Testing the derivative depths

The global over-the-counter derivatives market is vast, opaque, potentially destructive and dominated by a handful of institutions. But bringing it out of the shadows to regulate won't be easy or risk-free either.

Given the traumatic shocks to the global financial system triggered by the collapse of Lehman Brothers in 2008, it sounded like a good idea to bring the trading of over-the-counter derivatives out of the shadows of the system and into the sunlight. The concept, however, appears to be easier to articulate than execute.

Last week the Australian Council of Financial Regulators produced a report on its proposed reforms of the OTC derivatives market, following up a discussion paper issued in the middle of last year. Not that much progress appears to have been made.

Most of the major global regulators and regulatory forums agree that the trading of non-exchange-traded derivatives should become more transparent and should be centrally cleared and a considerable amount of discussion and work has been underway to strengthen the resilience and reduce the level of risk within financial markets as a consequence of the inter-connectedness of the global institutions that dominate OTC trading.

The council’s report, however, makes it clear that the complexity of the markets, and their global nature, means that there isn’t a straightforward way to achieve the G20 objective of having all standardised OTC derivatives traded on exchanges and centrally cleared by the end of this year, with trades reported to central repositories and non-centrally cleared contracts subjected to higher capital requirements.

While the council said it believed various regulatory and commercial incentives were driving markets towards centralised arrangements, it leans towards allowing the market and participants to lead the move towards the use centralised infrastructure – trade repositories, counterparties for clearing transactions and trading platforms – rather than mandate their usage.

The concerns about imposing a new centralised architecture on OTC derivatives relate to the potential fragmentation of global markets, regulatory inconsistencies and the complexities that could be created if jurisdictions had potentially conflicting central clearing mandates. There are also potentially significant new costs that could be added to the system, particularly if transactions had to be cleared across multiple jurisdictions.

There is a particular issue in mandating central clearing of OTC derivatives trading in Australia, where the market is only about two per cent of the global trading and where trading could well be driven offshore if costs increased and liquidity decreased, putting Australian institutions at a competitive disadvantage if they were forced to clear through a domestic central counterparty.

Centralising clearance also means centralising and transforming risk within the central counterparty, which takes on the obligations of both buyers and sellers, which could be another reason the council isn’t in a rush to embrace the concept.

There are also concerns that, given that the establishment of a central counterparty would result in a significant increase in the amount of high-quality collateral required, there could be a shortage of suitable high-quality Australian liquid assets to support an increase in central clearing.

Against that, it would be difficult for Australian regulators to be comfortable about the exposures of the institutions they regulate, and the derivatives markets they regard as systemically important, if most of the clearing of them occurred offshore.

The council certainly, albeit cautiously, supports mandatory reporting to trade repositories for key products and participants, which would bring greater transparency to the markets. It would enable the market to determine the industry structure for repositories, including whether they operated cross-border, although it would licence and supervise any repository operator.

In terms of the discussion about mandating central clearing, however, the council would prefer to let the market sort it out, arguing that new prudential requirements and margin requirements for non-centrally cleared contracts will provide incentives for central clearance and reduce the risks involved in bi-lateral clearing.

It has, however, preserved the option of intervening and mandating central clearing if the market doesn’t develop in the fashion and at the pace it desires. Similarly, it wants to wait until it has access to transaction data from trade repositories before it decides whether it should be mandatory to trade some forms of derivatives on exchanges or electronic trading platforms.

It is worth noting that sovereignty over ASX’s clearing and settlement systems was cited by the federal government as a key factor in its decision to block ASX’s merger with the Singapore Exchange. Some forms of securities trading are, apparently, more easily regulated than others.

Essentially, the council’s conclusions appear to be focused on buying more time to watch what happens offshore and to see how markets and institutions evolve to respond, while hopefully gaining access to more and better-quality information on OTC derivatives trading in the meantime.

The inter-dependencies between some key OTC derivative markets, like the Australian dollar-denominated interest rate derivatives, and other domestic capital and credit markets means that there are systemic implications to any changes to their regulation and infrastructure – and potentially systemic risks if the current framework is left unchanged.

The global OTC derivatives market is vast, opaque and dominated by a handful of global financial institutions. The lack of transparency means it is impossible to determine with any precision how much of a threat it might be to global financial stability or where its vulnerabilities lie. The suspicion is that the markets could confirm to Warren Buffett’s famous description of derivatives as "financial weapons of mass destruction".

They need to be brought into the sunlight, at least, and ideally the trading in globally-significant OTC products should be regulated, occur on regulated platforms and be centrally cleared. The Council of Financial Regulators’ report, however, suggests that the process of dragging that activity out of the shadows of the system isn’t going to be straightforward or without its own risks.

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