The financial crisis revealed that improved regulation of over-the-counter (OTC) derivatives and markets, together with enhanced market transparency would be necessary to limit excessive and opaque risk-taking through OTC derivatives and to reduce the systemic risk posed by OTC derivatives transactions, markets and practices.
In 2009, G20 countries committed to changing the rules for OTC derivatives markets in order to strengthen their security and transparency. In particular they agreed to increased standardisation of derivatives, mandatory central clearing for standardised derivatives, increased collateral requirements for non-centrally cleared derivatives, required registration of all transactions with trade repositories (TRs), and the implementation of a unique international identification scheme (legal entity identifier - LEI). Such commitments require both national and international regulatory developments. In April 2012, the Principles for Financial Market Infrastructure were published by CPSS and IOSCO in an effort to update and broaden former standards applicable including the Dodd-Frank Act in the US and the European Market Infrastructure Regulation (EMIR) in Europe.
This month, a new edition of the Financial Stability Review “OTC Derivatives: New Rules, New Actors, New Progress” was published by Banque de France. It brings together articles from experts in the sector to review progress made so far in terms of regulatory developments for OTC derivatives and markets, and to lay out remaining issues and future challenges that need to be addressed in order to achieve an international regulatory framework that is comprehensive, adequate and consistent.
Central clearing is deemed to improve liquidity and reduce risk in the OTC derivatives market. Central counterparties (CCPs) can indeed insure against counterparty risk through mutualisation, enable implementation of adequate margin requirements, save on collateral through greater netting efficiency and promote transparency in the market. As higher risk becomes concentrated through CCPs, CCPs must be properly governed, supervised, their competitive environment should be carefully monitored and their potential failure must be organised in order to avoid market turmoil. Therefore, clear principles applying in the event of recovery and/or liquidation of such market infrastructures need to be defined.
Central TRs and the implementation of unique LEI contribute to increasing transparency by improving the quality and consistency of data. This can then be used to facilitate the calculation of overall exposures across financial institutions and to allow a better understanding of the interdependence between financial players. It is argued however that transparency should be extended to include secured and unsecured interbank lending which are the underlying benchmarks for interest rate derivatives, also the most common class of OTC instruments. Moreover, while progress has been made to standardise the identification of entities in a universally acceptable manner through the LEI, the more complex question of the standardisation of the depiction of financial products, instruments, contracts across markets and jurisdictions remains an important challenge for policy-makers to address.
The treatment of non-centrally cleared derivatives also needs to be clarified. The G20 reform requires stricter margin and higher collateral requirements for such derivatives. This risks giving rise to direct or indirect costs, which would not necessarily reflect the risks incurred for market participants and the public. Such collateral requirements may also be pro-cyclical and exacerbate, instead of alleviate, financial market stress. Finally, and in the context of increasing demand for high quality collateral assets following the financial crisis, increasing collateral use is boosting the share of encumbered assets on banks’ balance sheets. Collateral use may therefore add to the complexity, opacity and interconnectedness between financial market participants.
Finally, regulatory developments on OTC derivatives and markets require an international framework but also demand updating and adapting national regulation in a way that results consistent across jurisdictions. Moreover, coordination is key to assess the appropriateness and the interactions of different regulations that are developed and being implemented concomitantly (e.g. Basel III).