al, ‘Evolving Banking Regulation – A marathon or a sprint?’ (Global Issues and insights, KPMG, 2010) p35.

15. Ibid p5.16. Bank for International Settlements, ‘Compilation of

documents that form the global framework for capital and liquidity’.

17. Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 Pub L No 111-203, HR 4173.

18. Glass AW, ‘The Regulatory Drive towards Central Counterparty clearing of OTC Credit Derivatives and the Necessary limits on this’ (2009) 4 Capital Markets law Journal pp79, 86,

19. Braithwaite JP, ‘The Inherent Limits of ‘Legal Devices’: Lessons for the Public Sector’s Central Counterparty Prescription for the OTC Derivatives Markets’ (2011) 12 European Business Organisation Law Review pp87, 95.

20. See scheme comparing OTC derivatives market initiatives in the EU and US: Cli#ord Chance and ISDA, ‘Regulation of OTC Derivatives Markets: A comparison of EU and US Initiatives’ November 2010, Futures Industry, p35-39.

21 Johnson C, ‘The Enigma of Clearing Buy Side OTC Derivatives’ (2009) 20 (11) Futures & Derivatives Law Report pp3, 8.

22. Gregory J, Counterparty Credit Risk: The New Challenge for Global Financial Markets (John Wiley & Sons 2010) p380; Grant J, ‘Clearing houses’ tactics trigger concern’ Financial Times (28 June 2011).

23. Metcalfe R et al, ‘Joint ISDA, AFME and BBA response to the European Commission’s public consultation on derivatives and market infrastructure’ (9 July 2010) p17.

24. Du$e D and Zhu H, ‘Does Central Clearing Counterparty Reduce Counterparty Risk?’ March 6 2010, Graduate School of Business, Stanford University pp1-2.

25. Ibid p25.26. Pirrong C, ‘The Economics of Central Clearing: Theory

and Practice’ 2011 (1) ISDA Discussion Papers Series p. 2, p. 1527. Commission, ‘Antitrust: Commission probes Credit Default

Swaps market’ (29 April 2011). 28. Pirrong C, ‘The Clearinghouse Cure’ (Winter 2008-2009)

31(4) Regulation Cato Institute pp44, 47-48; Pirrong, C. ‘European Union Demonstrates the Regulatory Shape of Things to Come’ Seeking Alpha (2 May 2011).

29. Du$e D and Zhu H, ‘Does Central Clearing Counterparty Reduce Counterparty Risk?’ March 6 2010, Graduate School of Business, Stanford University pp1, 25.

30. Gregory J, Counterparty Credit Risk: The New Challenge for Global Financial Markets (John Wiley & Sons 2010) p381.

31. Due to the complexities of how interoperability in the CDS markets should function in practice, it is estimated that such arrangement is "ve years in future. Interview (phone) with Christopher Jones, Risk Management Director, LCH.Clearnet (London, 13 June 2011).

32. Pirrong C, ‘The Economics of Clearing in Derivatives Markets: Netting, Asymmetric Information, and the Sharing of Default Risks Through a Central Counterparty’ (2009) University of Houston pp1, 25-26 <http://ssrn.com/abstract=1340660> accessed 10 March 2011;

33. Ibid p27.

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www.i-law.com/financialcrimeEditorAssociate editors: Joanna Gray, Professor in Financial Regulation, Law School, University of Newcastle Upon Tyne Karel Lannoo, Chief Executive, Centre for European Policy Studies Dr Nicholas Ryder, Reader in Commercial Law, University of West of England George A. Walker, Solicitor and Professor in Law, Centre for Commercial Law Studies Vincent O’Sullivan, PwC, Financial Services Regulatory Centre of ExcellenceProduction Editor: Marketing: Sales:Subscriptions orders and back issues: Please contact us on 020 7017 5532 or fax 020 7017 4781. For further information on other "nance titles produced by Informa please phone 020 7017 5532. ISSN 1473-3323 © Informa UK Ltd 2010Published 10 times a year bywww.informaprofessional.com Printed by: Halston Printing GroupCopyright: While we want you to make the best use of Financial Regulation International, we also need to protect our copyright. We would remind you that copying is illegal. However, please contact us directly should you have any special requirements. While all reasonable care has been taken in the preparation of this publication, no liability is accepted by the publishers nor by any of the authors of the contents of the publication, for any loss or damage caused to any person relying on any statement or omission in the publication. All rights reserved; no partof this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means,electrical,mechanical, photocopying, recording, or otherwise without the prior written permission of the publisher.Registered O$ce: Mortimer House, 37-41 Mortimer Street, London W1T 3JH. Registered in England and Wales No 1072954.

34. European Union Committee, The future regulation of derivatives markets: is the EU on the right track? (House of Lords 2009-10, 10-93) p38 para 117.

35. Pirrong C, ‘The Clearinghouse Cure’ (Winter 2008-2009) 31(4) Regulation Cato Institute p44, p48.

36. Gregory J, Counterparty Credit Risk: The New Challenge for Global Financial Markets (John Wiley & Sons 2010) p. 382

37. International Monetary Fund, ‘Global Financial Stability Report –Meeting New Challenges to Stability and Building a Safer System’ (World Economic and Financial Surveys 2010) p101.

38. Lord Turner of Ecchinswell, ‘The Turner Review – A regulatory response to the global banking crisis’ (Financial Service Authority March 2009) p83.

39. Gregory J, Counterparty Credit Risk: The New Challenge for Global Financial Markets (John Wiley & Sons 2010) p382

40. Ibid p297-8 and 382.41. Duquerroy A et al, ‘Credit default swaps and "nancial

stability risks and regulatory issues’ (13 Financial Stability Review, Banque de France 2009) p75, p83.

42. Ibid p84. 43. Pirrong C, ‘The Clearinghouse Cure’ (Winter 2008-2009)

31(4) Regulation Cato Institute pp44, 48. 44. Johnson ‘The Enigma of Clearing Buy Side OTC

Derivatives’ (70) p6-7.45. Culp, CL. ‘The Treasury Department’s Proposed Regulation

of OTC Derivatives Clearing and Settlement’ (2009) CRSP Working paper No. 09-30 pp1, 32

46 Grant J, ‘Quick View: One or more trade repositories?’ Financial Times (18 November 2009).

47. Metcalfe R et al, ‘Joint ISDA, SIFMA and LIBA response to the European Commission Sta# Working Paper’ (31 August 2009) p12.

48. Financial Service Authority & HM Treasury, ‘Reforming OTC Derivatives Markets – A UK Perspective’ (December 2009), p.20 ‘The UK Authorities support capital requirements that are proportionate to the risk they assume rather than being used as a tool to directly in#uence market structure’.

49. Williams et al, ‘Consultation on counterparty credit risk: capitalisation of bank exposures to central counterparties; and treatment of incurred valuation adjustments’ (KPMG March 2011), p1.

50. ISDA et al, ‘Re: Basel Committee on Banking Supervision Consultative Document: Capitalization of bank exposures to central counterparties’ (Joint ISDA, BBA, IFF and GFMA response, 4 February 2011) p5.

51. Wuyts G, ‘Stock Market Liquidity: Determinants and Implications’ 2007 (2) Tijdschrift voor Economie en Management pp279, 309

52. Ibid, p280. 53. Commission, ‘Proposal for a Regulation of the European

Parliament and of the Council on Short Selling and certain aspects of Credit Default Swaps ’COM (2010) 482 "nal.

54. Ibid p2; PIIGS countries: Portugal, Ireland, Italy, Greed and Spain.

55. Ibid Chapter 5, arts 16-25, p30.56. Can"n P, ‘ Report on the proposal for a regulation of the

European parliament and of the Council on Short Selling and certain aspects of Credit Defaults Swaps’ AF-0055/2011, Committee on Economic and Monetary A#airs, Chapter 1, art 4, p17 and Chapter 3, art 12, p22.

57. European Central Bank, ’Credit Default Swaps and Counterparty Risk’ (August 2009) pp3, 5.

58. PWC, ‘6 June 2011 – including updates on MiFID, EMIR, Basel III and Sovereign debt management’ .

59. Cli#ord Chance, ‘The Dodd-Frank Act and the Proposed EU Regulation on OTC Derivatives – impact on Asian Institutions’ December 2010 pp15-16, raises some important questions in regards to the opportunities for Asian institutions.

60 44 %, 39 % and 13 % in respectively Europe, the US and Asia. See Deutsche Börse Group, ‘The Global Derivatives Market – An Introduction’ (white paper 2009) p13.

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