The economic crisis during 2007-2008 has brought to the fore the systemic importance of the effect of over-the-counter (OTC) derivatives on the entire financial market. Cases such as the default of Lehman Brothers and the bailout of AIG substantiated the need for limiting the risks posed by OTC derivative transactions and practices. In September 2009, G20 leaders committed to reforms of global OTC derivatives markets at the Pittsburgh summit, which set a clear direction for standard-setting bodies and jurisdictions in promoting global standards. Substantial progress has been made in setting international standards, though much work still requires finalization. This article will outline the issues covered under the reform, summarize the current status, and discuss the challenges faced by global financial community.
Pre-crisis market condition and reform necessity
OTC derivatives are traded outside a formal exchange such as the NYSE, TSX, and AMEX. According to International Swaps and Derivatives (ISDA) research, the notional outstanding value of the OTC derivatives market was $440.1 trillion in 2011, down from $475.3 trillion in 2007 (see figure 1). The OTC market is much bigger than the exchange-based market, as exchange traded derivatives only account for 10% of all transactions (Financial Stability Board 2013). OTC transactions contributed significant risk relative to the overall derivatives market.
Source: ISDA OTC Derivatives Market Analysis, Mid-Year 2012
Prior to the crisis, the OTC derivatives market was largely unregulated. In conducting a transaction, two participants would negotiate the contract over the phone or through a broker, and the transaction would be cleared bilaterally without the involvement of third parties. The ISDA Master Agreement is commonly used to govern the trades, and covers issues such as the netting of transactions, the circumstances under which outstanding transactions can be terminated by one side, and the valuations in the event of an early termination. Collateral arrangements are covered under a credit support annex (CSA) to the ISDA Master Agreement, which typically would require a variation margin but not an initial margin (ISDA 2013).
Several issues associated with the pre-crisis OTC derivative market contributed to high systemic risk. Firstly, the lack the transparency contributed market uncertainty in the event of a crisis, as participants had no information regarding counterparty’s exposures. Regulators were not aware of the buildup of risk concentration on large dealers. They were also prevented from making timely decisions due to lack of information. To ward off uncertainties upon the advent of the crisis, market participants had to wind up their exposures, which triggered prevailing collateral redemption that further stirred up panic and worsened market liquidity (Financial Stability Board, 2013).
Secondly, effective risk management was not in place to mitigate counterparty credit risk, a major weakness in OTC derivatives markets and a source of systemic risk. Basel II, initially published in 2004, required banks to hold capital to cover the risk of a counterparty default. However, Basel II didn’t capture issues such as mark-to-market losses due to changes in the counterparty’s credit quality, and didn’t provide sufficient provisions to address asset value correlations (Financial Stability Board 2013).
Components and issues covered under reform
In view of the considerable weaknesses in OTC derivatives market, G20 leaders agreed on the reform of market regulation. The G20 Pittsburg mandates included four elements regarding OTC derivatives reform:
Later in 2010, G20 agreed to add margin requirements for non-standardized transactions (Bank for International Settlements 2013). All regulatory reforms were developed around the five elements, which are abbreviated as TR, exchange/platform trading, CCP, capital and margin. The initial implementation deadline set by G20 was the end of 2012.
Among those components, central counterparties (CCPs) clearing is critical in diminishing counterparty credit risk and reducing systemic risk. CCPs function similarly to an exchange clearing house. It would require initial and variation margins from the counterparties (Noyer 2010). Failure of one participant does not directly affect other participants as they still have the trades in place with the clearing house, therefore contagion risk in the event of crisis is largely reduced. Nevertheless, risk concentration on CCPs should be closely supervised and monitored by regulatory bodies.
The mandate of reporting requirement (TR) is designed to improve transparency of overall OTC derivative market. Information would be standardized and aggregated, and made available to both market participants and regulators. Better risk management can be constructed with information available, and more informed decision-making can be achieved.
Having recognized the reality that not all instruments will be clearable through central counterparties, G20 proposed strengthened capital and margin requirements for non-centrally cleared transactions to mitigate the risks associated with such instruments. Higher capital and margin requirements also provide incentives for participants to use central clearing (Financial Stability Board 2013).
International initiatives and jurisdictional implementation
International initiatives have been taken by various standard-setting bodies (SSBs) such as the Financial Stability Board (FSB), Basel Committee on Banking Supervision (BCBS), Committee on Payment and Settlement Systems (CPSS), and International Organization of Securities Commissions (IOSCO). Each of them has issued broad recommendations and principles applicable to OTC derivatives market regulation.
In particular, FSB assumed more of a role in coordinating and monitoring the work undertaken by international SSBs. CPSS and IOSCO conducted analysis on specific topics and issued reports recommended by FSB. Basel III was issued by BCBS as the latest international regulatory standard on bank capital adequacy, stress testing and market liquidity, and provides specific recommendations on capital and margin requirements for banks (Bank for International Settlements 2013).
Despite significant progress achieved in setting international standards, there are still much to be completed after the end of 2012 deadline. Some important work that is currently being undertaken includes the guidance on margin requirements for non-centrally cleared OTC derivatives (BCBS and IOSCO); final standards on the capital treatment of exposures to CCPs (BCBS); guidance for recovery and resolution regimes for financial market infrastructures such as CCPs and TRs (CPSS-IOSCO and FSB); and guidance on authorities’ access to data held by TRs (CPSS-IOSCO). Figure 2 provides the detailed explanations.
Figure 2: International policy development
Source: FSB OTC Derivatives Market Reforms, Fifth Progress Report on Implementation
In FSB’s opinion, as of April 15 2013, sufficient international guidance was available to jurisdictions even though standards in a few areas are still being finalized, and “any necessary reforms to regulatory frameworks should be made without delay” . Reporting to trade repositories (TRs), central clearing and platform trading of standardized OTC were the priorities for all jurisdictions.
At the jurisdiction level, reforms are being implemented in consistent with G20 mandates, including through Dodd-Frank Act in the United States, European Market Infrastructure Regulation (EMIR) in the EU and Financial Instruments and Exchange Act (FIEA) in Japan. The Dodd-Frank Act required the Commodity Futures Trading Commission (CFTC) and SEC to establish rules and definitions for the new OTC derivatives with dealer registration commencing at year-end 2012 and mandatory clearing beginning in March 2013. EMIR entered into force in August 2012, with the clearing obligation took effect in March 2013. FIEA was amended in May 2010 with implementation commencing in November 2012 (Financial Stability Board 2013).
By the end of 2012, no jurisdiction had fully implemented the requirements to meet the G20 commitments, though trade reporting and central clearing infrastructure were operational across several jurisdictions for all of the five major asset classes including interest rate, credit, equity, commodities and foreign exchange. As of April 2013, less than half of the G20 jurisdictions had put in place the legislation needed. Fig 3 and 4 illustrate the progress of regulatory reform among 19 FSB members.
Figure 3: Regulatory reform progress across 19 FSB member jurisdictions
Source: FSB OTC Derivatives Market Reforms, Fifth Progress Report on Implementation
Figure 4: National progress of reforms
Source: FSB OTC Derivatives Market Reforms, Fifth Progress Report on Implementation
Major challenges ahead
The most pressing challenges are related to issues arising from cross-border transactions, with concerns around regulatory uncertainty compounded by emerging conflicts and overlaps between different jurisdiction regulations. By their nature, cross-border transactions will be subject to the regulations of multiple jurisdictions. In the absence of agreement between regulators, extraterritoriality has the potential to cause regulatory conflicts and duplications for the derivatives industry. To minimize additional costs involved in ensuring compliance, avoid the emergence of opportunities for regulatory arbitrage, and diminish the incentives of off shoring activities, regulators across jurisdictions should cooperate and coordinate in dealing with the cross-border impact of regulation and the harmonization of rules.
To promote international cooperation, FSB urged a group of major regulators to pursue further discussion in identifying cross-border application of rules, potential inconsistency and overlaps, and developing options for addressing those issues. In response, leaders of major jurisdictions including the US, the EU, and Japan met in November 2012 and agreed on a set of high-level operating principles. Important issues were addressed in the joint press statement “Operating Principles and Areas of Exploration in the Regulation of the Cross border OTC Derivatives Market” that was published at the beginning of December 2012 (US Commodity Futures Trading Commission 2012).
The OTC derivatives market reforms agreed to by the G20 nations aiming at reducing systemic risks posed by OTC derivatives will make the market more transparent by enforcing reporting to trade repositories, and by promoting central clearing and exchange or electronic platform trading. Non-centrally cleared transactions will subject to higher capital and margin requirements. The reform has achieved significant progress in setting up the standards and infrastructure, despite much implementation work remained to be finalized.
The global SSBs have recognized the importance of coordination in achieving regulation harmonization. The efforts taken by SSBs and jurisdictions will meet G20 commitment on OTC regulatory reform and ensure global financial stability.
List of Standard-Setting Bodies
Basel Committee on Banking Supervision (BCBS): The BCBS, established by the G10 Central Banks in 1974, provides a forum for regular co-operation among its member countries on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. The BCBS formulates supervisory standards and guidelines and recommends statements of best practice in banking. In this regard, the BCBS is best known for its international standards on capital adequacy and the Core Principles for Effective Banking Supervision.
Committee on Payment and Settlement Systems (CPSS): The CPSS provides a forum for co-operation among its member central banks on issues related to payment, clearing and settlement systems. It monitors and analyses developments in such systems as well as in cross-border and multi-currency arrangements and it formulates broad oversight standards in these areas.
Financial Action Task Force on Money Laundering (FATF): The Financial Action Task Force (FATF) was established by the G7 in 1989, and is an inter-governmental body with 36 members whose purpose is the development and promotion of policies, both at national and international levels, to combat money laundering and terrorist financing. The FATF is responsible for setting the international standards for combating money laundering and terrorist financing, and works to generate the necessary political will to bring about the required national legislative and regulatory reforms. It also monitors members’ progress in implementing necessary measures, reviews money laundering and terrorist financing techniques and counter-measures, and promotes the adoption and implementation of appropriate measures globally.
Financial Stability Board (FSB): The FSB was established in April 2009 as the successor to the Financial Stability Forum (FSF). Its mandate is to coordinate at the international level the work of national financial authorities and international standard setting bodies and to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies. It brings together national authorities responsible for financial stability in significant international financial centres, international financial institutions, sector-specific international groupings of regulators and supervisors, and committees of central bank experts.
International Association of Deposit Insurers (IADI): The IADI, founded in 2002 with members and associates representing over 70 jurisdictions, is a non-profit organization domiciled at the Bank for International Settlements in Basel, Switzerland. IADI provides a forum for international cooperation among deposit insurers, central banks, and international organisations on issues related to financial stability, deposit insurance, and resolution activities. As part of its objective to enhance the effectiveness of deposit insurance systems, IADI, together with the BCBS, published the Core Principles for Effective Deposit Insurance System s and issued a methodology for the assessment of compliance with the Core Principles.
International Organisation of Securities Commissions (IOSCO): IOSCO is the international policy forum for national regulators of securities and futures markets. IOSCO develops and promotes standards of securities regulation in order to maintain efficient and sound markets. It draws on its international membership to establish standards for effective surveillance of international securities markets and provides mutual assistance to promote the integrity of markets by a rigorous application of the standards and effective enforcement against offences.
Organisation for Economic Cooperation and Development (OECD): The OECD aims to promote policies designed to achieve sustained economic growth and employment in its member countries. In the area of promoting efficient functioning of markets, the OECD encourages the convergence of policies, laws and regulations covering financial markets and enterprises.
Bank for International Settlements. (2013, January). International regulatory framework for banks (Basel III). Retrieved from Bank for International Settlements: http://www.bis.org/bcbs/basel3.htm
Financial Stability Board. (2013, April 15). OTC Derivatives Market Reforms. Retrieved from Financial Stability Board: http://www.financialstabilityboard.org/publications/r_130415.pdf
Hallara, C. H. (2013, April). Containing extraterritoriality to promote financial stability. Retrieved from Bank of England: http://www.bankofengland.co.uk/financialstability/Documents/tucker_fsr13…
Ingves, S. (2013, April). Regulatory reforms for OTC derivatives: past, present, future. Retrieved from Bank of England: http://www.bankofengland.co.uk/financialstability/Documents/tucker_fsr13…
ISDA. (2013, June 7). ISDA Publishes 2013 Standard Credit Support Annex. Retrieved from ISDA:http://www2.isda.org/news/isda-publishes-2013-standard-credit-support-an…
Kono, M. (2013, April). Overview of international work towards OTC derivatives markets reform and remaining challenges. Retrieved from Bank of England: http://www.bankofengland.co.uk/financialstability/Documents/tucker_fsr13…
Noyer, C. (2010, July). Redesigning OTC derivatives markets to ensure financial stability. Retrieved from Banque de France: http://www.banque-france.fr/fileadmin/user_upload/banque_de_france/publi…
US Commodity Futures Trading Commission. (2012, December 4). Joint Press Statement of Leaders on Operating Principles and Areas of Extrapolation in the Regulation of the Cross-border OTC Derivatives Market. Retrieved from US Commodity Futures Trading Commission: http://www.cftc.gov/PressRoom/PressReleases/pr6439-12
Walter, E. (2013, April 6). Regulation of Cross-Border OTC Derivatives Activities: Finding the Middle Ground. Retrieved from US Securities and Exchange Commission:https://www.sec.gov/News/Speech/Detail/Speech/1365171515202#.Uhs_eRu1HkM