26 June 2008 — David Knott, DFSA Chief Executive, Speech at the Risk Korea 2008 Conference
Address by David Knott, Chief Executive,
Dubai Financial Services Authority (DFSA)
at the Risk Korea 2008 Conference
26th June 2008
I am delighted to be taking part in this Korea Risk 2008 Conference. Given the volatility of global financial markets over the past twelve months, this seems to be an ideal time to consider some of the regulatory and risk issues associated with Korea's policy direction.
At a more personal level this has been a wonderful opportunity to again visit friends and colleagues in Seoul, including your regulators with whom I have enjoyed a cordial relationship over many years, going back to my regulatory days in Australia. Since moving to Dubai in 2005 I have valued the new relationship that has evolved between the Dubai FSA and the Korean regulators, reflected by our entry into a Memorandum of Understanding with the Financial Supervisory Commission in 2006.
More broadly, the economic links between Dubai and Korea are going from strength to strength, particularly in tourism, trade and construction. In May of 2007, the Dubai Chamber of Commerce and Industry and the Seoul Chamber of Commerce signed their own Memorandum of Understanding. 119 Korean firms are presently registered with the Dubai Chamber and in February of this year the Government of Dubai announced a plan to invest up to US $20 billion in Korea. All of these connections add to my pleasure in joining you this morning as we think about the future pathway for financial markets, with special emphasis on derivative markets.
It is natural that regulators and risk managers should focus on vulnerabilities when thinking about the liberalization of financial markets. Indeed, it would be remarkable if even the most ardent advocate of globalization did not pause to reflect upon the events of the past year, including the role played by derivative and structured products, some of which have gone so badly wrong. But it is equally important for us to avoid discrediting entire product segments; or abandoning proven distribution mechanisms like securitization; or blaming all our woes on market speculators. Instead we need to carefully identify the particular means by which otherwise credible products and market mechanisms have been exploited or abused - together with any areas of public policy or industry practice that have proved defective - and to provide responses to mitigate against repetition.
Above all, we need to ensure that our recent experiences do not undermine the continued liberalization of financial markets that has added greatly to the world's prosperity over the past decade and for which Asia, and not least Korea, can take a share of the credit.
I will therefore begin with a brief review of Korea's extraordinary journey over the past 10 years which, I believe, should assist to signpost our direction for the decade ahead.
Korean Financial Crisis and Reform Program
We are all aware that the Korean financial and corporate sectors have undergone tremendous restructuring since the Asian financial crisis. In today's context it is useful to remind ourselves that although aggressive speculation against the won in late 1997 contributed to Korea's woes, the real mischief lay in deeply embedded structural inefficiencies that had undermined the strength of the economy and left it exposed to crisis.
In retrospect it is easy to understand how those inefficiencies had been disguised by the relatively benign and stable economic environment enjoyed during the earlier part of the decade. However, we now know that the real economy had been in decline since 1995; that the domestic banking system was fundamentally flawed; that the corporate conglomerates – chaebols – were excessively geared; that there was no effective domestic capital market to counter-balance the excesses of the banking system; and that foreign sourced funding was, by 1997, comprised primarily by short term portfolio investment.
This combination of domestic institutional weakness and over-reliance on international "hot" money quickly consumed Korea's international reserves in the second half of 1997, reducing available reserves to around US$ 5 billion. It is understandable that there was resentment against the currency speculators whose actions undoubtedly exacerbated the extent of the crisis. But Korea was quick to acknowledge that the basic problems lay at home and could only be addressed through a major program of reform.
No-one who witnessed the traumas of that period could be unsympathetic to the Korean people who suffered so much. Nor could anyone fail to be moved by the depth of national spirit that saw families volunteering household gold ornaments – (including their precious dol-ban-ji) – to be melted down in order to shore up national reserves. But the most impressive story of all is the realism and commitment with which Korea set about to restore its economic fortunes; and the determination with which that commitment has been maintained over the past decade.
I will not dwell at length on the details of Korea's post-crisis reform program. Obviously, the first priorities were to stabilize and then rebuild foreign exchange reserves and to recapitalize the banking system. But the long term success of the reform program necessitated major structural changes to increase transparency in the financial and corporate sectors; to overhaul the regulatory system; to raise standards of governance; and to promote greater competition and diversity in the economy, including through the building of broader based capital markets.
The creation of an integrated supervisory system to oversee all financial institutions was central to that strategy. In 1998 legislation was passed to establish the Financial Supervisory Commission and the Financial Supervisory Service, integrating the supervisory functions of the previous four banking, insurance, securities and non-banking supervisory authorities . That new regulatory model has been critical to the achievements of the passed decade and has been further modified by creation of the Financial Services Commission in March of this year and a clearer demarcation between its role and that of the FSS. I am sure we will hear more about this from subsequent speakers, but I view this latest change as a renewal of the reform commitments first undertaken in 1997 and a highly positive signal of Korea's determination to further develop its services sectors and to engage in the global financial marketplace. The policy priorities announced by the new Financial Services Commission are clearly targeted towards those objectives.
In a sense, this is recognition that the work commenced in 1997 is not yet finished. But these are challenging times for Korea, with significant political obstacles confronting the next generation of reform. It is still possible that in 10 years time 2008 will be viewed as the second major milestone in Korea's post crisis journey, which is an exciting possibility for those of you who will be participants. On the other hand, we may look back on 2008 as a lost opportunity, a time at which reform fatigue took its toll on the public's will to take the next steps. These are questions for the Korean people to decide. But in making that decision it does seem relevant to reflect on the enormous gains that have been made through reforms already undertaken.
Of course, it was not possible to achieve these gains without embracing foreign participation in the domestic market. This was recognized as part of the 1997 program which included "increased competition" as a central plank of the reform agenda . Foreign banks were permitted to establish subsidiaries and brokerage houses by mid 1998 and since that time there has been a gradual opening of Korean markets – including the derivatives market - to foreigners.
There has also been substantial success in building Korea's domestic capital markets capacity. The launch of the Stock Index Options Market in 1997; the formation of the Korea Futures Exchange in 1999; and the consolidation of the three domestic markets into the Korea Exchange in 2005 have all been important steps to building that capacity. To put these achievements into perspective let me give you three quick examples:
KOSPI 200 Options
First, the outstanding growth of Korea's options market. In 2005, KOSPI 200 options traded on the Korea Exchange accounted for 79% of global trading in indexed options; with total derivatives trading on the Korea Exchange accounting for 27% of the global exchange traded derivatives.
In 2006, despite substantial global market growth in indexed options trading outside Korea, KOSPI 200 options were still the most active traded index options in the world, with institutional investors accounting for 34% of trading, retail investors 39%, and foreign investors 26%. The success of the Korean options market has been highlighted by the recent agreement with the Chicago Board Options Exchange to share development opportunities.
Asian Financial Institution & Corporate Bond Markets
Korea's performance in developing a bond market (both financial institution and corporate bonds) has been a second notable success, with issuance just over 60% of GDP at the end of 2007 . While this is not large by some international comparisons, it far exceeds growth over the comparable period in most other emerging markets. If government bonds are added to the total, Korea's leadership position (measured as a percentage of GDP) is again apparent.
Thirdly, by the end of 2007, Korea Exchange was ranked the 12th largest of the World Federation of Exchanges by total value of share trading; the 6th largest exchange by total value of bonds traded; was in the top 5 exchanges by value of securitized derivatives traded; was ranked number 6 for number of stock index futures traded; and was ranked number one for number of stock index options contracts traded, measured both by volume and by notional value.
So let's be clear about one thing. Hard decisions have been taken by Korea over the past decade and those decisions have paid off. In my opinion, the country is well prepared to take the next steps, notwithstanding events that have emerged in recent months to test the resolve of public opinion.
One of the most important of these next steps will be the commencement of the Capital Market Consolidation Act (CMC Act) next February, which I'm sure will be discussed later this morning. A key feature of this reform is the central licensing regime that will permit financial investment companies to offer a range of financial services in a number of financial investment products, including exchange traded derivatives and OTC derivatives, thereby removing the current institutionally driven regulation. Having overseen the introduction of a similar program in Australia in 2002/03, I have a good understanding of the CMC's potential to launch a new platform for Korea's development as an internationally competitive and innovative financial marketplace.
Of course, with opportunity there usually also comes risk, and it is quite proper that the risks of further opening up the Korean economy to international competition and, in particular, to expanded derivatives markets should be discussed. Let me set the scene for commenting on those risks by first providing a snapshot of the international derivatives market, in particular the OTC derivatives market which is central to some of these concerns about risk.
Global Derivatives Market
The derivatives market landscape is presently divided into two markets; those traded on exchanges and those traded over the counter (OTC). Measuring the size of these markets is complicated by reporting discrepancies between volumes (the norm for exchange traded) and notional amounts outstanding (the norm for OTC). Nevertheless, it is clear that the OTC markets by value are the dominant markets after including all forms of derivatives trading. However, there are some interesting differences between the markets.
With respect to exchange traded derivatives North America is the largest market with the Americas accounting for 47% of volume (some 7.2 billion contracts in 2007). Asia Pacific follows with 28% of volume (4.3 billion), with the rest of the world accounting for the balance.
Activity volumes on these exchanges is dominated by equity derivatives and indexes (aggregating approximately 65% of volume) with interest rate and commodities together accounting for a further 33% . Again, the caution needs to be noted that measurement by value would produce different outcomes. In particular, the relative importance of interest rate products would rise substantially.
In relation to the OTC markets, statistics available to date confirm that for the last 3 years London has been the single largest financial centre for derivatives trading (accounting for approximately 41% of total global turnover by value in 2007). The United States is the next largest market accounting for approximately 19% of total global turnover (Korea came in at number 20 out of 54 countries with an average daily turnover of US$ 23 billion in 2007).
In product terms the OTC markets are dominated by interest rate, credit default swaps, and FOREX transactions (in aggregate approximately 85% of value) with equities and commodities playing a relatively small part in the markets.
Finally, the growth rate in the OTC markets in recent years has been dramatic and has gained additional impetus from the recent turmoil in global financial markets as investors seek to manage their exposures through derivative contracts. .Notional amounts of all categories of OTC contracts rose by 15 % to US$ 596 trillion during the second half of 2007, following a 24% increase in the first half . Growth remained particularly strong in the credit segment, where the notional amounts of outstanding credit default swaps increased by 36% to US$ 58 trillion.
Key Regulatory Issues
So, against that background, I want to talk about some of the policy risks and regulatory challenges for more openly engaging with such an important but complex market.
These questions have become increasingly relevant and are being expressed more vocally than ever before. Some of the issues, such as the efficiency of post-market infrastructure, are familiar territory for regulators and risk managers . For example, in 2005, the UK FSA and Federal Reserve Bank of New York commenced initiatives to reduce back office backlogs. That regulatory action - together with a number of other developments including migration to electronic platforms and increased resources dedicated to back office operations – has significantly improved the efficiency of transaction confirmations.
More recently, earlier this month, the Federal Reserve Bank of New York outlined comprehensive measures to enhance OTC credit derivatives market infrastructure. While such measures have been under discussion for some time, the fall-out from the subprime crisis, and in particular the near failure of Bear Stearns, has provided additional stimulus for action. The initiatives are aimed at mitigating systemic risk by improving efficiencies in clearing and default management of OTC products. Key regulators and firms participating in credit derivative markets have agreed to establish a central clearing house for credit default swaps and to incorporate a protocol for managing contract defaults.
But the two issues that have created the greatest noise over recent months are, first whether OTC markets have become so similar to exchange traded markets that they should be regulated along similar lines and, secondly, whether the derivative markets (both OTC and exchange traded) are enabling speculators to distort the international pricing of key commodities, principally oil and food.
On the first question of OTC regulation, I believe that the standardization of many OTC derivative products and the "anonymous" manner of their clearing and settlement makes it increasingly difficult to justify a materially different regulatory approach from exchange traded derivatives. Those who support the continuation of the current differentiation usually invoke competition reasons for doing so, and that consideration cannot be dismissed lightly. On the other hand, these markets are very different to the specialized and tailored private treaty transactions that were contemplated when the OTC market was exempted from regulation. There is now a certain degree of regulatory arbitrage in place, and that is seldom a positive thing for market integrity. This debate is particularly active in the United States and, hopefully, a rational policy outcome will emerge. For reasons that I will now explain, it is likely that this debate will to some extent intersect with the second set of issues relating to speculation (and market manipulation).
Moving then to deal with those issues, I find it quite difficult to separate the notions of derivatives trading and speculation. Apart from a vanilla hedging transaction one might expect to find an element of market or pricing speculation in almost all derivative transactions. All financially settled derivatives (which by volume dominate the market) can be regarded as speculative. On the other hand, the notion that market participants might engage in a pattern of behaviour deliberately designed to distort market pricing has long been proscribed as a form of market manipulation. In reality, the distinction between legitimate "speculative" trading and market manipulation can be a very difficult question for regulators to resolve, particularly in commodity derivative markets where it is common for trading strategies to be played out across a combination of physical, exchange based and OTC markets. This is the intersection of issues that I have referred to and forms part of my reasoning for supporting greater convergence in the regulation of the markets.
Dramatic Commodity Price Rises
Sudden and dramatic price increases in commodities as basic as food and oil will naturally cause alarm to Governments. We have already seen some interesting recent reactions:
For example, in 2007 rice futures were delisted by the Indian Forward Markets Commission; followed last month by a four month ban on futures trading in other key agricultural commodities . 20% of the National Commodity & Derivatives Exchange's turnover comes from these suspended commodities, or 80% of total agricultural futures trading.
These measures were taken in response to widespread concern that derivatives speculation was causing artificial price inflation in basic foodstuffs. This was done despite the findings of an expert committee which was unable to determine any causal relationship between trading on the futures market and the wholesale or retail prices of agricultural commodities.
Interestingly, that committee found that as the Wholesale Price Index of rice declined throughout the period when futures trading in rice was allowed, and increased only after de-listing from the exchange, speculation in futures markets could not be said to have exerted any strong upward pressure on spot prices for rice.
In the United States, there has also been intense scrutiny to determine whether abuse of the derivative markets has been a major contributor to rising food and oil prices.
However, in recent testimony provided to the Senate Committee on Homeland Security and Government Affairs, the chief economist of the US regulator (the CFTC), Mr Jeffrey Harris, stated that there is little economic evidence to demonstrate that prices were being systematically driven by speculators in these markets . He further stated that the economic data shows that overall commodity price levels were being driven by powerful fundamental economic forces and the laws of supply and demand.
I am not arguing that speculators are irrelevant to recent price bubbles and I am not sure that Mr. Harris would give exactly the same answer if he were giving evidence to the Senate today (circumstances in the energy markets are changing at an unprecedented pace as I write this paper). But, as a recent report has noted, much of the motivation behind the increased investment in these markets from hedge funds, pension funds, sovereign wealth funds and others has been an expectation that commodities would outperform equities and bonds . In this respect the derivatives markets are no different from other asset classes which from time to time become over-invested, resulting in pricing bubbles that eventually burst as the underlying fundamentals assert themselves. We see this all the time in equity markets and we may well shake our heads at the folly of investors and their capacity to repeat the mistakes of history. But it is another thing altogether to ascribe improper motives to such investors or to liken them to those dishonest few who deliberately set out to distort markets for their own advantage. So we need to take care with words like "speculators" and to be clear about precisely what allegation or assertion is being made.
Notwithstanding the probable over-exuberance of current energy markets, spurred by migration of investment from alternative under-performing asset classes, I agree with Mr Harris of the CFTC that you cannot ignore the influence of key fundamental forces at work, some of which stem from policies (or lack of policies) adopted by national Governments over many years in the energy and food sectors. I draw an analogy to Korea's difficulties in 1997 which were not helped by currency speculators but which were basically attributable to the underlying inefficiencies that I have discussed this morning. It has always been politically tempting to blame the speculators (Lenin purportedly said they should all be shot) but there is a real danger that politically inspired solutions may do long term damage to the legitimate and important operation of these markets.
This does not mean that regulators are powerless to intervene to assist the correction of pricing bubbles. I have already given a few examples of recent regulatory interventions that seem entirely sensible and rational. Moreover, you will all be aware of the great debate arising from the sub prime crisis about what additional forms of intervention might be available to banking regulators to slow down credit-driven pricing bubbles.
In the equities and derivatives markets, it has been much rarer to expect regulators to intervene to curb market exuberance and there are some very serious issues to consider before mandating such intervention through, for example, increased margining requirements or the imposition of trading limits. But that is not to say that such additional forms of intervention should be ruled out. The idea that regulators should do more to "lean against the wind" in order to constrain pricing bubbles deserves careful consideration and an open mind.
In the meantime, as I said earlier, we need to carefully review and redress any specific circumstances that have led to distortion of otherwise credible products or to manipulation of markets. If there are technical deficiencies in the design of some contracts, for example, that lead to such distortion then by all means the regulator should intervene. That appears to have been the case with some of the US agricultural futures products to which the CFTC responded earlier this month.
I also stress the need for the regulators of commodity and futures markets to have the necessary surveillance and enforcement skills to monitor trading and to aggressively pursue suspected cases of manipulation. As the regulator of a newly created commodities futures exchange in Dubai - the Dubai Mercantile Exchange - I know that this involves highly specialized skills that differ from those required elsewhere in our business.
Finally, any gaps in the regulatory system that need to be closed in order to ensure effective regulation should receive international support, including urgent resolution of the future direction for OTC markets regulation.
So, there are several issues for us to consider and some interesting possibilities for the development of new forms of regulatory intervention. We must ensure that this work is inspired by intellect rather than emotion.
International Regulatory Cooperation
Let me conclude with a brief comment on the policy tension that may arise from seeking to facilitate the efficient international operation of markets, on the one hand, and ensuring their effective oversight, on the other. Regulators are constantly under pressure to harmonize their requirements, and to place greater reliance on home country supervision, in order to reduce the costs of conducting international business. This is an entirely legitimate concern and the regulatory community has moved quite sympathetically in that direction over the past decade, particularly in Europe but, more recently, across the Atlantic as well. The concept of "mutual recognition" between regulators has fairly widespread support and has led to a regulatory passport for the marketing of financial products between relevant jurisdictions. The Dubai FSA is a strong supporter of this model.
Special needs and considerations apply in the case of international exchanges that manage the mobility of the world's capital markets. It has become customary for regulators of domestic exchanges to recognize reputably supervised foreign exchanges and to facilitate intermediary access between them. By and large this has served us well, but it can lead to concerns about the capacity of the home regulator to maintain effective oversight of market manipulation, particularly if key trading information lies outside its grasp. This has been an on-going issue for some of the US legislators who believe that arrangements to facilitate trading on the UK ICE exchange by American intermediaries has diminished the oversight capacity of the CFTC.
In January 2006, the CFTC permitted the trading of oil futures on the ICE Futures market in London from trading terminals in the US. ICE then began to trade a new WTI futures contract on its London exchange. Like OTC markets, ICE has exempt status.
A Senate subcommittee, enquiring into the role of market speculation, concluded that the CFTC's ability to detect and deter market manipulation was suffering from critical information gaps because traders on OTC electronic exchanges, and the London ICE Futures, were exempt from CFTC reporting requirements.
The subcommittee also recommended legislation to provide that persons trading energy futures "look-alike" contracts on OTC electronic exchanges and ICE should become subject to the CFTC's large trader reporting requirements; and that the CFTC should examine the price discovery function of ICE and the need for ICE to publish daily trading data as required by the Commodity Exchange Act. Draft legislation to implement these recommendations and to close the so-called "London loophole" was introduced into the US Senate last month; and only a few weeks ago we saw additional measures announced to increase CFTC power to direct US brokers to reduce their positions on the London exchange.
I should add that, to my knowledge, there is no evidence to support the claim that the so-called "London loophole" has given rise to market manipulation or carries any special causal responsibility for the blow out in energy or food prices. Moreover, given that the CFTC and the UK FSA moved quickly to finalize new information sharing arrangements to address the apparent oversights gaps, it is not clear why legislation is considered necessary. Nevertheless, I support greater transparency from electronic OTC markets and any additional powers that will assist regulators to effectively protect against their manipulation. These are legitimate issues for all jurisdictions to consider and can, I think, be accommodated without impeding the welcome trend of cooperation and mutual reliance between well regulated jurisdictions and markets. But policy makers need to remember - mutual recognition cannot work if both sides insist that their rules must be adopted 100% by the other side.
Ladies and Gentlemen, this is a really interesting time to be a financial services regulator and I wish there was time for me to expand this discussion to cover some of the broader regulatory ramifications arising from the events of the past 12 months. But I realize that you have a packed agenda today and that you have already been a generous and patient audience. I have attempted this morning to substantiate the case that Korea is indeed well prepared to further open its markets to global participation. Whether this can be achieved under the timetable that existed 3 months ago remains to be seen. But in my view, Korea's historical track record as a determined and resolute people, coupled with its own evidence that reform delivers dividends, will inevitably lead to this path. As risk managers your part in shaping the outcome will be vital because good public policy is ever at the mercy of those who implement it. Thank you and good morning.