Counter Terrorist Financing Policies Time For A Rethink 37877

October 2011
Issue 14.8
EU ................................................ 1
Vincent OSullivan, 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 ......................... 4
James 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 ...................................................... 7
Prof. George Walker, FRI executive editor, provides
an overview of the role of the UK Prudential
Regulation Authority.
UK .................................................... 11
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 provide a reassessment of the
nancing policies underpinning the current counter
terrorism policies.
EU .................................................... 13
Frederik Dmler, Researcher, University of Warwick,
provides a detailed and critical analysis of the proposed
European reforms of the credit default swap market.
Recapitalising European banks
Introduction
European 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 Lagarde
2
, 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 buer 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 aected 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 ocials initially questioned the gures underpinning the IMFs
calculations, particularly around the use of the Bank for International Settlements
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 reection
of how market sentiment is evolving. In September 2011, European banks were
facing diculties in tapping wholesale funding markets. The press
3
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
regions debt crisis. In response, the European Central Bank
4
(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 Europes
troubled banking system in an eort to avert a global credit crunch. Markets
are reecting 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 Bloomberg
5
.
Compulsory recapitalisation of European banks
In light of volatile market conditions, European ocials are coming around
slowly to the IMFs position and addressing the need for signicant capital
Financial Regulation International
.
October 2011
.
Issue 14.8
injection in many European countries. This is reected
by recent proposals propagated by the President of the
European Commission (EC), Jos 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 growth
6
,

the EC called for signicantly
higher capital reserves to help banks replenish their balance
sheets to withstand market turmoil amid the eurozones
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 specics, 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 ECs 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 buers
which prevent the distribution of dividends or bonuses
pending the recapitalisation, according the ECs proposals.
Getting stressed over stress tests
The proposals put forward by the EC would represent
a much bigger recapitalisation of European banks than
was envisaged in last summers 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 2011
7
, 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 aected 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. Specically, 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
eorts to stabilise the Greek situation more dicult. Reliance
on banks to eectively quantify private and sovereign risk
proved spectacularly unjustied 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 Greece
8
.
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 buer 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 Socit Gnrale. For example, Socit
Gnrale plans to free up 4bn in capital through asset
disposals by 2013 to increase CT1 capital
9
. 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 banks 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 signicant short-term funding
renancing needs. According to analysts, European banks
must roll-over around 1.7trn of senior debt of more than a
years 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
2
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 rms
10
. 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 Almunia
11
.
The French government, for its part, stands ready to
inject capital into its beleaguered banks, if necessary
12
. 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 ECs 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 paper
13
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 justied. 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 eect, 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 signicantly restructure their operations
and hive o any protable 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 protable international arms in Poland and the
US before passing EU state aid rules.
A case for tighter scal integration
Overall, 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 eorts to
address the sovereign debt crises were labelled reactive and
piecemeal by the EC President Jos Manuel Barroso
14
,
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 Greeces 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 Trichet
15
, 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
3
.
October 2011
.
Issue 14.8
4
envisioned cases of compulsory intervention from EU
leaders and the ECB in major scal spending items and
elements essential for the countrys 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 decits. However, following
the launch of the euro, an increasing number of countries
found it dicult to comply with the limits set by the Pact
(including Germany and France). Since 2003, more than
30 excessive decit 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 decit 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 OSullivan, PwC FS Regulatory Centre of Excellence.
Stephen Kinsella, Lecturer, Department of Economics, University
of Limerick, Ireland.
Endnotes
1. IMF, Global Financial Stability Report (September 2011)
www.imf.org/external/pubs/ft/gfsr/index.htm
2. 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/SB10001424053111904060
604576572442555810356.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. Socit Gnrale, Accelerating the transformation
(September 2011) http://phx.corporate-ir.net/External.Fi
le?item=UGFyZW50SUQ9MTA2Nzg3fENoaWxkSUQ9
LTF8VHlwZT0z&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. Joaqun 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 eects 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. Jos Manuel Barroso, Speech by President Barroso: A
Roadmap to Stability and Growth (October 2011) http://
europa.eu/rapid/pressReleasesAction.do?reference=SPEE
CH/11/657&format=HTML&aged=0&language=EN&g
uiLanguage=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:
the role ot sovereign guarantees, particularly in relation
to the newly established European Financial Stabilisation
Fund;
an assessment ot public guarantees on bank assets in the
light of the recent experience in several countries;
Summary of the OECD Banking Law Symposium on
Crisis Management and the use of Government Guarantees
You may be breaching copyright if you photocopy any pages from this publication. To purchase additional copies or site licences, please contact Mike Ellicott on 020 7017 5392
Check out previous issues at www.i-law.com/nancialcrime
5
the valuation and hedging ot contingent tscal liabilities
associated with government guarantees and the linkage
between guarantees and European sovereign debt issues;
the pricing ot government guarantees and the implications
for nancial sector competition; and
the containment ot moral hazard and taxpayer exposure.
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 OECDs 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 OECDs ongoing work on
the fallout of the global nancial crisis and major nancial
sector issues, of which the role of government guarantees is a
signicant component.
Keynote speakers included Christine Cumming, First Vice
President, Federal Reserve Bank of New York, Charles AE
Goodhart, Professor Emeritus, London School of Economics,
Mr Gumundsson, 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 specic exceptions, proved equal
to the task.
As it has turned out, a problem, which was initially
thought to be largely conned 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 benet 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 communitys 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 Zealands deposit guarantees and Irelands
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. Insucient nancial institution supervision
coupled with blanket guarantees can jeopardise the nancial
viability of the state.
It would be hard to imagine a more dicult situation
than that in which Iceland found itself. The Governor of
the Central Bank of Iceland, Mar Gumundsson, 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 dierent 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
.
October 2011
.
Issue 14.8
6
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 eective
resolution regime and would not work if the sovereign itself
was in nancial diculties. Jerey Manns stressed that while
the US bailout program served to stabilise markets, it had
little deterrent eect, 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 benets
would make assistance more publicly acceptable. He
advocated the creation of a Federal Government Investment
Agency which would share in benets 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 Minskys 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 aairs
warrants since in a tranquil state of the world there is a
tendency to under-estimate risk. This can be magnied
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 diculties 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 eciency 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 eective mechanisms for resolving SIFIs and an end to
TBTF safety net hostage-taking. Eva Hpkes outlined key
aspects of the Financial Stability Boards (FSB) work and
recommendations in this regard. She noted that the FSBs
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 months
(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 insucient
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 oer 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
7
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
dicult 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 justied 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 ocial 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 eectiveness and costs of
government guarantees on bank bonds. These were largely
eective 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 eects 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 Panettas
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 oer
beneciaries 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 eorts 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 2011
1
. 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 2011
2
. 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 PRAs purpose as being
fundamentally dierent from that of previous regulatory
regimes and that it would lead to a signicantly dierent
model of supervision to that which was in use pre-2007
3
.
Hector Sants highlighted four specic 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
.
October 2011
.
Issue 14.8
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 identied 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 rms
4
. Sants also
referred to the need to ensure eective 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 PRAs 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 PRAs 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
PRAs 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 crisis
The lessons from previous crises were summarised in the
joint May paper
6
. 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 insucient
to ensure depositor condence.
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 FSAs 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 FSAs
separate work on requiring rms to prepare comprehensive
pre-crisis internal Restructuring and Recovery Programmes
(RRPs).
New approach
The 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 principles
The single objective of the PRA would be to promote the
safety and soundness of regulated rms and in so doing
minimising any adverse eects 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 systems 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 rms 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 scope
The 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 signicant 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 framework
The 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 aect 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
aect the execution of a rms business model under
dierent 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 supervision
The PRAs 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 PRAs 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 identication of
risks and actions in preparation for failure or resolution
7
.
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 specied 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 policy
Prudential 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 benet analysis (para 105) and be responsible
.
October 2011
.
Issue 14.8
10
for ensuring that remuneration policies and practices were
properly risk aligned (para 107).
5. PRA authorisation and approval
The 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 signicant inuence
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 Authority
The strategic objective of the FCA will be to protect and
enhance condence in the UK nancial system with three
operational objectives of securing an appropriate degree of
consumer protection, promoting eciency and choice in
the market for nancial services and protecting and
enhancing nancial system integrity. The FCAs regulatory
approach is summarised in terms of preventative action,
tackling problems rather than symptoms, dierentiation,
securing fair and safe markets, engaging with retail consumers
and ensuring credible deterrence in addition to proper
transparency and disclosure as well as accountability
8
. 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-os between dierent objectives
(para 1.14) of all this is already reected in the FSAs new
post-crisis supervisory response, especially in such areas as
product regulation.
PRA supervisory comment
It 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 FSAs original principles based approach
to supervision and More Principles Based Regulatory
(MPBR) policy with enhanced intervention already being
secured under the FSAs 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 dened 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 conduct
9
. 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 rms
culture (para 59) which reects earlier FSA statements
on ethical culture
10
. The precise level of supervisory
intervention in individual internal decision-taking remains
unclear. Theoretical and operational diculties also continue,
having regard both to the desirability and feasibility of
supervisory sta in being able to challenge all signicant
internal management judgements in large complex nancial
groups.
The most signicant 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 signicant 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
clarication 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 reected in the FSAs own internal
supervisory and regulatory reforms adopted in response
to the nancial crisis and identied in such key papers as
Lord Adair Turners 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 signicant 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 eective elements of the earlier FSMA regime should
nevertheless be retained and incorporated into the new
system, including specically 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 eectively 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.
Endnote
1. 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 oering
and seek to reach out to a diverse and dierent 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).
Introduction
It 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
communitys nancial crime agenda. Traditionally terrorist
have relied on two dierent 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-sucient.
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-eective, quick, reliable, and represent a safe means
of transferring funds.
Counter terrorist nancing policies
The 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 oence 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 nancing policies time for a rethink?
.
October 2011
.
Issue 14.8
12
fund their attacks
1
. SARs have become an integral part of
the UKs 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 movements
2
. 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 dicult to
separate the wheat from the cha
3
. Furthermore, the
eectiveness 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 2006
5
(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 eectiveness of asset freezing is relatively low and as a
disruptive strategy its eectiveness 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 terrorists 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 eect on both suspected terrorists
and their families can be devastating.
7
This was an issue
raised in A v HM Treasury
8
. The Supreme Courts judgment
was signicant 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 aect 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 eective
remedy
10
. In response to the Supreme Courts decision
the Treasury implemented the Terrorist Asset-Freezing
(Temporary Provisions) Act 2010
11
. 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.
Conclusions
Counter-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
sucient cash to contribute toward the terrorist attacks of
11 September 2001, the diculties of incapacitating those
terror groups by nancial means cannot be overstated.
Therefore, it may be argued that eective 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 its 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.
Endnotes
1. 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-eorts to combat the nancing
of terrorism are costly and ineective, 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.Intl 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).
13
Introduction
Credit 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 2007
1
. 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 G20s
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 Commissions reaction is in many
respects disproportionate as CDSs merely reected the
underpriced risk in the mortgage market, although
acknowledged problems of opaqueness and concentration
in the interconnected CDSs market amplied the crisis.
Despite this discrepancy, it could be imagined that the reform
potentially would have market-improving benets.
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 reect 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
swap
4
.Although less controversial than the restrictions on
short selling of CDSs an analysis of the consequence of the
Market Abuse Directives 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 G20s commitment to change
the OTC market, including CDSs, is reected 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 eect
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
nancial turmoil of 2008
What 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 125
7. 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.
.
October 2011
.
Issue 14.8
14
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 partys
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 eect 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 signicant.

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 magnied 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 diversications eects.
What role did CDSs play in the nancial 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 dicult 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 Lehmans bond debt of US$150bn,
which suggests that derivatives, including CDSs, were not
the cause of Lehmans 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 osetting 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: AIGs net notional
amount of protection sold (US$493bn) was double the
size of all other dealers aggregate positions. AIG could
15
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 AIGFPs (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 signicant amounts of mortgage-backed
securities (including the risky sub-prime mortgages).
Furthermore, an even larger exposure to the mortgage
market was evident outside AIGFPs CDS portfolio and
therefore is AIGs 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 diversied assets did neither trigger rating
downgrades nor collateral requirements. Rather it was
mainly AIGs 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 CDS
The worlds political elite of G20 decided in April 2009
(London Summit) that standardisation and resilience of
credit derivatives should be encouraged particularly through
CCPs
5
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 stage
7
. Figure 1 provides an
overview of the regulatory measures to accommodate G20s
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
communications
8
, generally suggests enhanced counterparty
risk mitigation through the use of CCPs and improved
transparency through trade repositories.
Central Counterparties
Regulatory agencies authorising clearing eligible CDS
products on CCPs
In accordance with the G20s commitment that all
standardised OTC derivatives should be cleared through
CCPs, the Commission proposes a bottom-up and a top-
down approach. The former aords 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
obligation
9
.
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 itself
10
.
For example, nine major CDS traders, on the Commissions
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 2009
11
. 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 2012
12
.
Figure 1. OTC derivative reform in Europe
European Market
Infrastruction Regulation
Capital Requirements Directive IV Markets in Financial
Instruments Directive II
CehIral couhIerparIies
1rade reposiIories
CreaIer capiIal requiremehIs !or O1C
relative to centrally cleared derivatives
Lxchahge Iradihg requiremehIs
SIahdardisaIioh
.
October 2011
.
Issue 14.8
CCP Benets
Although a comprehensive cost/benet 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 dened in various ways, is thought of
as an initial spark and a proceeding chain reaction, would
the CCPs role mainly be to stie 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 members 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 eect, the CCP would
disperse the losses on all the CCP members (like insurance
losses are shared among policyholders) if the default were
suciently severe
13
.
Mitigating risk concentration in CCPs
The 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 repositories
As 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 its DTCCs 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
DTCCs subsidiary in Europe could be interpreted as a
sign of mistrust in the transatlantic cooperation, practically
making this provision superuous.
The two nancial infrastructure companies, Bolsas
y Mercados Espaoles 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 DTCCs 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
derivatives
The Commissions proposal amending the treatment of
counterparty credit risk would both signicantly 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--vis derivative
counterparties as these allegedly proved insucient during
the crisis.
Uncertainty on CCPs risk weight
With 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
16
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.
Lxchahge Iradihg
The main change to OTC derivatives is that clearing
eligible and suciently 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 claried liquidity measure,
although potentially based on frequency and size of
transaction.
Standardisation
In 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 suciently ambitious in order
to eectively encourage increased platform trading
15
are
not reached, regulatory intervention from ESMA should
be adopted.
Evaluation
Although as argued above CDSs merely reected 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 III
16
, and regional level in Europe and the
US
17
. This section looks to critically evaluate, challenge and
elucidate the adverse eects of the four main components
of the game-changing European CDS reform.
European market infrastructure regulation
Clearinghouses
Although a large part of AIGs CDS position could not have
been traded through a CCP due to its customised nature
specic to CDOs
18
CCPs are suggested as the quick x
for OTC derivatives and particularly CDSs
19
reected in
EMIR and Dodd-Frank
20
. The industrys 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 specic 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 benets 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 CCPs
Risk homogeneity increase risk contained in CCPs
A clearing member would initially benet 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
reected 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 specic transaction which
suers; 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 ESMAs suggestions to the
specic 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 OTC
21
.
1rade-o!!: haIural mohopoly (sysIemic risk) v
compeIiIioh (ihe!!ciehcy ahd risky CCPs)
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
17
.
October 2011
.
Issue 14.8
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 benet 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 CCPs 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 ratings
22
.
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 CCPs 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, Due 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 eect and therefore increase the exposure to
counterparty default and/or increased collateral as a
consequence
24
. Hence fewer CCPs, which can cross clear
multiple products, eg CDS and interest rate swaps jointly
are recommended as the economic benets of bilateral
clearing, which allow for cross clearing of multiply
products, otherwise would exceeds the benets of CCP
clearing
25
.
This suggests that multilateral netting eects will
encourage a natural monopoly due to the inherent scale
and scope eciencies and therefore could raise antitrust
concerns
26
. 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 prot sharing arrangements
27
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 benets for clearing members to gather in the
same CCP as this enable the CCP to comprehend each
counterpartys risk better, rather than if dealers are dispersed
in several CCPs
28
.
Despite the fact that market forces will diverge towards
a natural oligopoly or monopoly which is more ecient
in normal times
29
, such institutions will create signicant
systemic risk and moral hazard problems in excess of a
single large clearing members default
30
, 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 eects
be noticed as the proposal encourage interoperability of
CCPs. This allows CCP members from dierent 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 aect other CCPs, its
members and ultimately the market in general
31
. 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.
A CCP Irahs!ers wealIh !rom dealer's crediIors Io
derivatives dealers
Although multilateral netting improves overall welfare
for derivatives dealers, the redistribution of wealth to its
derivatives counterparties would only improve eciency
if derivatives counterparties incur a higher cost than
other creditors to bear default risk
32
. The reasoning is that
the CCPs multilateral netting mechanism reduces the
collateral posted and the replacement cost to the benet of
derivatives counterparties at the expense of the derivatives
dealers 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 rm
33
.
This suggest that CCP netting would not be preferable to
the defaulting parts creditors as their claims are devaluated
relative to the derivatives counterparty.
Supranational v National CCP authorisation and
supervision
The 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 default
34
. 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 signicance 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
CosI o! cehIral clearihg cah exceed behe!Is vis--vis
bilateral CDS trading
Pirrong asks the question, why has the industry itself not
established CDS clearinghouses earlier if the benets to
the clearing of these products for CDS traders are so
18
evident? The contention is that economic costs of clearing
CDSs centrally exceed the benets 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 CCP
36
. Two-thirds of eligible CDSs are expected to be
CCP-cleared according to the IMF
37
and according to the
Turner Review 50-75% of all standardised CDS contracts
can be CCP-cleared
38
. Please note that a clear denition or
consensus of what constitutes an eligible or standardised
CDS contract is not yet established which arguably
confuses and complicates matters and make specic 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 volatile
39
,
asymmetric in exposure prole, contain wrong-way risk
(ie strong correlation between counterparty and the credit
quality of the reference entity)
40
which is magnied by the
concentrated market structure
41,
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 diculties in osetting 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 prot
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 prot
nor aim to manage market risk (only counterparty risk). And
hypothetically if the models were to be improved this benet
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
evaluated
43
.
Secondly, many CDSs trade infrequently and therefore it
is dicult 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 suered 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.
SIahdardisaIioh o! CDSs cohsIraih hedgihg ahd
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 buyers
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 oer
44
. 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-users
45
. 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 amplied panic
(eg Lehman). The market very much acknowledges this
and initiated a process of reporting CDSs to the DTCCs
TIW trade repository, which today virtually report all
existing CDSs globally. Furthermore, third country trade
repositoriess 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
.
October 2011
.
Issue 14.8
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 CFTCs Gary
Gensler assured European regulators information access
46
,
DTCCs establishment of its duplicated CDS trade
repository in Europe seems like a lack of condence in this
transatlantic cooperation.
Capital Requirements Directive
Discrepahcy ih O1C ahd CCP capiIal requiremehI
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
derivatives
47
not aligned with the actual risk inherent in each
contract form
48
. 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 dicult 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
economy
49
. 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 t 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 proles 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 dierent risk-weights
according to risk prole.
Markets in Financial Instruments Directive
At rst, the Commissions proposal to transfer more OTC
traded CDSs to exchanges seems reasonable considering
general benets of exchanges: increased pre-trade price
transparency which should reduce the chance of obtaining an
inaccurate prices; ecient 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
EMIRs 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 'nancial innovation spiral' compromised
If the nal standards set by the ESMA meet the Committee
of European Securities Regulators (CESR, ESMAs
predecessor) targets of an suciently ambitious thresholds
which would eectively 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 suciently commoditised) on
exchanges would limit the OTC markets inherent benets
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 sucient liquidity and trade
frequency in order to establish accurate price formation, low
trading cost, resilience, anonymity etc
51
. And importantly
liquidity attracts more trading and thereby even more
liquidity and vice versa
52
. 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 diculties. 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 signicantly and eectively undermine
the benet 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
institutions 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 CDSs
It 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 Swaps
53
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 Commissions proposal would only give the competent
national authority in coordination with ESMA the power
to restrict naked CDS positions in exceptional situations
55
,
the European Parliament in response to the Commissions
proposal suggested even stricter requirements for uncovered
CDSs
56
, 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 aect 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 ineective and also dicult 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 sucient. 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 present
57
. It should therefore be questioned how much
a formalised regulatory CDS framework for pre- and post-
trade transparency will add besides rigidity.
Conclusion
In answering the rst question this paper raises, the
European Commissions 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 reected 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 Lehmans counterparties thus amplifying
panic in the web of concentrated CDS dealers.
On the other hand, AIGs 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, AIGs CDS positions merely reected AIGFPs
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 markets
59
.
In light of this, the Commissions 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 dierent 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 reected 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
.
October 2011
.
Issue 14.8
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 signicant scope and scale benets
(eg more ecient netting and the CCPs overview of all
participants in that segment) and therefore constitute a
signicant systemic risk. The contagious eects of a CCP
failing are inevitably diminished in a competitive market
(encouraged by the commission) although this market would
be inecient 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
eects 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 institutions creditors to
its derivatives counterparties, as the counterparties incur
reduced replacement costs and collateral postings at the
expense of the CDS dealers creditors. In the absence
of netting the defaulting institutions (non-derivatives
counterparty) creditors could claim the non-oset in-the-
money positions: a claim that the derivatives counterparties
would hold ownership of in a CCP netting environment.
Secondly, from a specic 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 magnied 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 benecial 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
EMIRs 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 dierent risk proles, which arguably
allow CCPs to benet from risk prole in excess of the rigid
threshold of 2%. Rather a framework of conditions should
encourage prudential risk proles (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 magnied, 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-qualied for exchange trading
if naked CDS trades are curtailed, although evidence of
its detrimental eects are absent; and nally (4) the price
transparency exchanges oer 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 MiFID
59
indicates the diculties
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, ecient 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 structures 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 overhaul
60
which could
diminish the European and American monopoly power of
the derivatives market
61
. 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 Dmler, 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 Ocer
and Christian Krohn, Managing Director from the Association for
Financial Markets in Europe.
Endnotes
1. ISDA Market Survey, Notional Amount outstanding at
year-end, all surveyed contracts, 1987-present.
2. United States Government Accountability Oce, 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 ecient, safe and
sound derivatives markets: Future policy actions COM
(2009) 563 nal; Commission, Communication from the
Commission Ensuring ecient, 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,
ecient, 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 Sectors 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: Cliord 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.
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 Commissions public consultation on
derivatives and market infrastructure (9 July 2010) p17.
24. Due 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. 15
27. 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. Due D and Zhu H, Does Central Clearing Counterparty
Reduce Counterparty Risk? March 6 2010, Graduate School
of Business, Stanford University pp1, 25.
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.
23
.
October 2011
.
Issue 14.8
www.i-law.com/nancialcrime
Editor: Dalvinder Singh, Associate Protessor ot Iav, School ot Iav, Lniversity ot Warvick dalvinder.singhvarvick.ac.uk
Associate 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 OSullivan, PwC, Financial Services Regulatory Centre of Excellence
Production Editor: Catherine Quist 020 7017 6242 catherine.quistintorma.com
Marketing: anet van Bochoven 020 3377 3200 janet.vanbochovenintorma.com
Sales: Mike Lllicott 020 7017 3392 mike.ellicottintorma.com
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 2010
Published 10 times a year by: Intorma Iav 8 linance, 12 Bolt Court, Iondon LC4A 3DQ tel 020 7017 3332 tax 01206 772 771
www.informaprofessional.com Printed by: Halston Printing Group
Copyright: 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 part
of 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 Oce: 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.
31(4) Regulation Cato Institute p44, p48.
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.
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.
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 Departments 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 inuence 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. Cann 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 Aairs, 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. Cliord 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 Brse Group, The Global Derivatives
Market An Introduction (white paper 2009) p13.
24

Counter Terrorist Financing Policies Time For A Rethink 37877

Uploaded by

Copyright:

Available Formats

You might also like

Counter Terrorist Financing Policies Time For A Rethink 37877

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Counter Terrorist Financing Policies Time For A Rethink 37877

Uploaded by

Copyright:

Available Formats

October 2011

You might also like