From the day it was launched in 2007, the Global Financial Centres Index has ranked London as the risk-management capital of the world — a distinction the city achieved in part because the Financial Services Authority (FSA) offered a “soft-touch” regulatory environment that allowed innovative finance.
Over the past few years, however, London has become known as the risk-management debacle capital of the world as well — emerging over the last year as ground zero for JPMorgan Chase’s multi-billion-dollar loss, UBS’s multi-billion-dollar rogue trader and the rigging of the London Interbank Offered Rate (LIBOR).
In late June, Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler accused London of providing a regulatory “loophole” where U.S. banks could carry out risky OTC trades, focusing attention again on London’s regulatory restructuring. That focus began two years ago after Chancellor of the Exchequer George Osborne announced he was breaking the FSA down into several individual entities — a reversal of the 25-year process that created the Authority from disparate entities. Gensler’s accusation raises the question of whether London blowups are a symptom of lax regulation or simply a result of London’s role as the world center for over-the-counter (OTC) derivatives trading.
“In a way, it’s both,” says Mary McDonnell, who runs McDonnell & Associates in Chicago. “London offered more flexibility on what you could trade, which meant that products came into existence there that regulators didn’t understand,” she says. “You could argue they wouldn’t have gotten so big if they hadn’t been lax on the OTC front.”
She points out that the City grew for a variety of reasons beyond just lax treatment of OTC derivatives. “For one, it allowed portfolio margining, which appealed to anyone who was trading any sort of energy book, currency book or anything that involved both futures and OTC stuff,” McDonnell says. “They could get a reduction in their futures margin there, which they couldn’t in the United States.”
Then there’s its location, which allowed for trading across the Asian, European and American time zones, leading to a concentration of trading talent that drove many U.S. banks, brokerages and other companies to set up trading and risk management in London while keeping their operations people at home — a development that McDonnell believes led to poor oversight from home.
“This is an industry-wide problem — the operations and risk people don’t talk to each other,” she says. “But it’s even harder to talk when you’re on the other side of the ocean.”
The UK ranked 16th in the Corruption Perceptions Index, with a score of 7.8 — that’s well behind squeaky clean New Zealand or Denmark, but also well ahead of the United States (rank 24, score 7.1) and France (rank 25, score 7).