G20 2019

Market Fragmentation on G20 Agenda

Several global financial heavyweights are concerned about the growing threat from deleterious market fragmentation. In separate events on two ends of the globe, market fragmentation took center stage.

The first event was the International Swaps and Derivatives Association (ISDA) 34th Annual General Meeting which was held on April 9-11, 2019, in Hong Kong, in a panel entitled: “Market Fragmentation- Key Issues and Impacts” . The other event was the Commodities Futures Trading Commission (CFTC) Global Markets Advisory Committee (GMAC) meeting held on April 15, 2019, in Washington, D.C.

The GMAC meeting hosted Shunsuke Shirakawa, the Vice Commissioner for International Affairs, at the Japan Financial Services Agency.  Shirakawa made a presentation entitled: “Overview of Financial System Issues for the 2019 G20 Japan Presidency.” Following Shirakawa, Steven Kennedy, the Global Head of Public Policy at ISDA made a presentation entitled: “Regulatory-Driven Market Fragmentation.” Kennedy hosted the Hong Kong panel, where Shirakawa was a panelist.

Japan is hosting the G20 Summit in Osaka on June 28-29, 2019; as a result, Japan will chair the meeting. Market fragmentation has been put on the agenda, said Shirakawa at both events.

In Hong Kong, Shirakawa, speaking in English, said that on issues like supervisory practices, global regulators have not achieved equivalence, as a result, “this could give rise to market fragmentation along national lines.” He continued, “Against this backdrop, we proposed market fragmentation as one of the priorities of Japan’s G20 presidency. The FSB (Financial Standards Board and IOSCO (International Organization of Securities Commissions) have launched an initiative to identify the sources of harmful market fragmentation.”

Shunsuke Shirakawa
Shunsuke Shirakawa

Shirakawa identified three categories of market fragmentation caused by regulatory and supervisory issues: inconsistency in implementation of international standards, extraterritorial application of market regulation, incompatibility in host and home regulatory and supervisory requirements.

Shirakawa then listed examples of markets where regulatory and supervisory issues led to market fragmentation: cross-border trading and clearing OTC derivatives, banks cross-border management of liquidity, and information sharing across borders, including data collection.

The problem with market fragmentation, according to a Japanese businessman who was quoted in a recent ISDA paper, is, ““Fragmentation can impair financial stability by reducing market liquidity and trapping scarce resources. It can drag efficiency and economic growth. Combatting market fragmentation should be our common goal.”

That same paper listed several areas of derivatives market fragmentation: extra-territorial, capital, non-cleared margin, clearing, trade execution, benchmarks, netting, and data reporting.

As an example, on the issue of clearing the ISDA noted, “Some jurisdictions (eg, Japan) require certain trades (eg, yen-denominated swaps in Japan) executed within their borders to be cleared at central counterparties (CCPs) within their borders that are subject to local supervision. Clearing mandates in jurisdictions with closed currency markets also create de facto CCP location policies.”

That was not the view of all.

Patrick Pearson is the Head of Financial Market Infrastructure and Derivatives at European Commission and was also on the panel in Hong Kong.

“Powerful people in Europe have pointed out that a fragmented market is not necessarily bad. A fragmented market can actually give rise to innovation; it can give rise to competition.” Pearson said. “A year and a half ago it was promulgated by LCH that if you move certain rates into EUREX you would never be able to get rid of the spread. Costs would rise, but if you look at what the market has achieved, a fragmented, competitive market has shown that the spread is zero, that the incremental cost is zero: because of innovation and competition.”

Kennedy, speaking at GMAC in D.C., linked fragmentation to the failure of globalization. Kennedy first referred to the “golden arches doctrine” first coined in the 1990s by Thomas Friedman, which held that no two countries which have McDonald’s franchises go to war with each other, Friedman mused, because having McDonald’s franchises indicates they each have strong enough middle classes that war has too far a cost.

As Kennedy noted that since the doctrine was first coined in the 1990s, two countries with McDonald’s franchises did go to war, and Kennedy, noted, maybe the view of globalization should be changed as well.

“Not too long ago there was a deep and a wide belief in the virtues of globalization, in the benefits of global markets, and the integration of economies.” Kennedy said. “Maybe it means the benefits of globalization weren’t as advertised. More importantly and more seriously, in the financial crisis,  and to some the crisis exposed the flaws in the global financial market approach.”

Erik Tim Müller is the Chief Executive Officer (CEO) of Eurex Clearing AG and when he spoke at the meeting at GMAC, he said in clearing the problem is not fragmentation but concentration, with many products having only one clearing option.

“In the CCP world, we have the opposite of fragmentation, we have concentration. So, if you look at some of the major asset classes where clearing became mandatory, they essentially ended up in one CCP.” Müller said.

He said that Eurex entered clearing for Euro SWAPs because they were trying to provide clearing alternatives in one of the assets he mentioned, which only had one clearing option.

The ISDA listed the following as solutions to market fragmentation in its paper.

  • Recognize the important role that global markets play in generating sustainable economic growth while developing regulations that address jurisdictional concerns.
  • Reduce the gap between global standards and national regulations to ensure greater consistency in implementation.
  • For smaller jurisdictions or those with limited market activity, implement the global standards when and where appropriate. In the meantime, market participants from larger jurisdictions should be allowed to engage in de minimis derivatives activity in these smaller jurisdictions.
  • Implement a risk-based framework for the evaluation and recognition of the comparability of derivatives regulatory regimes.
  • International standard-setting bodies (FSB, IOSCO, CPMI, BCBS) should establish a process that would enable national regulators to implement equivalency and substituted compliance determinations in a predictable, consistent and timely manner.
  • International standard-setting bodies should also regularly review reform initiatives to ensure they remain relevant and appropriate, and are efficiently and effectively achieving policy goals.