The presentations during the conference, with the exception of the keynote speeches, were covered by Chatham House rules, designed to ensure that the presenters felt comfortable to talk openly to those gathered.
In the spirit of those rules we have drawn together some of the most interesting, but unattributed speaker commentary organized into three key themes: capital and capital markets; geopolitics as well as regulation, regulators and risk. In this third article of the series we look at the discussions centred on regulation, regulators as well as the key risks that may potentially impact capital markets.
In parallel to the geopolitical tension creating issues for many capital market participants, another speaker pointed to the issue of regulatory fragmentation, which is a real problem for financial institutions that are operating globally.
In the banking context, the Basel III requirements were mentioned as generally having the same spirit and principles internationally, but then being applied inconsistently at a national level. This creates real challenges for large banks. It was the perfect riposte to Jean-Paul Servais’ call for more ‘principles-based’ regulation, and standards in his keynote earlier in the day.
Data was another example of operational friction cited as a problem created by divergent interpretations of similar regulatory efforts. In this context data portability, data sharing and data usage can be impeded and lead not only to inefficiencies, but potentially even exposure to regulatory action.
There was also discussion of regulatory arbitrage as a result of the differences between regulatory regimes, which is not an outcome that regulators intend.
Systemic risk and passive investing
One of the most interesting discussions was sparked by the yen-carry trade which was also mentioned by FCA CEO Nikhil Rathi in his speech as an illustration of the rapidity of market reaction to certain events, as well as systemic vulnerability of the financial system more generally.
One factor that amplified the rapid unwinding of the yen-carry trade was the homogeneity of investors in the market as a result of the popularity of passive investing strategies. It highlighted the fact that the dominant position of capital held in passive trading funds could be problematic for markets.
The increase in passive strategies is predicated on the efficient working of markets as driven by active investors. As investors have shifted away from active strategies to passive, this has led to a reduction in research and price discovery.
Regulators were called upon to encourage the entry of new active investors into the market. In particular, disclosure rules on short sellers were singled out for criticism for discouraging price discovery on assets that are overpriced.
The idea of exchanges acting as a “last line” of defence against aberrant orders was mooted by one of the speakers, with the argument made that “a trade that is not executed is one that puts nobody out of business.”
But with the exchanges dealing with billions of orders this is already a challenge, and may be even more difficult as the use of AI models might amplify market reaction to certain events.
Future regulatory focus
Another area raised was consumer protection. While the speakers lauded the intent of the rules, they suggested that they vary across jurisdictions. This is leading to suboptimal banking outcomes. And while the UK FCA’s consumer duty was held out as a success in encouraging better consumer outcomes, the elephant in the room remains the inability of regulators and governments everywhere to effectively deal with cyber-crime and fraud.
One of the speakers suggested that the regulatory pendulum since the pandemic has swung too far in the direction of risk reduction at the expense of the creation of value and the support of economies. This sentiment was echoed in different ways by a number of the other speakers. They reiterated the fact that there must be some tolerance for losses in financial markets, and that the appetite for risk “must be higher than zero” if capital is to be available to support growth.
According to one of the speakers, regulatory uncertainty is something that can be viewed as part of the risk basket, and it goes beyond financial regulation with extensions to uncertainty connected to taxation and government policy. It can be difficult to make good long-term strategic decisions about capital investment, in particular when the shifts in rules and taxes and policy can be dramatic. Implied was the fact that businesses require some stability in order to thrive.
In support of the FCA’s proposed regulatory agenda, one of the speakers suggested that the T+1 reforms have been a surprising boon and have led to:
- a forced modernization of workflows, which has improved efficiency; and
- dramatic improvements in trade matching capabilities.
But another speaker argued that a ‘more measured pace’ can sometimes be more helpful when managing capital suggesting that perhaps having secondary markets acting as a ‘half way house’ between opaque private and totally transparent and instantaneous public markets might be a good structural solution and compromise.
Finally, a very interesting question arose, in the context of a discussion about technological innovation, about whether regulators could ever accept the fact that AI functioning autonomously or coupled with human operators can in itself be fallible.
GRIP Comment
We are in the midst of a post-pandemic watershed moment where, for the first time in a long time, the value of risk taking is being extolled even in the face of the potential for loss. It was a real relief to be hearing speakers, even those representing regulators, arguing for fewer safeguards, less regulation and more innovation and risk taking.
For far too long the mantra of ‘safety first’ has permeated areas where it really does not naturally belong. Financial market regulators are not regulating airlines where there is absolutely no room for risk. Indeed, it can be argued that the taking of risk is something that underpins efficient and well-functioning capital markets and is integral to capitalist economies, their ability to grow, adapt and compete.
And speaking of watershed moments the suggestion that the relative shortage of active investors is hurting both markets and the passively managed funds that have become dominant investment vehicles is also a first hint, in a long time, that perhaps there is both a need and an opportunity for these critical market players.
Finally, the concept of ‘amplification’ is a cause célèbre of sorts – whether applied to catastrophic storms, social media or, indeed, financial markets. But it is interesting to note that in connection with financial markets technology enabling more rapid action or reaction can have a negative impact (for example Yen carry trade unwinding, SVB / First Republic bank failure) but can also have a positive impact (for example market efficiency improvements as a result of T+1 reforms).
