Smoke, mirrors and…OTC derivatives reform

This article was published on the INFINZ website.

For those keeping score, the US$639 trillion over-the-counter (OTC) derivatives market was mandated by the G20 to emerge into a new world of transparency and safety by the “end of 2012”.1   Specifically, these ‘financial instruments of mass destruction’ (according to the Sage of Omaha) were to be made transparent through trade repositories and tamed by standardisation and clearing through strong central counterparties (CCPs).

So, as a deeply indebted and far-flung trading country which ought to have an interest in such matters, it seems like a good time to ask: “what has happened?”The cheerleaders at the Financial Stability Board (FSB) insist that the G20’s mandate has been realised, if measured according to commitment.2   But this commitment has yet to translate into realisation of the goal that all (or even most) derivatives are centrally cleared - and recorded progress is not such as to suggest that this outcome is in any way imminent. In its latest scorecard (as of 31 October 2012), the FSB says that international policy work on the safeguards for global clearing is substantially completed and implementation is proceeding at a national level.  Accordingly, the FSB has shifted its focus to the market infrastructure – CCPs, trade repositories and organised trading platforms – which, it notes “is in place and can be scaled up”.The FSB does acknowledge that there is still some way to go.  Regulatory uncertainty remains a “significant impediment to further progress”, in particular the issue of cross-border consistency.  The use of trade repositories “has plateaued” and the data are not coordinated internationally.  Industry must accelerate work in relation to standardisation of products and processes, around which further clarity and consensus is required.  While it’s hard to give a very accurate scorecard of progress in the absence of comprehensive data from trade repositories, the FSB estimates that something like 10% of credit default swaps (CDS) and 40% of interest rate swaps are being centrally cleared.  The uptake with respect to forex, equity swaps and other products is, it seems, negligible (indeed, according to Australian regulators there is currently no viable central clearing solution for some of these categories).So if the intent of this reform truly is to “kill off the OTC market” (as suggested by an Irish banking official recently), there’s clearly a long way to go.

Regulatory progress

In terms of progress by the major jurisdictions, Europe has enacted the European Market Infrastructure Regulation (EMIR), and technical standards to implement its principles will be adopted by year-end.
In the United States, the OTC reforms are part of the Dodd-Frank Act and are tied up with the implementation of the Volcker Rule.  Key points include that central clearing will be required for all entities trading “eligible” standardised swaps (‘eligible’ is a work in progress) and any “major swap participant” will be subject to more stringent requirements for capital, margin, reporting and record keeping.  Regulation in this area is a mini-industry, with the Commodities and Futures Trading Commission alone producing no fewer than 29 final rulemakings, with a further 20 regulations still to come.4
Closer to home, Australia has produced draft enabling legislation and a full report on progress.5  Implementation of Basel III by APRA will result in banks’ OTC derivatives positions being subject to higher capital requirements where transactions are not centrally cleared.  Of necessity, overseas CCPs would need to be used by Australian (and New Zealand) firms, with the consequence that there are significant threshold regulatory and cross-border issues to be resolved.6  The bottom line, though, is that Australian regulators are content at this time to assess market developments and will not be implementing mandatory clearing of swaps.
New Zealand (which isn’t part of the G20) is also adopting a ‘steady as she goes’ approach.  The topic of OTC derivatives regulation warrants just three column inches in the Reserve Bank’s latest Financial Stability Report, where it is noted: “New Zealand banks are considering how they can ensure that they have access to the appropriate clearing infrastructure”.  The Governor accords this the cheery sign-off that the Reserve Bank “welcomes these moves” and “will continue to monitor developments”.

Local market infrastructure

With its natural focus on Europe and the US, the FBS notes that CCPs are now available to clear “some” products in all five asset classes (commodities, credit, equity, forex and interest rate) across the FSB jurisdictions. 
In terms of infrastructure available to Australasian banks and companies, it is unlikely (as noted above) that there will be a clearing house in Australia or New Zealand for the full range of OTC contracts.
Regionally, however, this capability is being established, with Japan, Singapore and Hong Kong leading the way.
  • Japan is probably farthest advanced.  Japan Securities Clearing Corporation (a clearing house owned by Tokyo Stock Exchange) has established a CCP, which began clearing specified CDS transactions earlier this year and plans to move to clear interest rate swaps (IRS).  Japan’s parliament approved the Financial Instrument and Exchange Act in May 2010, which requires central clearing and reporting for JPY IRS and CDS. 
  • Singapore has endorsed the G20 proposals and prepared a consultation paper but has not yet announced legislation.  SGX started clearing vanilla SGD/USD interest rate swaps in October 2010 and has been clearing commodity derivatives since 2006.
  • The Hong Kong Monetary Authority has indicated that Hong Kong Exchanges and Clearing Limited will be the only licensed domestic CCP.  Hong Kong will require local financial institutions to clear all IRS and non-deliverable forwards at an authorised CCP and to report them to a local trade repository run by the Central Bank by the end of 2012.  HKEx is also considering clearing Chinese RMB denominated OTC derivatives.
  • In South Korea, the government has finalised plans for a mandatory CCP and was to have established a CCP by mid-2012.  However, the country is going to miss its proposed start date of January 2013 because of delays in passing new legislation to formalise the relevant requirements.

Other headwinds

Even restricting oneself to the output of BIS, IOSCO and FSB, the literature on implementation of OTC derivatives reform is vast, and traverses a huge range of legal and practical issues.  Here are some more to think about.

  • Many CCPs = more TBTF:  In a perfect world, there would be just one CCP, in order to achieve the maximum benefit of netting and to better enable resolution of counterparty defaults.  We don’t inhabit that world.  Due in part to insolvency regimes and in part (one suspects) to the dictates of mercantilism and national pride, there will be quite a large number of domestic and regional CCPs and other trading facilities.  Indeed, many CCPs require their direct members to be registered in the CCP’s home jurisdiction.  In future, operational links may permit multi-lateral netting and cross-margining.  But the immediate effect of running most or all of the enormous notional OTC market through CCPs is that financial regulators will need to add them, together with the ‘globally systemically important financial institutions’, to their “too big to fail” list and think about extending credible resolution regimes to them.  In this regard, it is important to note that CCPs currently do not have ‘bail in’ or other bank-like capital to mitigate the risk of their becoming the taxpayers’ problem.
  • Show me the money:  Achieving the systemic stability aims requires collateral, in the form of ‘cash’ or safe securities, and lots of it.  Exactly how much additional collateral is not entirely clear, but IMF estimates are north of US$200 billion and may be much more.  The problem?  The world is just not producing sufficient safe assets to cover all the new liquidity and collateral needs (and if we continue to rely on the US to produce annual trillion-dollar-plus deficits to fulfil this need, the bond market won’t necessarily consider the product thereof “safe” for the indefinite hereafter). 
  • Velocity:  Collateral once posted generally doesn’t just sit there, but is recycled or – to employ the vernacular – rehypothecated.  Or at least it used to be until MF Global went bust, sending Herstatt-like shivers up the spines of many collateral and portfolio managers, who are increasingly looking for segregation of their posted cash resources.  Good for the posters, but not so good for the velocity of money and its bedfellow nominal GDP growth.
  • Direct and efficiency costs:  The capital and margining costs of the new regime are being recycled to companies through new fees and charges based on the credit value adjustment (CVA) and funding value adjustment (FVA).  It could be argued that this does no more than make transparent something that was already there, shrouded by spreads or otherwise mixed into pricing.  However, there are some legitimate fears that additional CCP margining might raise hedging costs beyond previous levels, leading (among other things) to a less than optimal level of hedging and correspondingly greater financial volatility.
  • Transparency:  The goal of a transparent market will not be met while the CCPs are entitled to treat information about their margining policies and their collateral books as proprietary.
  • Vague Hague:  There is literally not a soul in the world who knows what the governing law would be if there was ever a CCP bust-up and the collateral had to be split (one of the reasons that the solutions are inherently domestic in this most international of spheres).  The Hague Convention on Indirectly Held Securities (even it had been ratified by more countries than Switzerland and Mauritius (!)), regrettably, holds no completely satisfactory answer.7

What will it feel like when we get there?

Stepping away from the quite legitimate question of what has happened to implementation of this G20 initiative, should we all sleep more comfortably at night even if it were fully in place by year-end?
Commentators suggest that the risk has really just been moved around rather than reduced.8   They also fear for the macroeconomic implications of creating all this ‘safe collateral’ and ferreting it away into the custody of clearinghouses.  Which might be more of a concern if that’s what really happens, but from the clearinghouses the collateral is often just recycled back to the banks and – who knows – may be placed back on deposit with the central banks from whence it came, in the wondrously futile merry-go-round that is the modern financial system. 

Last words

OTC market reforms have come a long way since the issues with Lehman and AIG prompted the G20’s call for action.  But, as far as these reforms have come, we’re still nowhere near the ultimate goals of transparency through trade repositories and risk reduction through well-designed central clearing. 

Will some momentum be lost once the artificial deadline of ‘end of 2012’ passes?  Some of the challenges that remain suggest that this is possible, particularly in relation to international coordination around resolution regimes – without which, frankly, the regime is not worth having.It remains to be seen whether industry and regulators will heed the FSB’s plea to accelerate their progress.  If they don’t, this reform may become another international achievement that can go straight into the pool room, right next to the Doha trade round, TPP and (lest we forget) the ‘Hague-slash-Mauritius’ Convention on Indirectly Held Securities.

This article was written by Ross Pennington, Partner.


1   G20 Pittsburgh release, September 2009: “All standardised OTC derivative contracts should be traded on exchanges or electronic
     trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.”  OTC derivatives should be
     reported to trade repositories.  Non-CCP contracts should be subject to higher capital requirements.

2   Refer for example to FSB’s 5 November 2012 release “Jurisdictions declared approaches to central clearing of OTC derivatives” and its “OTC
     Derivatives Market Reforms – Fourth Progress Report on Implementation” (31 October 2012).

3   APRA, ASIC and RBA Report on the Australian OTC Derivatives Market (October 2012), pg 2.

4   CFTC testimony to Senate Committee

5   The Derivatives Transaction Bill and the OTC Market report referred to above.

6   The subject of a separate report entitled Ensuring Appropriate Influence for Australian Regulators over Cross-Border Clearing and Settlement
     Facilities (July 2012).

7   See for example Maisie Ooi "The Hague Securities Convention: a critical reading of the roadmap" Lloyd's Maritime and Commercial Law
     Quarterly 467.

8   See, eg, Lisa Pollack “Central Counterparties Are Too Big To Fail” at FT Alphaville, but the literature on this is large and pretty consistent.

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