Patrick Pearson, head of market infrastructure unit, European Commission
"We want an absolute degree of clarity for the markets that no action will be taken, at any point in time, until this has been sorted out."
London - It sounded almost as if Patrick Pearson was taking a financial version of the Hippocratic Oath: First, do no harm.
Pearson, the head of the European Commission's financial markets infrastructure unit, was speaking about the importance of addressing cross-border application issues. The regulatory solution, he said, came down to agreeing a narrow application of Europe's rules, a wide application of "mutual recognition" and an agreement not to actually do anything until the first two issues were resolved.
"We want an absolute degree of clarity for the markets that no action will be taken, at any point in time, until this has been sorted out," he told a TradeTech conference on swaps and derivatives. The "worst place to be", he said, would be having firms subjected to inconsistent, different rules in just a couple of weeks' time.
"We've got 23 working days to do this - not a lot of time. That's why you will find that a lot of the regulators are spending most of their time in video conferences, travelling across the Atlantic or elsewhere, to try and sort this out before the first of January."
Pearson noted that extraterritorial application of Europe's own rules was not on the list of ESMA standards that were being agreed.
"Are we going to apply our rules to branches of European firms operating in the United States, or Hong Kong or Singapore or Brazil?" he said. "If so, how are we going to do this … and how is this going to interact with the rules in place in those other jurisdictions?"
The Commodity Futures Trading Commission (CFTC) is weighing whether to require strict adherence to Dodd-Frank rules beyond US shores if there is a connection to a US entity, but this has worried many European regulators who argue the concept of mutual recognition should hold sway. Under mutual recognition, for instance, a US overseas branch could be subject to local laws as long as they were designed to achieve roughly the same outcomes as the laws in the parent's home country.
Pearson was asked whether, if the CFTC pulled back on its plan for extraterritorial application, Europe could as well. He said he believed in symmetry and that this was the basis of diplomacy and negotiations.
"We have the means to do this, we have provisions in our European law that says we have the flexibility to take decisions to make sure the global system works. The question is, does the CFTC have similar mechanisms? The answer is yes."
The bottom line, he said, came down to whether the five CFTC commissioners were prepared to go down that route.
'Monsters in the darkness'
After Pearson addressed the conference, two other senior officials joined him in a panel discussion.
Edwin Schooling Latter, head of the payments and infrastructure division at the Bank of England, asked: "So what are the monsters out there in the darkness?"
He wondered if some of them might even be at the heart of the next crisis and he outlined what his top three issues were - margin models being too pro-cyclical, fragmentation in the clearing arena and CCPs' own risk planning.
Meanwhile, Piebe B. Teeboom, a senior policy advisor for the strategy, policy and international affairs division at Dutch regulator AFM, voiced his concern over the political hijacking of the regulatory discussion and the need to ensure there was a balance between achieving investor protection and ensuring healthy market activity.
Schooling Latter said markets were moving to a world that relied on margin collateral for protection against counterparty credit risk. "My worry is that the models used to calculate that margin requirement are too pro-cyclical," he said. "Why do I worry about that? We see a lot of discussions, a lot of lobbying, motivated by the desire for margin efficiency, which means low amounts of margin."
Schooling Latter said it was important that sane and conservative margins were set in good times, so that those who provide margin are protected against liquidity risk when things go wrong. The question participants should be asking CCPs should be not how low the margin requirement was, but how stable it would be when prices became more volatile, he said
His second big worry was that central clearing itself became more fragmented, which was more likely if fears about dealing with different jurisdictions were not addressed.
"We don't want to replace a complex, opaque, interconnected network of big dealers with a complex, opaque, interconnected network of CCPs. One of the fundamental risk benefits that a central counterparty brings is multilateral netting. If everyone's using different CCPs, you can't multilateral net with the same effectiveness," Schooling Latter said.
Finally, he was concerned about the need for sound risk management.
"It's not just about reducing the probability of failure. It's also about having a plan for when failure does occur," he said. "CCPs cannot eliminate risk, but they can find better ways of managing it and distributing it. CCPs have failed in the past and we must have plans for what happens if they fail in the future. Anyone who uses a CCP must know what that plan is. "
Teeboom said that AFM wanted to strike a balance between achieving greater market transparency and recognising the importance of market efficiency and competition.
" In those terms, what's really concerning, or really frightening sometimes, is that some of these rather technical things get hijacked by political discussions and that due to the nature of those discussions, an inappropriate structure is pushed upon a certain part of the market that, you know, is actually meant for another part," he said.
"From our perspective, as members of EMSA working with all of our European colleagues, we of course have an interest in having the European market work appropriately, and obviously a lot of that has taken place here in the UK. And what concerns me sometimes is that people tend to think from their own particular market structure but do not see the whole picture," he said.
He added that such people did not sufficiently recognise the need for a place where there could be sophisticated bespoke trades. "You shouldn't regulate that away because we need it."
The result, he said, is that rules are drafted based on how some people want the market to work rather than how it does work.
"There is a clear need to regulate non-equity instruments better, but at the same time you should be aware of differences that they have in terms of their characteristics, the ways that they are traded, the means that they are used by financial market participants. So applying an equity market structure, one on one, on those types of instruments, to our mind is not the right approach. "
Nonetheless, the European Commission's Pearson struck an optimistic note in his address.
"Do we know what we're doing, are we fully confident that we prepared, are the regulators confident that they don't have to improvise again as they did in 2008 and made up the rules as the incidents unfolded over 24 hours in separate banking failures," Pearson said. "I think the answer is yes."