Derivatives & Society: Governing Risk in the Post-Pandemic Era

Normally, at a WFE conference, I would have the opportunity to greet you in person. I hope we will see this day again soon but until then I am very happy that we are able to continue our cross-border dialogue using the tools technology gives us.

And as I stand (virtually) in front of you, I am reminded of how we all ended up here; in our home office, or kitchen table, or maybe a few of you are in an eerily quiet financial district. We are all in a global pandemic that has upended normal life and commerce. You might say that we are all living in a crystallised tail risk.

Today I want to consider how we think about risk, and how risk in the financial system and in commerce impacts our societies.

Meaning of risk

The English word ‘risk’ can be traced back to the Greek rhizikon. It appears in Homer’s Odyssey as a metaphor, meaning “difficulty to avoid in the sea”. Many of us may remember the difficulty Odysseus had navigating in earshot of the Sirens’ song.

The Greek word passed into Middle Ages German as rysigo, meaning “hope for economic success”. In these two meanings we can observe much about our modern idea of risk: the possibility of loss, yet closely linked to the possibility of gain.

Risk can be abstracted into mathematical models, but it is ultimately — and importantly — situated in a social context.

Risk in the financial system

The prudent management of risk is central to successful enterprise, and particularly salient to financial institutions. For the financial system as a whole — that is to say, “systemic risk” — we must also balance loss and gain, and balance the competing priorities of stability and efficiency.

These choices have very real repercussions: for the flow of finance to business; for crisis management; and, ultimately, for social outcomes.

The term “systemic risk” is telling – it’s about risk occurring system-wide – often in complex systems. In the case of derivatives markets, the system is not just complex, but global. It is for that reason that so much policy coordination for risk management in derivatives markets occurs at the global level.

G20 & international financial architecture

Indeed, it was a cross-border crisis in financial markets that gave rise to today’s pre-eminent global economic forum: the G20. The 1997 Asian Financial Crisis exposed weaknesses in the international financial architecture. Many people questioned the policy prescriptions of the IMF at the time. They also questioned the legitimacy of the G7 group of advanced industrialised nations taking decisions with such wide-ranging implications for the international community. The growing importance of emerging markets meant it was time to expand the inner circle of global economic governance.

Since then, the G20 has spawned the Financial Stability Board, which focuses on systemic risk. At the G20 Pittsburgh Summit in 2009, the group undertook to radically reform financial regulation following the Global Financial Crisis.

Today, I want to reflect on how risk governance has developed over these decades. I will also consider how we might best govern risk in the post-pandemic era. In asking these questions, I hope to set the scene for this week’s discussion of the evolving role of derivatives and market infrastructures.

Accomplishments post-Pittsburgh

Firstly, what has been accomplished during the tenure of the G20, and particularly in the years following the Pittsburgh Summit? I have already mentioned that the formation of the G20 substantially expanded the number of seats around the world’s top economic table. Why is this important?

In the year 2000, G7 members represented 79% of global output and 75% of global wealth. Twenty years later, the figures were 32% and 54%, respectively. By contrast, the G20 represents 86% of global output and 89% of global wealth. Clearly, the legitimacy of global economic policymaking rests on the engagement of emerging economic powers; the highly populated and increasingly wealthy Asian nations of India and China, alongside regional economic powerhouses like Saudi Arabia, South Africa and Brazil.

For those who believe in a rules-based global economic order, the legitimacy of the international financial architecture is important in itself. But what about the substantive achievements of the G20 related to financial markets?

If we look just at the progress on OTC derivatives since Pittsburgh, we observe the following:

• Clearing mandates have now been implemented in 17 G20 jurisdictions;
• The share of centrally cleared notional outstanding in OTC interest-rate derivatives grew from nearly 40% in 2009 to over 70% as of the end of 2018;
• the share of centrally cleared notional outstanding in OTC credit derivatives grew from the single digits to nearly 60%;
• Margins posted on non-centrally cleared derivatives have gone from $130 billion at the end of 2017 to $173 billion at the end of 2019, a 33% increase.

These are huge accomplishments for financial stability.

Furthermore, the G20’s Financial Stability Board has been a key forum for the coordination of pressing policy issues:

• climate-related financial disclosures
• shadow banking reforms
• pandemic-response support measures

As volatility spiked in the spring of 2020, the FSB helpfully noted that:

“capital markets – assisted by determined policy actions – have remained open,
and enabled firms to raise new and longer-term financing.”

This came at a time when the WFE and others were encouraging policymakers to restate the desirability of financial markets remaining open.

Meeting future challenges

This brings me to my second question: how can the G20 consolidate its gains and ensure it meets the risk-governance challenges of the future?

We must not forget that the implementation of OTC derivatives reforms is unfinished. The pandemic has delayed implementation of some of the margin requirements for non-centrally cleared derivatives. Only eight G20 jurisdictions have comprehensive capital requirements in force for non-centrally cleared derivatives.

Certain groups would seek to roll back elements of the Pittsburgh agenda. In my view, it must not only be completed, but defended.

Transparency and understanding of markets

A core part of the Pittsburgh agenda was to increase the transparency of risks present in derivatives markets, and a core means of doing so – while also giving investors a fairer deal – was to bring these trades onto market infrastructures. Enhancing the understanding of our financial markets and infrastructures is an ongoing challenge.

On the one hand, this is about bolstering volumes on lit markets and ensuring high-quality trade reporting. These are among the worthy endeavours that the people in our organisations undertake every day.

On the other hand, there is the arguably even more challenging task of enhancing the general understanding of derivatives markets and how they are situated in a social context.

Warren Buffett’s 2002 characterisation of derivatives as “financial weapons of mass destruction” was widely hailed as prescient, and to an extent remains in the public consciousness. We all know that statement is partial, at best. And, of course, no one knows it more so that the boss of Berkshire Hathaway, a major player in derivatives markets!

As with the equity finance raised on stock exchanges, the risk transferred on derivatives exchanges is an essential lubricant of modern commerce.

• Hedging helps firms plan for the future and frees capital for productive use.
• Banks are able to extend fixed-rate mortgages to home-buyers only because of these liquid derivatives markets.
• Farmers rely on derivatives to reduce their exposure to volatile commodities markets.
• Recently, the WFE has published a white paper on sustainable commodity derivatives, and is engaged in a project on this topic in collaboration with the UN.

Conclusion

Clearly, our derivatives markets and clearing infrastructures are closely intertwined with the prosperity and equity of our societies. Yet they will only be appropriately used, and appropriately regulated, if they are understood.

So, I want to leave you with a parting thought; enhancing the (appropriate) transparency and understanding of derivatives and central clearing belongs to all of us – market infrastructures, market participants, regulators and academics.