OTC Derivatives Reform — Asia Takes up the Challenge

“Doing nothing is not an option.” Futures Industry Association (FIA) President John M. Damgard issued this message at the FIA Asia Derivatives Conference in Singapore in November. Against the backdrop of sweeping changes in the regulatory landscape for derivatives, an impressive roster of speakers from across Asia discussed both the impact of the U.S. Dodd-Frank Act and Europe’s Markets in Financial Instruments Directive (MiFID) on non-U.S. customers, brokers, and clearinghouses.

In his keynote address, U.S. Commodity Futures Trading Commission (CFTC) Commissioner Scott D. O’Malia set the tone of the conference by stressing the core tenets of over-the-counter (OTC) derivatives reforms that form the basis of the G-20’s response to the 2008 financial crisis:

• All standardized OTC contracts should be exchange traded; cleared through central counterparties (CCPs); and reported to trade repositories.
• OTC contracts that are not cleared by a CCP should be subject to higher capital requirements.

Given the opaque nature of the OTC derivatives market, these proposed reforms are designed to reduce counterparty risk, protect against market abuse, and ultimately enable regulators to better assess, mitigate, and manage systemic risk. In reality, though, any international coordination of derivatives regulation would face three main challenges. Different jurisdictions need to agree on the contours of regulatory reach. Achieving international agreement on detailed principles and standards is critical to facilitating global regulatory convergence, and  harmonizing how legislation and regulations are implemented through active dialogue and consultation among the various jurisdictions is vital to both mutually recognizing and avoiding contradictory regulation. 

The entire Asia Pacific interest-rate derivatives market only accounted for 7.7 percent of the global volume in June 2010. Will the new mandatory regulations increase hedging costs for market participants? More specifically, should clearing be mandated through home-country CCPs, or by participating in global CCPs that are mutually recognized? Would it lead to a trade war between Asian financial centers for cross-border transactions?

Major Reforms Already Underway
While the markets require clarity, certain jurisdictions on this side of the globe (Japan, Australia, and Singapore) have initiated proposals to implement the G-20 commitments. In November 2010, Singapore Exchange (SGX) launched the first central-clearing platform for OTC financial derivatives in Asia. It is not a mandatory requirement and currently only covers interest-rate swaps, but it will expand to include certain non-deliverable forward foreign-exchange contracts. The Monetary Authority of Singapore (MAS) is reviewing its policies and will conduct a consultation by the end of this year on all aspects of the Financial Stability Board’s recommendations with regard to implementing the G-20 commitments. 

Meanwhile, the Hong Kong Monetary Authority (HKMA) and Securities and Futures Commission (SFC) in Hong Kong have issued a consultation on a proposed regulatory regime for OTC derivatives that would establish a clearing house for derivatives transactions and create a trade repository for data collection. In response, CFA Institute submitted a comment letter to HKMA and SFC that applauded the efforts taken and highlighted our 2009 U.S. member survey  in which 68 percent of survey respondents said that all standardized and standardizable derivative contracts that currently trade over-the-counter should be required to trade on a regulated exchange. Seventy-eight percent agreed that such contracts should have to clear centrally, and 66 percent indicated that electronic reporting of over-the-counter trades would provide an appropriate level of transparency for those derivatives that continue to trade OTC.

Although the OTC derivates market in Asia is relatively small compared to the U.S. or Europe, regulators are making the right move by committing to the development of a regulatory regime that is on par with international standards but also takes into account local market conditions and characteristics. Although the end-2012 implementation deadline is probably a stretch for most Asian countries, connecting Asian participants to global counterparts — including the U.S. for input on systemically important products — is likely to be a key focus for regulators. The progress taking place in non-G-20 jurisdictions like Hong Kong and Singapore is definitely a promising start.