Evolution of Financial Market Infrastructure Governance

There are institutions upon which the functioning of society has come to depend. Many of these exist outside the realm of general consciousness. But recent events have shaken the collective conscious awake to our dependence upon institutions of which many had not previously been aware. The Society for Worldwide Interbank Financial Telecommunications (SWIFT) is one such institution, and its use as a geopolitical weapon has highlighted how organisations that enable the financial markets to run smoothly are critical to the world we live in. People who may have been only vaguely aware of SWIFT’s existence, will feel its absence in a multitude of tangible ways.

SWIFT is the main system through which banks communicate with each other, but there are other, lesser known, ‘back office’ infrastructures that are also of fundamental importance. Some of the most critical are Financial Market Infrastructures (FMI) (by which we mean central counterparties (CCPs) and central security depositories (CSDs)) which are often described as the ‘plumbing’ of the financial markets. CCPs protect transacting parties from counterparty default by interposing themselves between buyers and sellers. They also allow parties to net off their positions against each other to reduce the overall number of transactions necessary. CSDs provide a process through which delivery and payment obligations can be simultaneously discharged and keep a reliable record of securities ownership and rights. These FMIs handle a mindboggling volume of clearing and settlement traffic daily, and any failures or interruptions could transmit major shocks throughout the financial markets. Their size, centrality and interconnectedness make it vital that these technology-heavy, systemically important institutions are well run.

It has become the orthodoxy that regulation has a role to play in marshalling effective corporate governance. This has been the subject of much study in relation to corporations and banks but little attention has been paid to FMIs. In a recent paper, we look at how corporate governance in European FMIs has evolved and how it may continue to evolve in the digital transformation. In doing so we identify a number of areas which deserve regulatory attention.

In Europe, the regulation of FMIs began just over a decade ago in European Market Infrastructure Regulation (EMIR) which was a necessary response to the mandatory usage of CCPs following the financial crisis. Central Securities Depositories Regulation (CSDR) followed soon after. Governance aspects of EMIR took inspiration from governance regulations already in place for banks and CSDR followed suit. Consistency in regulation is desirable but only in so far as the problems being addressed are also consistent. Banks and FMIs differ in important ways, such as their orientation towards risk, their public interest imperative and the level of competition in the market. These differences remain true even in relation to the FMIs that hold banking licences, because such licences are for limited purposes ancillary to their primary clearing or settlement activities. With these factors in mind, we consider how and to what extent governance strategies, which may have originated to tackle excessive risk-taking in banks, meet the requirements of FMI governance. We raise concerns about the appropriateness of variations (or lack thereof) in their respective approaches. For example, independent directors have long been a valued tool of corporate governance, but the balance between independence and expertise needs to be carefully weighed in the context of low public profile, complex, systemically important, technology heavy businesses such as FMIs. The independence requirements in EMIR and CSDR provide less flexibility than in the Capital Requirements Directive IV, applicable to credit institutions. However, when dealing with systemically risky institutions, the trade-off between independence and expertise may need to favour the latter, especially given the specialist and rare nature of the necessary skillset in FMIs.

Looking ahead into the short to medium term future, the pressures on governance begin to shift anew. FMIs are in the vanguard of pivotal developments in Fintech. A look at distributed ledger technologies alone reveals innovations that may prove transformative to the sector. Research and experimentation with distributed ledger technology is taking place across the globe and the sector. Use cases are abundant and include the Australian Stock Exchange (ASX) replacing their post-trade systems with a permissioned distributed ledger technology system, and the Bank of Canada’s Project Jasper, which has been experimenting with distributed ledger technology in clearing and settlement since 2016. Winners and losers will emerge from the current incumbents and new entrants. New operational risks will also emerge, particularly as systems are transitioned from legacy systems to digital ones. Regulatory adaptation is both inevitable and necessary.

There are important balances to be found between the profitable pursuit of existing business lines and new technological opportunities, and the need for resilience to withstand attacks and a robust approach to risk and systemic safety. Taking a corporate governance perspective, our research identifies some of the issues that will need to be addressed. We suggest there is an increasingly urgent need for FMI governance regulation to further evolve to ensure FMIs can respond and innovate as needed, whilst adhering to fluid public interest boundaries.

Eilís Ferran is a Professor of Law at the University of Cambridge.

Eleanore Hickman is a Lecturer at the University of Bristol Law School.