"Risk in a Networked Economy"Keynote Address by Shane Tregillis, Assistant Managing Director, Monetary Authority of Singapore at the FOW Conference, 16 September 2003
1 I commend FOW for organising the 10th Asia-Pacific Derivatives Conference in Singapore. As has been the case for the past 9 years, the regional derivatives industry will greatly benefit from the quality of exhibitors and speakers at this annual conference.
2 My theme today is "Risk in a Networked Economy".
3 It should be no surprise that as a regulator, my talk at this conference should be about risk. Like most regulators around the world, MAS is concerned to understand the risks posed by the institutions we regulate.
4 But why a focus on networks? The recent power failures in the US and Canada of 14th August this year are a stark reminder of the realities of our networked world and its consequences. The grid failure in one distribution node somewhere in the United States left Canada's capital Ottawa, its financial hub Toronto, its primary industrial corridor and about a quarter of the Canadian population in the dark for more than a day. The impact of the cascading failures across the network was sobering. Power supply was disrupted for millions of people in 8 States.
5 The currency crises in emerging markets during the decade of the 1990s further illustrate cascade effects across networks. First the Mexican crisis in 1994-1995, the Asian currency crisis 2 years later in 1997, the Russian ruble crisis of 1998 and then the Brazilian crisis of 1998-1999. Transmitted through trade and financial system linkages, the currency crises spread from one country to another.
6 There are clearly huge efficiencies in global networked systems. But, as these and other episodes illustrate, there are also new risks with potentially serious spillover effects.
7 So it is no wonder that there is a current buzz about network theory. A buzz that can be seen from the rapid diffusion of the economic and scientific research on network theory into popular science publications such as Albert- Laslo Barbieri's "Linked: the new science of networks" and " Six Degrees: The Science of A Connected Age" by Duncan Watts.
8 Network theory is also now appearing in the management literature: always a sure sign that high academe has come down from its tower and hit the streets.
9 So what is a network? what are the features of networks and can this help us better understand financial sector risks?
10 At its most simple a network is a series of links and nodes. Recent studies on network theory tend to show that many real world networks self-organize into complex hub-based networks where a few nodes will have many connections, with most nodes having only a few links.
11 These features are readily observed in the financial sector where complex, overlapping hub-based networks based on geographic, institutional and other characteristics are common. A securities exchange is a classic example of a network hub where links among multiple buyers and sellers converge at a specific node. An increase in density of the links to the node (the exchange) creates positive benefits for all participants - captured in the concept that liquidity creates liquidity: clearly illustrating the concept of positive network externalities.
12 Looking at the financial system in network terms focuses our attention on the robustness of the network as whole, what factors could result in serious network disruptions, where are the risks in a networked system and what is the best way to mitigate and control these. Network theory is both comforting and disturbing at the same time.
13 It is comforting in that some of the work clearly shows that multiple hub-based networks are very robust in the face of random failures. This seems to be borne out for the financial system. Despite some high profile failures of institutions, the steep downturn in equity markets post the high tech bubble and other external economic shocks, the financial system has proved remarkably robust to date.
14 But it is also disturbing as it confirms the commonsense notion that a failure in a hub where there are dense connections can result in serious failures of the network itself.
15 Traditionally, the key hubs in the financial system have been the large investment and banking institutions engaged in multiple activities in many locations across the globe. And this remains the case. So regulators continue to pay special attention to these institutions.
16 But increasingly regulatory effort is also directed to other critical network hubs, for example, clearing organisations that are at the centre of dense transaction linkages in the domestic and global clearing and settlement process. Current work of the CPSS-IOSCO is on developing global risk management standards for such central-counterparties. MAS is the co-chair and actively involved in this work.
17 But September 11, the potential to un-bundle activities and events such as the electricity network collapse in the US have also reinforced that the financial sector transactions operate within a more complex layering of other networks, located in distinct geographical hubs. In this world it is important to not only focus on the key hubs of activity since the links also matter.
18 We now more clearly appreciate that the transport, power and other basic physical infrastructure are critical links underpinning financial sector activities. In many jurisdictions, including Singapore, regulators have been mapping these key linkages, and our BCP planning now extends to encompass the wider physical and human infrastructures that support the operations of our financial Institutions.
19 We are also looking more closely at the links within and between firms. One example of these types of important links arises from the trend to outsource functions to different locations as entities strive for increased economies in a more demanding environment. As regulators we need to better understand the details of the outsourcing agreements, the transaction and information flows, the technology that facilitates the links and what this might mean for the risks faced by the regulated institution.
Unique Characteristics of the Financial Sector
20 The financial sector has some unique characteristics as a network. For a power grid, the commodity that is sent across the network is electricity; for transportation networks, these could be passengers or airplanes; for the financial sector, most often the commodity transferred is risk itself.
21 The great innovation of financial derivatives is that they allow firms to disaggregate and trade risk separately from the underlying financial instrument or commodity. Ideally, this means those less able to bear these risks sell them to those that can -- thereby creating a more efficient and sound financial system. But this all depends on whether ex post these risks do end up with those best able to manage them. The current concern of some regulators is that increasingly this might not be the case.
22 Some of you may have heard about a computer program called Netmap that visually maps complex network relationships across multiple dimensions. I have seen it used for investigation purposes, and it is impressive.
23 It is interesting to speculate what a global Netmap would show if it were possible to map risks in the global financial system as a whole. Would the cluster of risks map onefor-one onto those institutions with the strongest capital and risk management capabilities, or would we see some unexpected clustering of risks?
24 The problem is that for regulators a global Netmap system does not exist. So it is not always easy to have a clear picture of where the concentrations of risks are in the system, especially as risk transfer products become more complex and sophisticated.
25 For example, the Bank of International Settlements (BIS) drew attention in its annual report in June 2003 to the huge growth of credit-risk transfers, shifting risk from banks to the buyers of securities and loans, and on to the sellers of credit insurance. From a few billion dollars worth of loans passed on through credit risk transfers in the early 1990s, the figure has grown to an estimated US$2 trillion by 2002.
26 There are some concerns that the large banking institutions have been hedging their credit exposures by selling the risk to others such as investment companies and investment funds. One concern is whether the net recipients of these credit risks, that is the insurers and investment funds, have similar specialized credit expertise to that of the banks.
27 Moreover, the transfer of credit risks has taken on an international dimension. Before the introduction of instruments such as credit default swaps, collateralized debt obligations, credit linked notes and the like, credit risks were largely confined to institutions in the domestic financial systems where they arose and where domestic regulators could monitor them. With the growing popularity of credit derivatives, such credit risks can be transferred across national borders, and borne by foreign institutions (regulated by regulatory authorities) that may not have the best knowledge of local conditions.
28 But, we need to keep these concerns in perspective. Many commentators also argue that credit derivatives have lowered the degree of contagion posed by recent financial shocks by dispersing the risks more widely throughout the financial system.
29 MAS, for its part, will continue to monitor the use of derivatives, including credit derivatives, in the Singapore market in line with our oversight of the financial markets and institutions. In the recent July 2003 revision of banking statistics collected by MAS, a new requirement was put in place to collect information on the gross and marked to market values of all derivatives used by banks, including credit derivatives, on a monthly basis. When this takes effect in March 2004, it will allow MAS to have a better understanding of the risk and derivative exposures held by banks in Singapore.
30 Going forward, regulators may need to examine more closely the techniques adopted by financial institutions to hedge credit risks arising from their credit protection sales to banks, and ensure that insurance companies and other net sellers of credit protection have comprehensive systems to better assess their credit risks.
Recent Regulatory Developments in Singapore
31 I mentioned previously in passing the role of geographic hubs. Singapore's financial sector is not only domestically oriented but also serves as a regional and, in some areas, as an international hub for financial sector activities. MAS has been focusing on the resilience and robustness of our financial system in Singapore. We have undertaken several initiatives to strengthen the governance and risk management capabilities of our regulated financial institutions. We have also been updating our legislative and regulatory framework for capital market regulation.
32 I will briefly mention a few initiatives that MAS is undertaking relating to the regulation of markets and clearing facilities for derivatives. MAS will soon be seeking feedback on the second phase of amendments to the Securities and Futures Act in 2004. The consultation paper will include proposed amendments arising from our review of the legislative framework for exchanges, trading platforms and clearing houses.
33 MAS' oversight of clearing facilities under the SFA is currently restricted to facilities that clear securities and futures contracts that are traded on exchanges or other organised trading platforms.
34 But with the increasing use of standardised OTC contracts, clearing facilities for these contracts have emerged. These facilities pose risks similar to those of facilities that clear exchange-traded instruments. We consider it prudent for MAS to have the power to regulate such clearing facilities operating in Singapore or targeting Singaporean investors where they pose risks to MAS' regulatory objectives. The amendments to the SFA passed by Parliament recently will allow MAS to do this.
35 The MAS consultation proposals relating to exchanges and trading platforms are aimed at better focusing the scope of the SFA. Our objectives are to foster investor confidence, minimise systemic risk, and facilitate efficient capital flows and risk transfers. The efficiency and quality of the price interaction process are at the core of these objectives. MAS is proposing to refine the definition of markets in the SFA to regulate only those trading platforms that perform a price interaction function. This will include platforms that pull together or consolidate multiple single dealer bulletin boards where they perform a price interaction function.
36 Trading platforms involving OTC derivatives are not currently regulated under the SFA. The SFA's regulation of derivatives extends only to exchange-traded futures contracts. While complex and bilaterally negotiated trades remain a significant feature of OTC trading, there has been a trend towards standardised terms and centralised electronic trading. MAS will consult on our proposals to regulate platforms for the centralised trading of OTC derivatives where they perform a price interaction function. We will continue to exclude from our regulatory framework OTC markets where price interaction does not take place, for example, where contracts are tailor-made and negotiated bilaterally outside an organised exchange or platform.
37 We will also propose changes to the regulatory framework for clearing facilities. Our key objectives in regulating clearing facilities are to ensure their safety and soundness, and reduce systemic impact in the event of a default or failure. However, not all facilities that engage in clearing and settlement pose risks to these objectives. Technological developments have made the value chain of clearing and settlement longer, more easily outsourced and more difficult to define with precision. For example, facilities that simply perform a trade confirmation function are unlikely to pose systemic risks even though they form part of the clearing and settlement value chain. We therefore are considering introducing a designation approach for the regulation of clearing facilities.
38 Under this approach, entities seeking to engage in the clearing and settlement of securities and futures contracts need not apply to MAS for approval before commencing operations. Only facilities designated by MAS will be regulated under the SFA. Facilities identified for designation will be those that are considered important in terms of financial stability and public confidence following an assessment of the nature and extent of the risks posed by the facility.
39 I would strongly encourage you to give us your views and comments on these proposed policy changes that will be released for public consultation over the next few weeks.
40 The Singapore derivatives and risk management industries have done remarkably well over the past 20 years. Turnover on SGX-Derivatives Trading for the first eight months of 2003 is already up by 7.7% compared to the same period last year, which was already a record year. This puts it in a good frame as it marks the 20th year of the founding of SIMEX next year in 2004. I commend SGX-DT for trading a diversified range of financial products catering to the risk management needs of institutions not only in Asia but also globally.
41 The derivatives markets continue to innovate and develop. For example, credit derivatives have developed rapidly and provide many useful ways for market participants to better manage credit risks and take positions in a range of products and markets. These are positive market developments that we encourage. At the same time it is important that all institutions involved in our increasingly networked financial system have a good understanding of the risks involved and the capabilities to manage them.
42 We will continue to work with market participants to ensure that our supervisory approach promotes high standards of risk management while at the same time facilitating financial sector innovation and growth in Singapore.
43 I once again commend FOW for organizing this challenging conference program, and wish everyone a successful conference over the next few days.
44 Thank you.