Fireside Chat with Bank of Canada Governor Tiff Macklem

Well, thank you, Sonia. It is a real pleasure to be here. Sonia, you forgot to mention my most important accomplishment though over many years, and that was I was chair of the board of GRI when we hired Sonia. So look, it's great to be back and it's a real pleasure to be part of this risk symposium. It's wonderful to see such an impressive mix of market participants, policy makers, and practitioners.

And I am looking forward to our fireside chat. So, I'm going to try and keep my remarks short and leave more time for the conversation. I will say conversations like this matter, especially when uncertainty is high and we're all trying to manage the risks.

As we speak, the actions taken against Iran by Israel and the United States have increased volatility in energy and financial markets considerably, and there's a lot of uncertainty about the duration and fallout of this conflict.

My focus today though is going to be on some longer term changes we're seeing in the financial system. And I'm here today, as Sonia mentioned, really wearing two hats. Of course, I'm always Governor of the Bank of Canada. I am also chair of the Financial Stability Board's Standing Committee for the Assessment of Vulnerabilities, or as Sonia said, SCAV as we call it.

The role of SCAV is not to predict the next financial crisis and it's not to prescribe policy. The role of SCAV is really to step back and to connect the dots across markets, across jurisdictions to identify the systemic vulnerabilities. The goal is to understand the pressure points so they don't become fractures.

The global reach of the FSB complements the work of domestic regulators and central banks. It does that by giving us that international dimension. It also complements the work of the private sector. Market participants generally do a good job of managing the risk they face individually.

But systemic risk can build beyond the sightline of any single firm. We all have a stake in a well-functioning financial system that channels savings to productive investments and helps businesses and households manage their own risks. But to work well, the financial system needs a competitive marketplace. It needs clear rules and good information. And because money moves across borders, the perspective needs to be global with a degree of international coordination.

I'm going to start today with a quick overview of the broader risk landscape and then I'm going to dive in and go a little deeper on the growth of new players and in particular two areas of risk where SCAV has been paying a considerable amount of attention. First, leverage trading by hedge funds in government bond markets, and second, the rapid growth we're seeing in private credit. My goal is not to alarm, but it's to shed light on the systemic nature of these risks. It's to highlight the need to close data gaps, and it's to deepen understanding. The aim is not to impede the private sector. It's to help the private sector do what it does best, seek return while managing risk.

So let me start with the economic backdrop and the risk to the outlook. Despite trade disruptions and geopolitical risk, global growth has actually been quite healthy. The Bank of Canada's latest forecast has global growth continuing at about 3%. But risks are greater than normal and they look tilted to the downside.

Geopolitical risks are high with multiple conflicts playing out. Uncertainty about US trade policy also remains elevated. Global growth is being supported by a boom in AI and fiscal stimulus, but both could run into limits. Advances in AI and digital innovation have the potential to boost productivity and growth. But if the impact of AI is less profound or perhaps more disruptive than expected, growth could slow.

Fiscal flexibility is limited by high levels of sovereign debt and we are seeing term premium on government bonds has increased. In equity and credit markets, we're seeing compressed risk premiums and stretched valuations. This raises the risk of sharp reversals and increased volatility across asset classes.

These risks could also interact with vulnerabilities in the financial system. After the global financial crisis, we strengthened the regulation of banks and that made the system safer. As a result, riskier activities have migrated to non-bank financial intermediaries. And this growth in market-based finance has brought clear benefits. Diversified risk, improved access to credit, and increased efficiency.

But risks have not disappeared. They've migrated, too. And our global surveillance and regulatory frameworks haven't kept pace with the change. Our oversight was built for banking. Non-bank players generally don't have the same reporting requirements or levels of monitoring. That gap poses a challenge for global standard setters, national regulators, and central banks.

So with that backdrop, let me turn to two areas of rapid growth in non-bank finance that have our attention. And I'll start with leverage trading of hedge funds and sovereign debt markets. As governments around the world have issued more debt, non-bank financial intermediaries, particularly hedge funds, have become very large buyers of sovereign debt in many jurisdictions. They hold a large share of privately held government debt across FSB member countries. In Canada, they purchase up to 50% of government bonds sold at auction and they account for a big proportion of secondary market trading.

In short, they've become central to how sovereign markets function both globally and here in Canada. Their participation has important benefits. Hedge funds help distribute large volumes of issuance to end investors. They support liquidity and price discovery and as their name implies they hedge risks. Bond purchases are often covered by short positions in future contracts or interest rate swaps and that allows them to profit from small pricing inefficiencies. Now in normal times hedge fund participation makes the market work more efficiently.

The issue is what happens in times of stress. Hedge fund purchases of sovereign debt are usually highly leveraged. The funding is largely through repurchase agreements, repo markets, and typically it's very short-term. Globally, about half have an overnight maturity, and haircuts are low, zero or negative more than 80% of the time.

This leverage allows hedge funds to earn attractive return from small pricing discrepancies through basis trades and other relative value trades. This improves the efficiency of bond markets. But it also means the system is more sensitive to disruption. Higher funding costs or reduced access can force the positions to be unwound. Leverage can build up quietly and then unwind very quickly when conditions change.

One scenario we worry about is a shock to markets that leads to a spike in interest rate volatility which causes lenders to increase haircuts or curtail funding. And because repo funding is very short-term, that adjustment can happen very fast. If leveraged investors are forced to reduce their positions, they may need to sell sovereign bonds into already stressed markets. Prices fall, liquidity deteriorates, and stress feeds back on itself.

We've seen examples of this already. The dash for cash at the start of the pandemic, during the UK gilt crisis in 2022, and during the period of stress in Treasury markets last spring. The basis trade and other relative value trades are generally low risk for investors, but the scale of these trades and the speed at which they can unwind pose systemic risks. Short-term funding strains could cause severe dislocations in sovereign debt markets. And they are after all the backbone of our financial system.

And the cross-border nature of markets means that stress that begins in one jurisdiction could move to another. As hedge funds take on a growing role in government bond markets, it is increasingly important that they have robust funding arrangements and sufficient liquidity to weather periods of stress.

Public authorities also have some work to do. At the FSB, our first goal is to deepen understanding. That means better data on where leverage is building, how funding is structured, and how exposures are distributed across institutions and borders. And it means sharing this information across jurisdictions and with the private sector. Market-based finance is inherently cross-border. No single authority has a complete picture. So information must be pooled and shared.

There's also a need to strengthen infrastructure so that repo markets continue to function in periods of market stress and shocks are absorbed rather than amplified. Central clearing has the potential to both make access to repo funding more stable and to improve efficiency by increasing opportunities for netting.

Major jurisdictions are making important investments. The SEC has mandated that most Treasury collateralized repo transactions be centrally cleared by June 2027. The EU is also looking to increase the share of centrally cleared repos and the ECB will centrally clear some of its operations this year with through the cycle margining practices. This should improve repo market stability.

Here in Canada, the TMX is building a domestic tri-party repo solution. The Bank of Canada plans to use this infrastructure for its domestic repo operations by early next year. Additionally, once the TMX makes the necessary investments into its fixed income clearing infrastructure, we intend to centrally clear our own repo operations. This will make central clearing more attractive for market participants. These infrastructure improvements should also provide greater confidence that markets will keep working under stress.

Okay. The second area I want to focus on is private credit. What is private credit? Private credit is non-bank lending to firms and this includes direct lending by both large institutional investors and investment funds.

The market has grown quickly with a global footprint that now measures in the trillions of dollars. Growth in Canada hasn't been quite as fast, but Canadian pension funds and insurers are active, sophisticated players, and they have private credit exposures internationally.

Private credit fills real gaps. It provides financing to companies that may not be well served by traditional banking or public markets. It offers faster execution, more tailored structures, longer-term capital commitments, and greater flexibility for borrowers with complex or unconventional needs. It has increased competition in credit markets and broadened access to funding, and it's playing an important role supporting new investment cycles. Private credit is expected to be an important source of debt funding needed to grow AI infrastructure.

The issue is not with private credit itself. It's how private credit will behave under stress and the risks this poses to the broader financial system. And gauging those risks isn't easy. We don't have a lot of history. Private credit hasn't been through a full economic downturn. Like public and bank credit, it carries risks involving credit quality, underwriting standards, and the amount of total leverage taken on by firms.

But private credit is also intrinsically more opaque. Unlike public credit markets, private credit positions are not regularly marked to market. Assessing underwriting standards, covenant quality, and the true degree of embedded leverage can be difficult. Liquidity is also more limited. There can be a mismatch between investors' desire to exit and funds' ability to accommodate that.

Further, it can be hard to connect the dots across the system, both within the private credit sector and between private credit and the rest of the system. The opacity of private credit means investors may not have enough information about the quality of the loans held in their funds. A spike in defaults could prompt them to try to exit their positions quickly. This could cause severe strains, including spillovers to public credit markets.

Again, as with hedge funds, the concern is how stress in private credit could transmit to the core of the financial system. Banks and issuers are linked to private credit through lending, sponsorship, warehousing, and risk transfer. That means weaknesses in private credit could spill back into the regulated sector. And because private credit is increasingly global, those spillovers could travel across borders.

We've recently seen a few signs of strains in private credit markets. Although the recent high-profile defaults were contained, they have raised questions about the quality and transparency of underwriting.

At the FSB, we're working to improve understanding and the monitoring of private credit. Regulatory authorities need visibility into leverage, liquidity transformation, and underwriting practices. And we need to understand the interconnections between private credit and banks. Surveillance needs to be enhanced so we can monitor how risks evolve as this market grows. That includes tracking cross-border exposures, funding structures, and the potential for correlated stress across institutions and jurisdictions. And once again, global coordination is critical. Private credit sits at the intersection of markets and institutions. So we need cooperation across authorities and across borders.

Okay. I'm looking forward to the discussion. So, let me wrap up. The rise in non-bank players in global debt markets is not a problem to be solved. The growing participation of hedge funds and private credit in global finance is part of a healthy financial system.

New and rapidly growing players bring risks and vulnerabilities that need more attention. Risks may be growing faster than our ability to understand and mitigate them. Economic uncertainty is already high. We cannot afford to add financial instability to the mix.

We are counting on the private sector to be the first line of defense. And as we gain understanding of the systemic vulnerabilities, it's critical that we communicate with you. And we need to work hand in hand to strengthen core financial market infrastructure. Together, we can raise awareness and build resilience. So when the stress comes, because when the stress comes, we all need to be ready for it. Thank you very much.

It's a risk institute. They've got a backup plan.

Okay, good question. So to explain SCAV, maybe I just give you a snapshot of the FSB. So there are, this is a bit of an oversimplification, but there are three key standing committees at the FSB. There is SCAV, the Standing Committee for the Assessment of Vulnerabilities, and as its name suggests, it's about looking at the risks and the vulnerabilities in the global financial system. The second one is the Standing Committee for Supervisory and Regulatory Coordination. I think of that as the policy committee. Where there are risks, vulnerabilities, SCAV might refer those to the policy committee. I chair SCAV. Michelle Bowman at the Fed chairs what's known as SRC. And then the third committee is the Standing Committee for Standards Implementation. And what that does, it assesses how well countries are implementing the standards that have been agreed and what sort of impacts those are having. So you can think of, you know, it starts with vulnerabilities, then there's policy, and then there's implementation.

So coming back to SCAV, yes, I mean, I would say the focus is more macro-financial and it's more systemic. We're particularly interested in how vulnerabilities in one part of the system could have knock-on effects, spill over and spread to other parts of the system. There's obviously an important international dimension. And I have to say, to me that is one of the real values of the FSB. You know, as you know, domestically, hopefully you have pretty good line of sight within your border, but it's hard to have line of sight beyond your border. And so being able to connect what's happening here with what's happening elsewhere is hugely important. And obviously there are big international players that are here operating in Canada or investing, trading in Canada. Having that line of sight is critical.

As I said, it's not about trying to predict the next crisis. SCAV's job is not to prescribe policy. Where we do see issues, we can refer it to the policy committee of FSB. They're also the standard setters. I'm certainly in contact with the Basel Committee for example. And what I would stress is the post-GFC reforms have strengthened the resilience of the financial system. And I think despite everything we've been through in the last number of years, the financial system has held up very well. But the system is changing. It is evolving. That's a good thing. But we need to keep up. We need to make sure we understand those risks. You need to make sure you understand those risks. And that's where the FSB, I think, can play a role.

We do have, SCAV does have regular outreach with the private sector. In fact, we had a meeting here last fall. I brought in a number of leading hedge funds and private credit players here in Canada so that we could hear directly from market players. And where you'll see things from us, we just published a what we call a deep dive study, it's probably a 30-page study on repo markets. And so there's a lot of, it really does connect the dots globally. I learned a lot as we undertook this work. And yeah, so I mean, I think you want to sort of watch the stuff that is coming out of the FSB.

Well look, I think it's a real issue. I think certainly from the perspective of the FSB, Andrew Bailey who's chair of the FSB, I chair SCAV, we are committed to strengthening the surveillance function. I think look, the reality is we're in a world that is more uncertain. There are more risks. Against that background, there is going to be a real premium on understanding the systemic nature of those risks. And the reality is there's not going to be a regulatory response for every problem. The pendulum for one thing is kind of swinging away from regulating everything to taking a more targeted approach. That means we're going to be relying importantly on the private sector to be that line of defense. And the basics of risk haven't changed, you know, leverage, capital, liquidity. But the system has become, there are new players that is making the system more complicated. It's bringing benefits, it's bringing diversification, it's creating new access. But it is also bringing new complexity. It's also creating new interconnections.

And the reality is as it becomes more complex and there's more interconnections, it can be easier to hide leverage. That puts a premium on your due diligence. Make sure you really understand the risks that you're taking. Think about not just how things are working in normal times, but think about times of stress. I know you do, but think not just about, don't think about that narrowly. Think about what could the knock-on effects be. So, we I think have an increased responsibility to try to understand those. We get it. It's hard for you as an individual firm to have that macro-financial perspective to see those systemic consequences. So that's our focus and we will be doing our best to uncover those and to communicate with you. Look, we're going to have to become more nimble. World's changing faster. We got to catch up. We got to keep up.

Yes. So, yeah, I can tell you from experience, if you're in the regulated sector, you bemoan the new players. If you're the new players, you bemoan the incumbents. So yeah, there's a lot of bemoaning. Look, I think the reality is, you know, to go back to something I said, I don't think we see regulation as the solution to every problem here. There are real benefits to these new players and keep in mind, when we reformed, the post-GFC reform, they were deliberately trying to drive some of the riskier activities out of banking to other parts of the system. This isn't an unintended consequence, this was deliberate. What we need to make sure though is that they don't inadvertently come back into the core of the system.

Take private credit. One of the things you can see from the hairline cracks we've seen in private credit and those recent defaults is that the exposures to private credit are well known but actually banks also had direct loans to some of those players that are bankrupt. They also had revolving or funding some of the private credit players and they were also lending to some of the investors that were invested in private credit so they could take on leverage. So now these were very contained but it does show that yes there is a risk that things come back around. So we're, I don't think we're going to try to regulate market-based finance like we regulate banks. They don't take deposits. There's good reasons for that but we do need to make sure that when risks are diversified they are truly diversified and they are not spilling back and that gets back to trying to understand the linkages and the systemic consequences.

Part of that, and look, part of it is if we understand it, we share it, market players understand it, they take that into consideration as they manage their risks. Part of it has got to be also ensuring that our sort of core financial market infrastructure is evolving in line with the growth in certain parts of the system. So certainly the much bigger footprint of hedge funds in sovereign debt markets and the fact that they're funding a lot through repo markets that is putting a lot of focus on ensuring the infrastructure around repo markets is up to the task. So the, you know, I think before we, there are, I'm not saying there won't be any regulatory responses but given that there are important benefits, before you jump to regulation you got to make sure you really understand where the leverage is, who, where the counterparties, where are the potential spillovers. And that's really where we are.