The Financial Stability Board has released a report on market fragmentation, which was delivered to G20 Finance Ministers and Central Bank Governors ahead of their meetings in Fukuoka on 8-9 June. It sets out the conclusions from the FSB’s work on market fragmentation and identifies several areas for further work to address it.
Potential causes and evidence of market fragmentation
The most often cited sources of market fragmentation are difference in domestic/regional and international regulatory requirements and incomplete, delayed or inconsistent implementation of international policies and standards. Other potential causes include rapid technological developments in finance and capital controls, cited by the OECD (Organisation for Economic Co-operation and Development). Some market participants suggested that the supervisory architecture for global operations be reviewed, particularly in the areas of payments and new technology.
In a summary of a related workshop, the FSB noted that the discussion on securities and derivatives markets largely focused on the potential for fragmentation in central clearing arising due to rules that require certain types of transactions to be cleared nationally. Participants also discussed fragmentation connected with data standards, cyber security and crypto-assets.
Market participants discussed the frictions that arise from policies that require certain types of transactions, typically those denominated in that jurisdiction’s currency, to be centrally cleared at local, or locally supervised, CCPs. This may result in CCPs in more than one jurisdiction being used to clear the same instruments, and segmentation if local market participants are obliged to clear locally and foreign participants prefer to clear transactions among themselves at foreign CCPs.
This setup reduces netting opportunities across portfolios and increases costs by leading to higher total amounts of initial margin and default fund contributions, higher capital charges and greater counterparty risk.90 If the local participants in CCPs have highly directional portfolios this can exacerbate the effect. One workshop participant estimated that aggregate initial margin, capital and counterparty risk is around 5-20% higher than if the swaps were cleared in the same CCP.
Another market participant noted that the client clearing market has become highly concentrated; higher clearing costs have led to a decline in the number of CFTC-registered Futures Commission Merchants, from 90 ten years ago to 54 today, of which 17 are clearing derivatives trades and five account for 80% of the cleared volume. A few participants noted that greater concentration in clearing houses should be supported by strong regulation and supervision. Fewer clearing members in CCPs mean less scope to mutualize risk and end-users have less access to central clearing, which increases hedging costs and reduces returns to investors.
One market participant said that clients in emerging markets cannot directly access CCPs in advanced economies and are effectively paying three times the amount of a global clearing member for central clearing services. Some market participants noted the growing use of dark pools or other alternative order mechanisms that may benefit individual market participants by reducing market impact of their trading that do not contribute to price discovery and therefore reduce market liquidity.
One participant estimated that more than 50% of swaps or US Treasuries are traded in dark pools or other venues. A few other market participants said that the various liquidity requirements for banks were fragmenting liquidity by reducing the velocity of collateral. Regulations based on end-period balance sheets instead of period averages lead to year-end spikes in repo rates. They cautioned about collateral shortages in periods of stress.
Another issue highlighted by some participants was concentration in fragmented markets, which reduce the portability of derivatives contracts should a clearing member fail; even if contracts are exactly the same, a few market participants noted that assets may not be portable in a reasonable amount of time due to concentration among clearing members. One participant noted that the lack of a leverage ratio offset for customer margin increases stress on a CCP’s default management given that bank clearing members must come up rapidly with regulatory capital to port those positions onto their own balance sheets.
Participants discussed the need to make further progress on standardization of data reporting to provide better systemic risk monitoring by authorities at lower cost to financial institutions. The issue arises due to different reporting standards and requirements by authorities across jurisdictions (and also within the same jurisdiction). The issue is particularly relevant for OTC derivatives where transaction-level reporting is required and individual transactions often need to be reported several times.
While progress in harmonizing standards for data fields has been made by standard-setters (e.g. Legal Entity Identifier, Unique Product Identifier, Unique Trade Identifier, Common Data Elements), more work is needed to implement the standards to obtain comparability of information to allow for data aggregation and to streamline reporting processes. If harmonized reporting standards are achieved, then the use of artificial intelligence and big data become relevant and usable for the identification of risks.
Market participants highlighted cybersecurity as an area where approaches, subject to national sensitivities, should not be fragmented. They said that all stakeholders want the same outcomes, but complexity arising from different jurisdictions’ regulations and supervisory expectations lead to challenges and duplication from similar yet slightly different requirements.
They also noted the importance of basic minimum standards of cyber hygiene and the ability to detect and recover from a cyber incident. The FSB stocktake on cybersecurity regulation and supervisory practices reported that there were 56 schemes of regulations and guidance reported as targeted to cybersecurity and/or IT risk across the 25 FSB member jurisdictions. One participant estimated that, collectively, financial market infrastructures and chief information officers are spending 30-40% of their time on compliance with different rules rather than ‘fighting the bad guys’.
One market participant said that cryptoassets are global in nature, but their regulation varies around the globe. They should be subject to the same degree of rigor for AML/CFT purposes as traditional assets. A consistent regulatory approach across jurisdictions would help address such issues, including a common definition of cryptoassets.