OTC Derivatives Market Reform Considerations 4. International Developments

A report by the Council of Financial Regulators
March 2012

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4.1. Introduction

It is important that Australian policy responses be consistent with developments in the international regulatory environment. As with many other countries, the Australian OTC derivatives market is highly international in nature. Many Australian-based market participants are active in offshore markets. Similarly, many significant participants in the Australian market are foreign entities. Accordingly, regulatory developments in offshore jurisdictions are very likely to have some spillover effect on the configuration and activity of the domestic market. However, Australia is not alone in this, and the importance of cross-border harmonisation in regulatory approaches to OTC derivatives market reform is increasingly appreciated in all jurisdictions. To assist in coordinating domestic efforts, and to reduce the scope for regulatory arbitrage, multilateral agencies and standard-setting bodies have a number of relevant work streams under way.

4.2. The European Union and the United States

The legislative basis for the US regulatory regime is found in Title VII of the Dodd-Frank Act, passed in mid 2010; however, US authorities have granted temporary relief from the provisions of the Act while they develop detailed regulations and to allow some time for the industry to make preparations for compliance. The main relevant legislation in the EU, the European Market Infrastructure Regulation (EMIR), was agreed in February 2012. Draft technical standards are due to be submitted to the European Commission by 30 June 2012, with the aim of enacting the new regulatory regime by the end of 2012.

In both jurisdictions there will be a near-universal requirement to report OTC derivatives transactions to a rade repository, and regulatory regimes for trade repositories (swap data repositories in the US) have been set out.

The EU and the US have taken similar approaches to clearing requirements for OTC derivatives. Under a ‘top-down’ approach, the US Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), and the European Securities and Markets Authority (ESMA) can designate classes of OTC derivatives as subject to central clearing requirements on their own initiative, even if there is no CCP offering clearing services for that class. Under a ‘bottom-up’ approach, the regulators can act to mandate central clearing of OTC derivatives that CCPs have been authorised to clear.

Neither set of regulators has announced which classes of OTC derivatives will be subject to central clearing. In making their decision the US authorities must take into account factors such as the size of exposures, trading liquidity, availability of pricing data, systemic risk implications and the effect on competition. The factors to be considered by ESMA are broadly similar. Mandatory central clearing requirements in the US will apply to a broad range of participants, with exemptions for non-financial entities using OTC derivatives to hedge commercial risk. The SEC is also considering an exemption for small financial institutions. In the EU, mandatory central clearing is proposed for all trades involving financial institutions, or non-financial institutions whose non-hedging related trades exceed a certain threshold – an exemption will apply to pension funds for a number of years.

Both the EU and US regulatory regimes allow for the use of foreign CCPs to satisfy clearing requirements, provided that regulators can be satisfied that they are subject to comparable supervision in their home country.

In the US, the Dodd-Frank Act imposes margin requirements on dealers and major swap participants entering into non-centrally cleared transactions. The Act does not provide an exemption for transactions with end users (although US regulators have issued draft rules which propose that margin requirements would not apply to non-systemically important market participants and end users). The EU regime will similarly require financial counterparties (and non-financial counterparties subject to the central clearing obligation) to have procedures to both collect and post margin, and to require an appropriately segregated exchange of collateral or an appropriate and proportionate holding of capital for non-centrally cleared transactions.

As with other aspects of the G-20 commitments, the US legislative and regulatory framework for mandatory trading is more advanced than that of other major jurisdictions. In the US, a new category of electronic trading platform, the Swap Execution Facility (SEF), has been created, and draft rules relating to how SEFs should operate have been published. The US framework contemplates that any product that is mandatorily centrally cleared will be subject to a mandatory electronic trading requirement. The European Commission has adopted proposals for the Markets in Financial Instruments Regulation (MiFIR), which includes a framework for a new category of electronic trading platform, the Organised Trading Facility (OTF), and which will empower ESMA to mandate trading of OTC derivatives products on OTFs or other types of exchanges or electronic platforms. MiFIR will become law in each EU member state upon adoption by the European Parliament and the European Council.

4.3. Other Jurisdictions

In Japan, the Financial Instruments and Exchange Act was passed in May 2010, granting the Japanese Financial Services Agency (JFSA) the authority to regulate OTC derivatives. As in the US and EU, only those classes of OTC derivatives identified by regulators will be subject to mandatory central clearing, chosen on the basis of volumes and the effect of central clearing on settlement risks in the domestic market. Mandatory central clearing of these derivatives applies to any transaction where at least one counterparty is a financial institution or a dealer in derivatives. The Japanese regime requires that derivatives with credit events that are closely associated with Japanese corporate bankruptcy law be cleared by a Japanese CCP. Other prescribed OTC derivatives can be cleared through foreign CCPs that have been licensed by the JFSA, or which have an interoperability arrangement with a domestically authorised CCP. The rules regarding OTC derivatives are expected to be finalised by November 2012 with the passing of a cabinet ordinance and other measures. Japan does not include an execution mandate in its obligations for OTC derivatives; however, the JFSA anticipates establishing a draft regulatory framework to require certain OTC derivatives to be executed on electronic trading platforms.

Elsewhere in Asia, the Hong Kong Monetary Authority (HKMA) and Hong Kong Securities and Futures Commission (SFC) are currently consulting on their approach to mandatory central clearing. They expect to publish draft regulations in the first half of 2012, with the aim of having final regulations and necessary amendments to the Securities and Futures Ordinance passed by the legislature by the end of 2012. Hong Kong regulators have proposed initial mandatory central clearing of certain interest rate swaps and non-deliverable forwards. They anticipate an eventual phased expansion to cover other interest rate derivatives, foreign exchange derivatives and other asset classes such as equity derivatives. The requirements would apply to any trade involving a Hong Kong entity as a counterparty, or where a Hong Kong deposit-taking institution or securities licensee has originated or executed the transaction, provided that both counterparties exceed a volume threshold. The HKMA and SFC are considering whether to require clearing through a domestic CCP for certain systemically important products. Hong Kong authorities have indicated they will consider imposing capital requirements and margin requirements for non-centrally cleared derivatives in line with relevant international standards. Hong Kong authorities have announced an intention to introduce a legislative framework to allow for mandatory trading obligations, but do not expect to issue a mandate in the immediate future.

The Monetary Authority of Singapore (MAS) has released a consultation document outlining its proposed approach to central clearing of OTC derivatives. The MAS proposes to follow a similar ‘top-down’ and ‘bottom-up’ approach to the US and EU in designating OTC products for mandatory central clearing. The MAS has indicated that non-deliverable forwards and Singapore dollar- and US dollar-denominated interest rate swaps are likely to be subject to mandatory central clearing, while it proposes to exempt foreign exchange forwards and swaps. Mandatory central clearing requirements would apply to any trade where at least one leg of the contract is booked in Singapore, but with an exemption for entities with relatively small exposures. The MAS does not propose to mandate the use of a domestic CCP, allowing mandatory central clearing to take place through foreign CCPs subject to equivalent regulation in their home jurisdictions. The consultation document does not set out a timeframe for implementation, but the MAS has previously stated an aim to introduce the new regime, including changes to the Securities and Futures Act, by the end of 2012.

The Canadian Securities Administrators (CSA) is publishing a series of eight consultation papers on OTC derivatives regulation. It has proposed that a regulatory regime be created for trade repositories, and that there be a capacity to mandate reporting of OTC derivatives transactions. The Canadian regulators are also currently consulting on the approach to central clearing of OTC derivatives. The CSA has indicated that derivatives trades which are appropriate for central clearing and capable of being centrally cleared should be subject to mandatory central clearing, taking into account similar factors to those considered by US regulators. The CSA has also indicated that it may consider exempting smaller, non-systemically important participants from mandatory central clearing requirements. Canada is reviewing whether to require the execution of OTC derivatives trades on an exchange or electronic trading platform. However, the CSA has stated that a trading mandate could apply only to those products that have sufficient standardisation and liquidity, and that pose a systemic risk.

4.4. Work of International Groupings

4.4.1. Financial Stability Board

The FSB remains keenly interested in developments in OTC derivatives infrastructure, and is regularly monitoring progress by individual jurisdictions.[1] An OTC Derivatives Coordination Group has been established, comprising the chairs of relevant standard-setting bodies, with an initial focus being to establish adequate safeguards for a global framework for CCPs.[2] The FSB has also sponsored work on the key attributes of resolution regimes for systemically important financial institutions, with an aim of reducing concerns about too-big-to-fail institutions.[3] While the focus of this work to date has been on resolution arrangements for large globally active banks, this framework is also intended to apply to other financial institutions such as FMIs, and further work is being undertaken in this area.

4.4.2. CPSS-IOSCO

Given the crucial role of FMIs in the financial system, and to ensure that there are high standards of risk management in all jurisdictions, internationally agreed standards have been jointly developed by the Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO). Recent financial events and the push for more central clearing of OTC derivatives have motivated these standard-setting bodies to update these principles. A consultative report on the revised approach, Principles for Financial Market Infrastructure, was published in March 2011, and a final report is due for publication in coming months.[4] The Australian regulators would expect to apply these principles to Australian-based FMIs.

The CPSS-IOSCO draft principles also set out standards in respect of trade repositories that should be applied by regulators. These cover areas such as a trade repository's legal basis, governance, risk management, third party access arrangements and efficiency. There is also important ongoing work by CPSS-IOSCO to set standards for regulatory data access arrangements that would apply to trade repositories.

Against this evolving landscape, CPSS-IOSCO has published a report on standards for data reporting and aggregation that is expected to be adapted to domestic frameworks.[5] In addition to international work on standards for trade reporting and trade repositories, there is a major international initiative to develop unique Legal Entity Identifiers (LEIs) for entities transacting in financial markets.[6] This is largely an industry-led exercise, though with the strong encouragement and involvement of public sector agencies and standard-setting bodies. The adoption of LEIs across the industry is expected to facilitate the aggregation and analysis of data, as well as create opportunities for enhancing individual market participants' internal risk management and transaction processing systems.

4.4.3. IOSCO

In the past year IOSCO has published two reports in relation to the electronic trading of OTC derivatives. In broad terms, these reports describe preconditions to successful electronic trading and explain the different forms in which electronic trading can and does take place.

The first report highlighted that OTC derivatives are suitable for trading on an electronic platform when there is adequate standardisation of the product's contractual terms and operational processes, and when there is sufficient market liquidity.[7]

The report identified the following benefits to increasing the use of trading platforms:

  • more efficient price discovery
  • increased competition which may potentially lower trading costs and improve liquidity
  • reduction in systemic risk (due to enhanced market liquidity)
  • improved regulatory supervision of the market for misconduct (as a result of increased centralisation).

The report noted that other reforms such as central clearing, reporting to trade repositories and increased standardisation will also yield benefits in this regard.

The second IOSCO report provides a factual presentation of the different trading models currently available, and was intended to assist regulators and policymakers in developing or implementing derivatives trading policy proposals.[8] There is a wide range of trading models that can be described as electronic trading, from exchange trading through pre-trade transparent central limit order books, to trading on a platform operated by a participant who is a counterparty to every trade.

Significantly, the IOSCO reports are not prescriptive in recommending which type of electronic trading should be imposed by individual jurisdictions.

IOSCO has recently published a report setting out guidance for regulators in establishing any mandatory clearing obligations within their jurisdiction.[9] Recommendations cover matters such as:

  • processes for determining whether a mandatory clearing obligation should apply to a product or set of products
  • the factors to be considered around potential exemptions to a mandatory clearing obligation
  • the establishment of appropriate communications among authorities and with the public
  • the consideration of relevant cross-border issues in the application of a mandatory clearing obligation
  • the importance of monitoring and reviewing the overall process and application of a mandatory clearing obligation.

While the report is mainly addressed to regulators implementing mandatory regimes, it also provides information for stakeholders subject to any mandatory clearing obligations.

4.4.4. Basel Committee on Banking Supervision

In November 2011 the Basel Committee on Banking Supervision (BCBS) released a second consultative paper on the capitalisation of bank exposures to central counterparties.[10] Since then BCBS has been reviewing proposals with the intention that, consistent with the G-20 objectives, the final rules will provide capital incentives for banks to centrally clear derivatives for both clearing member transactions and client transactions. BCBS is currently refining the rules, with the aim of ensuring that there are sufficient incentives for clearing members to continue offering client clearing services, and to ensure that the rules do not lead to other unintended consequences. A final proposal will be presented to BCBS in the near future, for decision on the text of the rules and arrangements for their publication and implementation.

4.4.5. Margin requirements for non-centrally cleared transactions

Given that many OTC derivatives will not be centrally cleared, a working group to study and propose margin requirements for non-centrally cleared transactions was established in 2011.[11] This group is co-chaired by BCBS and IOSCO, with input from other Bank for International Settlements (BIS) committees, and intends to issue a consultative report on proposed international standards around the middle of the year. The key objectives of this work are to:

  • ensure consistency and comparability of margining requirements across international jurisdictions so as to limit opportunities for regulatory arbitrage and competitive inequalities
  • limit and mitigate systemic risk and interconnectedness in the derivatives markets
  • promote the safety and soundness of key participants in the derivatives markets.

These objectives recognise that consistently applied margin requirements on non-centrally cleared derivatives can reduce risk in the financial system. It is also acknowledged that the effectiveness of capital incentives to favour central clearing might be reduced in the absence of margin requirements for non-centrally cleared transactions. Accordingly, all non-centrally cleared derivatives may be subject to margining requirements, regardless of the reasons why a derivative is not centrally cleared. It is intended that entities entering bilateral transactions will collect and/or post initial margin as well as variation margin, unless they are exempted from doing so. An exemption from mandatory clearing would not necessarily lead to an exemption from margining requirements.

Footnotes

The most recent report is FSB (2011), OTC Derivatives Market Reforms: Progress Report on Implementation, October. Available at <http://www.financialstabilityboard.org/publications/r_111011b.pdf>. [1]

FSB (2012), Press Release, 10 January. Available at <http://www.financialstabilityboard.org/press/pr_100112.pdf>. [2]

FSB (2011), Effective Resolution of Systemically Important Financial Institutions: Recommendations and Timelines, July. Available at <http://www.financialstabilityboard.org/publications/r_110719.pdf>. [3]

CPSS-IOSCO (2011), Principles for Financial Market Infrastructures: Consultative Report, CPSS Publications No 94, Bank for International Settlements,March. Available at <http://www.bis.org/publ/cpss94.pdf>. [4]

CPSS-IOSCO (2012), Report on OTC Derivatives Data Reporting and Aggregation Requirements, CPSS Publications No 100, Bank for International Settlements, January. Available at <http://www.bis.org/publ/cpss100.pdf>. [5]

More information is available at <http://www.financialstabilityboard.org/list/fsb_publications/tid_156/index.htm>. [6]

IOSCO (2011), Report on Trading of OTC Derivatives, February. Available at <http://www.iosco.org/library/pubdocs/pdf/IOSCOPD345.pdf>. [7]

IOSCO (2012), Follow-on Analysis to the Report on Trading of OTC Derivatives, January. Available at <http://www.iosco.org/library/pubdocs/pdf/IOSCOPD368.pdf>. [8]

IOSCO (2012), Requirements for Mandatory Clearing, February. Available at <http://www.iosco.org/library/pubdocs/pdf/IOSCOPD374.pdf>. [9]

BCBS (2011), Capitalisation of bank exposures to central counterparties, November. Available at <http://www.bis.org/publ/bcbs206.pdf>. [10]

FSB (2011), OTC Derivatives Market Reforms: Progress Report on Implementation, October, p 3. Available at <http://www.financialstabilityboard.org/publications/r_111011b.pdf>. [11]