Ringing in the New Year

It is an interesting assignment, to say the least, when one has to write an article welcoming the New Year during a period of severe economic crisis, which the Nobel Prize winning economist Paul Krugman has described as a depression. The eurozone is making a desperate bid to shore up its defences against a debt crisis that threatens to take the global economy with it. The US is also coping with its fair share of debt related problems and it seems that 2012 would be a crucial year in its fight to control government expenditure.

The emerging economies have been the source of some cheer in the last few years since the financial crisis, but economies such as China and India are showing signs of over-heating and slowing down respectively. So what do we have to look forward to in this coming year? Actually quite a bit.

2012 offers a unique opportunity for the global economy and markets to address some of the imperfections that have plagued it for a number of years. Let us start with the reforms of the over-the-counter (OTC) derivatives markets.

In 2012, most of the regulation related to the Dodd-Frank Act (DFA) will be complete in the US, and the regulations would put in place a mechanism to effectively control the counterparty and systemic risk due to OTC derivatives. This is easier said than done, as a few years’ worth of regulation is going to be compressed into a few months.

The recent MF Global default has also put a question-mark over how much the global financial system can rely on exchanges and clearing houses to do its dirty job of controlling counterparty risk. But what the DFA and associated regulations will do is to force market participants to become more transparent in their dealings, particularly through the use of electronic trading platforms, clearing houses and trade repositories. The level of accountability built into the system is going to rise and it will be easier for the regulators to be able to keep tabs on the market on an ongoing basis, as opposed to merely hoping that it functions as desired, and then picking up the pieces when it doesn’t live up to expectations.

In Europe, the European Market Infrastructure Regulation (EMIR) is expected to bring about a similar effect. However, it has still not been passed as a law and will be implemented only by the end of 2012 at the earliest. Taking their cue from the leading markets, a number of regulators worldwide, including in markets such as Japan, China, Brazil and Korea, have begun to reform their own markets. New regulations and OTC derivatives clearing houses are already in place in markets such as Singapore and Japan. Hong Kong will also see a new clearing house begin functioning from end-2012.

Australia, however, has taken an interesting approach and has chosen to use the leading global clearing houses, such as LCH.Clearnet in the UK, for its OTC derivatives clearing requirements, as this would help it to tap into the available economies of scale and achieve greater cost efficiency.

Leading Financial Centres

The coming year is expected to be interesting from the point of view of the leading financial centres as well. The emphasis on the back-to-basics approach in the financial markets means that market centres such as Hong Kong, which has been one of the leading global initial public offering (IPO) markets in recent times, are coming to the fore. The advantage of being seen as a gateway to China has meant that Hong Kong is going to be a leading financial centre for some time, or at least until cities in mainland China such as Shanghai and Shenzhen take their rightful place in the global elite as the gateways to the burgeoning Chinese market.

On the other hand, a financial centre that has been considered to be a global leader for some time and has close ties to Hong Kong, is under stress. I am, of course, referring to London. The opting out of the recent European treaty by the UK meant that the country could be sidelined when the European economy does begin to recover. Also, due to the recent anti-UK tilt in European political and economic circles, it is possible that the UK would have to wage a losing battle to retain the domination of London over the continent’s financial markets.

For years, politicians in countries such as France and Germany have seen financial market jobs move to London. Now they have opportunity to strike back, and they are doing so through advocating tough regulations aimed at reducing risk in the financial system, such as those for hedge funds and high frequency trading. But besides being a means to reduce risk, these regulations would also be a medium to reduce London’s supremacy in the financial services domain. UK Prime Minister David Cameron may have opted for a short-term ploy to avoid a financial transactions tax when he refused to sign the European treaty, but in the long term his country faces an uphill struggle if it stays out of the EU, or just barely within it.

Moving onto a related topic, the increasing focus on high frequency trading (HFT) in both the leading global markets means that the global brokerages and buy side would have to become more vigilant regarding their HFT activities. In Europe, the European Securities and Markets Authority (ESMA), the capital markets regulator, has come out with guidelines for HFT. These include close scrutiny of the specific algorithms that firms employ in the market, something that the firms are wary about.

In the US as well, the Commodity Futures Trading Commission (CFTC) is in the midst of a process to define HFT and finalise relevant rules. This is being mirrored by regulators globally who are well aware of the tide of public opinion that is coming out against HFT which, rightly or wrongly, is being seen as a cause of greater volatility as well as instability, particularly in the equity markets.

In banking, the banks in the leading markets are preparing themselves for the Basel III rules. The various regulators are trying to bring their domestic banking guidelines in line with these rules, and the governments are trying to ensure that the domestic banks have sufficient liquidity in place to be able to meet the various reserve and other requirements.

One of the stated benefits of Basel III is that it is going to help GDP growth in the countries it is implemented in. I am sure that is one of the last things on the minds of the bankers. Right now, their sole concern is to ensure that they can meet the regulatory requirements, such as those related to risk and leverage, without sacrificing the profitability of their core businesses. But from a global and systemic point of view, the Basel III rules should help to make the global financial system more safe and robust.

From the point of view of a market participant in today’s capital markets, it does seem that if anything, there is over-regulation. However, a very important thing to remember is that after the financial crisis, there has been a period of great instability, volatility and uncertainty. From the common man’s point of view, the capital markets seem to have been policed inadequately. The ‘Occupy Wall Street’ protests and the various protests around Europe have shown the disenchantment of the average citizen with the corporate world and capital markets. In such a scenario, there is a need to increase transparency and accountability across the globe and that is what some of these regulations are intended to achieve.

2012: A Potential for Stabilisation

Hopefully, in this year we will achieve some of these desired objectives and address the difficult issues such as the debt crises that erupted in a number of economies. Once there is some more stability, 2012 could also be the year in which economic growth would once again return to the agenda.

In the last month of 2011, the US economy has proven that it is resilient. China has taken measures to account for possible over-heating such as controls in the real estate market. India also seems to be recovering from the worst of the recent inflationary period. Europe certainly is heading for a period of upheaval before there can be any recovery, but the positive is that its leaders seem to be more capable now of taking difficult steps to solve these issues than they were a few months ago.

We are not out of the woods yet, but the direction seems to be the right one. The coming year will not completely solve our problems, but it will go some way in being a part of the solution.


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