My Lords, I will speak very briefly to the amendments tabled by the noble Baroness, Lady Worthington, because my noble friend Lady Bowles has set out the position very well.
I am concerned that we see, in parts of this new legislation, a very libertarian view of how financial markets should be structured. Even libertarians will say to me, “Look, it all works in the long run, but in the short run there are an awful lot of victims and collateral damage”. Because of that, we are asking the Government to go back and relook at the changes they are proposing. The developing world, including some of the poorest people, will suffer from the volatility of many commodity prices. Particularly where that volatility is artificially created, it seems to me that we ought to expect the regulators to play a disciplined and effective role.
While I must admit that most of this legislation is beyond my comprehension—the markets are extremely complex—I am rather concerned that regulators, whom the Minister herself has said have great expertise, knowledge and understanding, should not be in a position to apply those to ensure that there is no market abuse. I will leave it at that, because all that has been far better said by others.
My Amendment 27 in this group amends the Minister’s Amendment 26. It is another probing amendment, because I am not quite sure exactly what the Minister’s amendment says. My noble friend Lord Sharkey and I were both very involved in the Financial Services Act 2012, which set in place the framework for regulation of behaviour by central counterparties. That was after the 2007-08 crash, which was, as much as anything, a severe liquidity crisis. The chaotic nature of the derivatives market meant that no particular financial institution knew whether the financial institution with which it would normally do business was about to collapse, because, in turn, it had complex derivative products with yet another financial institution that was about to go under.
I am very supportive of the decision that was made, obviously at a global level, to channel virtually all financial derivatives, particularly the standard ones, through central counterparties. The largest of those central counterparties was of course the London Clearing House. I think we all recognise that, in doing that, a great deal of risk cumulated at the central counterparty. That is mitigated by the central counterparties themselves by requiring collateral.
However, to give the Committee a sense of the size of this market, I was looking at a typical number for outstanding financial derivatives on any one day. It is approximately $600 trillion, so it is vast, and a good part of that is now run through central counterparties. The problem is that there is not enough quality collateral in the whole wide world to meet margin calls from the various central counterparties, even after they have gone through a compression or netting process, which of course was led by London. Part of the reason that London is so dominant in this arena is that it has such a large market share.
The way in which the sort of fiction works—that collateral sits in place to cover risk—is that low-quality collateral can be used in these cases through a mechanism of discounting it for its embedded risk. Frankly, there is a point at which you can discount junk as much as you like but that does not turn it into high quality. It might do so on paper or by calculation, but it does not in reality, so there is always a weakness and high risk at the central counterparties.
In that 2012 legislation, we were attempting to put in place a resolution mechanism for the moment when central counterparties went sour. It is easy to put a resolution mechanism in place when a single member fails, because the other members of the central counterparty bloc are usually in a position and have sufficient financial strength to step in, and there are requirements under that resolution waterfall to be able to do so. But when the problem is at a systemic level, the waterfall does you no good at all. Most of the amendments here are meant to strengthen the waterfall, but the reality is that when there is a systemic problem, the waterfall collapses in a matter of seconds—and the ultimate backstop is, basically, the taxpayer. With the numbers that I am talking about, your Lordships can see that the exposure for the taxpayer is very significant.
All central counterparties across the globe, no matter where they are located and what rules they sit under, tend to have exactly the same membership. So if one CCP goes, you can pretty much count on all the rest of
them going. In that environment, I am trying to understand the changes that the Minister is bringing forward under Amendment 26. I had understood that it was the Treasury that gave equivalence status to third-party central counterparties—I could be wrong because I am so out of date—if advised by the relevant regulator, which in this case would be the Bank of England. If I understand Amendment 26 correctly, it effectively extends the equivalence recognition to EU CCPs from one year to three years and six months. That is in primary legislation and we can make the decision whether we think that is appropriate.
I am rather troubled by proposed new paragraph (4), to be inserted by proposed new sub-paragraph (3) in Amendment 26, which says:
“The period determined by the Bank of England in a particular case”
under the rule I just described
“may be varied by the making of a subsequent determination.”
Can the Minister help me understand what on earth that means? Does it mean that equivalence can be extended by a decision of the Bank of England, say from three and a half years to 10 years? Does it mean only that the Bank of England could shorten the period of equivalence recognition and that it is limited by the three years and six months? I can see no way that there is any mechanism at all for scrutiny around this issue, even though it can represent a very serious chain of risk.
I just need some help to try to understand what power is being given to the Bank of England. It is a little like the previous question on the earlier amendment. What exactly is this power? What does it enable the Bank of England to do? What kind of scrutiny is there? Is there a sunset clause to it? How open-ended is this? I am just trying to understand those implications, so I would be very grateful if I could have the Minister’s help in doing that.
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