This week, I participated in a panel discussion on the topic of whether improved infrastructure can reduce the chances of another financial crisis. In particular, I was asked to discuss whether the current focus on reducing operational and counterparty risk would go some way to reducing the chance of another crisis.
Of course the improved post trade infrastructures, such as the current proposal to mandate greater central clearing, might have helped in the wake of the credit crisis, but they certainly would not have prevented it. This is because in the main, the extreme losses suffered in the crisis arose from investment activities in complex structured products such as CDOs and ABSs, which were not properly understood, priced or managed by those who invested in them. No amount of new infrastructure could have prevented this.
That said, when one looks back over history, most financial crises have led to an improvement in infrastructure. The Wall Street crash in early 1930s led to the introduction of the Glass Steagall Act in 1933; the DTCC was borne out of the chaos created by the 1960s Wall Street paper crisis and the Eurobond market administrative chaos of 1960s and 70s led to the development of Cedel and Euroclear. All these initiatives significantly improved market processes and made the global financial system a less risky place to do business. With this in mind, what can we expect from the current crisis?
First, we are beginning to see the beginning of real European harmonisation. An excellent example of this is Target 2 Securities, an initiative currently being undertaken by the securities industry with the aim of centralising the settlement operation for nearly all securities on to a single pan-European platform. Further evidence of harmonisation can be found with the increase in co-ordination around pan-European financial regulation, along with policymakers desire to see home grown European infrastructures in place.
The restructuring of the OTC markets will be another infrastructure development to be borne out of the recent crisis. This will create trading platforms with increased price transparency, the development of trade repositories and mandated usage of central counterparties. We may even see these types of initiatives trickle down into the OTC cash markets.
While there is great optimism about such improvements in infrastructure, it is worth applying caution. These proposed changes will take time to implement and while there will be plenty of good regulation, there is bound to be some bad. This is well illustrated by the ECs ill thought out proposals on hedge funds.
It is unrealistic to say that through infrastructure we can prevent another financial crisis from occurring; however with improved processes in place, at least next time around, financial institutions should have a more accurate picture of their risk exposures and will therefore be better placed to anticipate such a crisis.