Imagine a scenario where a New York based real estate fund wants to hedge the foreign currency exposure arising from an investment in an Australian property using a derivative purchased from a European bank.

Prior to the 2008 financial crisis, this fairly typical derivatives transaction would be subject to little, if any, regulation. Following the financial crisis, this same transaction would potentially be required to comply with three separate regulatory regimes.

Because of the global nature of many derivatives transactions, regulators recognised the need to develop a coordinated, harmonious regulatory framework. While the G20 nations demonstrated a remarkable level of coordination in developing this framework, the actual implementation of OTC derivatives regulation has not achieved the same level of harmonisation.

In fact, the implementation of OTC derivative regulation across regulatory regimes has been plagued by inconsistent and sometimes conflicting requirements, and inconsistent implementation dates – each imposing increased burdens on market participants.

These results can be attributed to the fact that different regulatory philosophies, rule-making processes and competing priorities exist in each country. These differences have also contributed to the creation of a regulatory maze for market participants, increased costs and, according to some market observers, fragmentation of liquidity pools.

A couple of recent examples help to illustrate these points. First, in March 2015, the BCBS and IOSCO released a framework to impose margin on OTC derivatives. This regulatory structure would form the baseline of a harmonious set of cross-border margin rules that would be implemented globally beginning on 1 September 2016.

The intent did not come to fruition due to the fact that there are several significant differences between the rules both in terms of the scope of coverage and within the rules themselves. More importantly, not all of the regulators were able to implement the rules on time. 

The margin rules went into effect on 1 September 2016 in the US, Canada and Japan. However, these rules did not go into effect in the EU, Australia, Switzerland, Singapore and Hong Kong, among others. Market observers have noted that this implementation delay has led to a refusal of banks in these jurisdictions to trade with US, Japanese and Canadian banks to avoid having to post margin on their trades.

Substituted compliance

A second example is the mechanism designed to promote harmonisation across borders: substituted compliance. Broadly speaking, substituted compliance, or equivalence as it is referred to in Europe, is the principle that if a market participant complies with one regulatory regime’s requirements, it will be deemed to have complied with a second jurisdiction’s requirements.

The goal is to minimise the regulatory burdens associated with trading OTC derivatives. However, two conflicting theories exist on how substituted compliance determinations should be made; through an outcome-based approach or a requirement-by-requirement approach.

The tension between these competing philosophies has slowed the pace of substituted compliance determinations and can be most clearly seen in the negotiations between the US and Europe regarding clearinghouse rules. 

These negotiations dragged on for over three years because of technical differences over the calculation of margin under the clearinghouse rules – differences that had competitive implications. The negotiations were only recently finalised as a regulatory deadline approached, which would have imposed significantly increased costs on European banks using US clearinghouses.

While significant obstacles currently exist to the development of a cohesive, harmonious cross-border regulatory framework, much progress also has been made. Regulatory discrepancies were inevitable but, early on, regulators recognised the need for increased harmonisation. 

Through the work of cross-border regulatory groups, such as the OTC Derivatives Regulators Group, progress has been made toward increased harmonisation of these rules. This work must continue in the upcoming years in order to create a more harmonious cross-border regulatory framework for market participants.