OTC Derivatives Regulation via CCP ~ where do we go from here?

In my last post on the Excelian blog, I talked about CCP and OTC Derivatives Regulation.

As time goes by, it will be interesting to find out at what stage we’re at in this big reform and how likely countries are looking to hit the looming deadline.

Why has all the attention been put on over-the-counter (OTC) derivatives?

It is because they have been recognised as a significant driver of the financial crisis, increasing the interconnection between banks and spreading contagion through financial institutions which used them. Also, they refer to transactions between two counterparties where the terms are freely negotiated. These derivatives may cover a range of products including credit, equities, foreign exchange, interest rates and other structured products.

This is the main reason why the G-20 Summit in Pittsburgh called for greater standardisation in OTC derivatives markets and wants implementation of reforms completed by end-2012, though certain jurisdictions look set to miss this target.

Following Pittsburgh Summit’s delivery of international guidelines, national authorities are now in the process of developing regulation in their domestic jurisdictions.

With the upcoming deadline, FSB (Financial Stability Board) has noted that while there has been progress in the major derivatives markets of the US, EU and Japan, there has been slower progress in other countries where major concern is about the overlap in regulation between countries.

The most recent report on the progress of the implementation of G-20 recommendations showed that ONLY Japan and US had adopted the legislation needed to enforce central clearing, while EU has only reached a political agreement on the issue.

Most authorities are only confident about meeting the deadline for central clearing on interest rates derivatives, but not other asset classes.

Also, there are significant delays in the implementation of trade repository reporting and the movement of standardised OTC contracts on to exchange or electronic trading platforms.

There is a significant commonality of approaches between EMIR and the Dodd-Frank Act in relation to the regulation of OTC derivatives markets, but there are also some significant differences. Here are some highlights but full details can be found at the following link from Mysys website: “OTC Derivative Regulations: Putting the Theory into Practice ”, October 3rd 2012 http://www.misys.com/misysblog/2012/q2/otc-derivative-regulations-putting-the-theory-into-practice.aspx]

Regulatory Act
- in the case of the US, they have passed a complex reform law, the Dodd-Frank Act, and the two major regulators (Securities and Exchanges Commission – SEC, and Commodities and Futures Trading Commission – CFTC) are creating practical rules that will be implemented by all banks and financial institutions
- EU is addressing these issues in the proposals to replace the existing Markets in Financial Instruments Directive (MiFID) with a new restated Directive (MiFID 2) and a new companion EU Regulation (MiFIR). This legislation is only likely to be adopted in 2013 and will itself also require extensive implementing measures before it comes into effect
Timeframe: in EU affected firms must be in place by January 1^st 2013, whereas in the US it is intended to be in force by the end of September 2012
Exemptions: in relation to product exemptions, Europe doesn’t provide any. However, the US expressly provides exemptions on equity and foreign exchange derivatives, such as FX swaps and FX forwards
Trading venue: Currently, in the US, there is little guidance about how the security-based swap execution facility requirement is going to work. In Europe, the EMIR and MiFID II aren’t aligned leaving trading venues being classed merely as regulated markets (e.g. London Stock Exchange), multilateral trading facilities (e.g. BATS/Chi-X) and organised trading facilities, which are a new kind of trading venue introduced by MiFID II
Margin requirements: the way margin requirements are to be calculated still remains unclear. When it comes to cleared OTC derivatives, they both show that the CCP will deal with the initial margin and daily variation margins. However, for un-cleared OTC derivatives, Europe stipulates daily margin calculation and segregated exchange of collateral at mark-to-market (or mark-to-model), whereas the US stipulates calculation of initial and variation margin, although there is no regulatory proposal to hold collateral from the swap dealer
Reporting to trade repositories: one of the main concerns with the OTC derivatives market is that regulators don’t have a full picture of the exposure of the firms they regulate, hence the requirement of trade repository. Essentially, these form a central database where information on positions is collected. Both US and European proposals require reporting of full trade data within one day of execution.
Asian regulators have been much slower implementing OTC clearing leaving a loophole ready for exploitation. Moreover, their delay in implementing the regulations leaves the door open, making it technically possible for financial institutions to avoid the stricter regulation in Europe and the US by moving some of their business to Asia, despite this going against G-20 guidelines.
Both the EU and the US regulators have paused progress on their proposals for margin rules for uncleared derivatives pending the outcome of the BCBS-IOSCO consultation on common international standards.

The issue “Regulation of OTC Derivatives Markets ~ A comparison of EU and US initiatives” dated September 28^th 2012 explains in details the way in which the two regimes treat different categories of counterparties and highlights certain other major differences between EMIR and the Dodd-Frank Act in relation to OTC regulation.

At the following link is possible to retrieve the pdf file with full details

http://www.cliffordchance.com/publicationviews/publications/2012/09/regulation_of_otcderivativesmarkets-.html

Who will be affected by OTC Regulation?

There are a number of different industry groups which will be affected by changes to OTC regulation like companies which manage the clearing infrastructure and also users of that infrastructure like financial and non-financial corporates.

Financial users of infrastructure put a large premium on ensuring that rules are standardised across jurisdictions.

Nevertheless, there is a contrast in peripheral markets like Australia where smaller domestically owned banks, not currently members of major clearing houses, do not agree with the push toward central clearing. They argue they have made significant investments in bilateral clearing relationships and should not be forced to convert to central clearing when they pose no systemic risk.

Infrastructure providers are looking for a more harmonised approach between jurisdictions. A race to the top by individual countries could lead to a competitiveness of local CCPs and encourage more regulatory arbitrage by the users of infrastructure.

Outstanding issues

These outstanding issues are for stakeholders to address.

How smaller markets will harmonise their legislation if differences remain between key derivatives markets? Contrasts in US and EU legislation could impact counterparties operating in those jurisdictions.

Regulators need to finalise rules for margin requirements on non-centrally cleared derivatives. Most jurisdiction state they are waiting to follow the guidance of the Basel Committee on Banking Supervision, which is currently out for consultation. While some jurisdictions, such as Singapore, already require higher margining requirements for non-centrally cleared derivatives, the final rules are likely to lead to pressure to converge toward an international norm, especially for smaller markets standing at a disadvantage to central markets.

Regarding exemptions, it’s not clear whether central banks should be covered by derivative regulations. EU has exempted its own central banks, but is unclear whether non-EU central banks will receive a similar exemption. In some jurisdictions, it has still to be stated which instruments or users will be covered by central clearing requirements and which will not and also on which size central clearing requirements will kick in.

The on-going delay to reform is another area that needs to be addressed.

International bodies estimate that a significant portion of interest rate derivatives will be centrally cleared by end -2012, while there is significantly less confidence on the progress for other asset classes.

For further reading, please check the following links: