Unfinished business; OTC derivative market reform

Unfinished business; OTC derivative market reform

Overall, “good progress” continues to be made across the OTC derivatives reform agenda, according to the Financial Stability Board’s (FSB’s) latest update. It is the eleventh report on regulatory progress since the G20 leaders committed to a fundamental overhaul of the global financial system in 2009.

The FSB’s brief summary of the recent work highlights that trade reporting requirements for OTC derivatives and higher capital requirements for noncentrally cleared derivatives (NCCDs) are mostly in force. Central clearing frameworks and, to a lesser degree, margining requirements for NCCDs have been, or are being, phased-in, while platform trading frameworks are relatively undeveloped in most jurisdictions.

These changes continue to fundamentally alter the structure of the OTC derivatives markets, significantly impacting the business models, profitability, legal entity structures, operations, data and technology of financial institutions’ derivatives businesses. And, this is all having to be done while keeping the original objectives in mind – improving transparency, mitigating systemic risk and protecting against market abuse.

“Much has been achieved objectively, across jurisdictions and on a global basis. The US, Europe and some Asia Pacific countries such as Japan and Australia are at advanced stages,” says Gaspard Bonin, deputy head of derivatives execution and clearing at BNP Paribas CIB. “Another big step recently has been progress around global consistency. Mutual recognition of CCPs, for example, between the US and Europe is a welcome development. 

“However, there’s a general question mark hanging over the market, industry and regulators,” Bonin adds. “How will the market work in the long-term? How sustainable is it with the new regulatory framework and how will it adapt? The next step for the market, broadly speaking, will be to digest the changes and understand the real outcomes once the dust settles.”

Nicholas Veron, co-founder and senior fellow of the European economic thinktank Bruegel and a visiting fellow at the Peterson Institute for International Economics in Washington DC, agrees with Bonin that is it too soon to judge the G20’s ambitious reforms of OTC derivatives markets.

Unforeseen consequences

However, he does note some unforeseen consequences of the G20- fostered move toward more central clearing, including the possibility of market fragmentation across currency areas, and the concentration of systemic risk in derivatives clearinghouses. Separately, Veron says the reporting of OTC derivatives transactions to trade repositories is far from delivering on its promise to help supervisors assess developments of relevance for financial stability.

Perhaps unsurprisingly, the success or lack thereof of G20 financial regulatory reforms is strongly correlated with the strength of the corresponding global institutional framework,” he explains in a recent research note ‘Financial Regulation: The G-20’s Missing Chinese Dream’. “In particular, the longestablished cooperation of the world’s main central banks through the BIS and its various committees has generally resulted in decent effectiveness of reforms within their remit, such as Basel III.

“By contrast, cooperation among securities regulators is of a more ad hoc nature, and IOSCO has generally found it difficult to agree on strong common standards and ensure their general adoption, as is illustrated by the G20’s failure on financial accounting standards convergence.” Veron adds that one of the reasons for the “lopsided design” and implementation of OTC derivatives reforms is the awkward overlap of responsibilities in this area between central banks with a financial stability mandate (represented in CPMI) and securities regulators with a marketintegrity mandate (represented in IOSCO). 

Veron adds that one of the reasons for the “lopsided design” and implementation of OTC derivatives reforms is the awkward overlap of responsibilities in this area between central banks with a financial stability mandate (represented in CPMI) and securities regulators with a marketintegrity mandate (represented in IOSCO).

To illustrate Veron’s point, trade reporting requirements covering over 90% of OTC derivative transactions were in force at the end of June 2016 in 19 out of 24 FSB member jurisdictions. By the end of 2017, 23 of these jurisdictions expect to have such requirements in force.  

However, authorities have recently raised concerns that restrictions on trade repositories reporting complete datasets to them reduces its usefulness to them when carrying out their regulatory mandates, including monitoring and analysing systemic risk and market activity. For example, eight jurisdictions (Argentina, Hong Kong, India, Indonesia, Korea, Mexico, Russia and Saudi) do not currently permit reporting to foreign trade repositories in at least some circumstances.

When it comes to capital and margin requirements, higher capital requirements for exposures to NCCDs are largely in force (with 20 jurisdictions having requirements in force that apply to over 90% of OTC derivatives transactions) although less progress has been made in the implementation of margin requirements for NCCDs.

Furthermore, around half of the member jurisdictions do not appear on track to have implemented variation margin requirements in accordance with the second and final phase, set for March 2017. “Such jurisdictions should urgently take steps to implement these reforms,” the FSB urged in September. “Certainly there has been incredible complexity foisted onto the market,” explains Luke Zubrod, director, strategic initiatives at Chatham Financial. “There are a multiple new intermediaries – clearinghouses, trading facilities, swap data repositories as well as numerous regulatory bodies and multiple jurisdictions.”

Zubrod recalls that in the immediate aftermath of the financial crisis there was an overwhelming public perception that derivatives were weapons of mass destruction, financial instruments capable of bringing economies to their knees. “In our discussions with policymakers and regulators in Washington DC and elsewhere, we thought it was important early on to tell the other side of the story – about commercial end-users that use derivatives as simple risk-reducing business transactions and that do so in quantities that are not systemically risky.

“That said, I do think the original G20 objectives were fair. AIG’s systemicallyrisky use of derivatives, for example, impacted taxpayers due to the resulting bailout, revealing a link between derivatives and the systemic health of financial markets. Therefore, the public urge to bring regulatory scrutiny and solutions to the derivatives market was appropriate. Clearly, a number of endeavors touching other areas of the financial market were also appropriate and reasonable.” 

Zubrod acknowledges there’s now good cause to think markets are safer than they were. Although some questions remain, for example: Was every policy and rule completely necessary? Are there areas where regulations can now be calibrated more finely in order to mitigate the effects of excessively onerous rules?

Since September 2015 there have only been a small number of additional regulatory steps taken by jurisdictions. This, according to the FSB, reflects the fact that most FSB member jurisdictions have already largely introduced regulatory reforms to require trade reporting of OTC derivatives.

In Argentina, the development of reporting infrastructure and associated reporting requirements is proceeding, but specific reporting requirements are not currently in force for OTC derivatives. Reporting requirements are in force for certain FX and interest rate OTC derivative transactions in Hong Kong; rules on reporting requirements with respect to the next phase of reporting (effectively covering all five asset classes) have been enacted and will have effect when reporting commences in mid-2017.

In South Africa, consultation has been undertaken to introduce reporting requirements across all asset classes – requirements are expected to be adopted by the end of 2016 and in force by mid-2017. In Switzerland, trade reporting requirements will phase-in once the first repository is licensed or recognised by the relevant Swiss authority. In Turkey, various phases of consultation have been undertaken since September 2015; rules are expected to be in force in 2017.

The regulatory cycle

According to Chatham Financial’s Zubrod, who also participates on the CFTC’s Market Risk Advisory Committee, any new rules will be an extension on existing requirements rather than new standalone requirements. 

However, in the US at least, much will depend on the outcome of the US election. Hillary Clinton, for example, is calling for the strengthening of regulation to prevent bailouts and protect taxpayers by restoring the so-called swaps pushout rule, which requires banks to conduct swaps trading via separate affiliates with higher capital requirements. She is also proposing to fully fund the regulators of Wall Street and has Garry Gary Gensler, former CFTC chairman from 2009 to 2014, in her corner. 

A victory for Trump, on the other hand, would see financial markets entering uncharted territory due to what can only be described as an absence of clear financial policies. Citi’s chief economist William Buiter stated recently that he sees possible tailwinds to growth coming from policy changes after the election, no matter which candidate wins. 

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