Yes; they are derivatives that would not complicate the resolution of a failing bank. They would not complicate it because they are relatively straightforward to value. As the noble Lord can imagine, some derivatives are extremely difficult to value. If I can just slightly elaborate on that, the excluded activities and prohibitions order limits ring-fenced banks to selling forwards and futures, plus a small range of options. They may only sell derivatives to hedge against three types of common business risk, namely currency, interest rate and commodity risk. Those are the most common business risks in which the market for derivatives is most liquid and, because it is liquid in those areas, it is easier to value them. To ensure that derivatives do not have any of the features that make them hard to value, the order requires that options contracts entered into must specify the amounts that may be bought or sold under the option, be at a specified price, and exercisable on a single specified day; or, in the case of interest caps or floors, interest rates must be based on a specified principle sum for a specified period.
The order also requires that ring-fenced banks may only sell derivatives that can be valued on the basis of observable market data or of a type traded on exchanges, and whose fair values are based on level 1 or 2 inputs under international financial reporting standards. Such instruments are more liquid and could be more easily valued in resolution. Article 12 of the order creates those safeguards, as well as placing caps on the net market risks of the derivatives portfolio, the gross size of the derivatives portfolio and the proportion of the portfolio that can be made up of simple options. I hope that that has gone some way to satisfy the noble Lord on that front.
The noble Lord asked about consultation. Consultation was issued in July last year, and the summary of responses was released in December of last year. We also consulted widely with stakeholders, including the Association of Corporate Treasurers, the CBI, non-financial companies, law firms and, of course, the banking industry itself. As a result of that consultation, we have made some changes to the legislation that are largely technical, but which will ensure that ring-fencing is fully compatible with the needs of UK businesses. For example, we made some small changes to the definition of “simple derivatives”, made it permissible for ring-fenced banks to have exposures to non-systemic insurers, made a series of technical changes to ensure that exemptions for payments and trade finance are operable, and removed the caps on payments and trade finance exposures. We also prohibited ring-fencing banks from having branches in the Crown dependencies. Therefore that is relatively technical stuff, but it has improved the legislation and has been a good exercise.
The noble Lord asked how the supervisors would supervise. The PRA is the principal supervisory body. It is in day-to-day contact with the banks. If it feels that it is not getting adequate information from the banks, it has extensive powers to require further information from them if it has any specific concerns. If a generic problem were to arise, it would obviously be in a position to discuss with the Treasury whether any further changes were needed in terms of the secondary legislation or in any other respect.
As to the question of timing, as the noble Lord said, the end point for the final implementation of the ring-fence is 2019. The justification for that is so that we can get all the secondary legislation done by the end of this year, which we expect to be able to do. The PRA then has to produce very detailed rules to make sure that the system is clear and works in the way that we wish it to do. On the basis of both the primary and secondary legislation, we estimate that it could take up to two years for all those rules to be finally in place, and then a final two years for the banks to implement the rules. That does not mean that the banks will not do anything in the mean time, because making this change obviously involves them in a huge amount of effort, activity and cost, so they are beginning to think about how they are going to do it. We have always thought that this timetable is measured and proportionate. The very fact that the banks know that we are moving in this direction means that some activities that they might have undertaken in the past they will not undertake in the interim period because they know what the new rules will be and that they will abide by them.