Derivative regulatory reform - an opportunity for an Asian response

Unsurprisingly, this has spawned a slew of regulations designed to address the counterparty risks and lack of transparency in over-the-counter (OTC) derivatives. In Sept 2009, the G20 countries agreed that by end of 2012, 'standardised' OTC derivatives ought to be cleared through clearing counterparties (CCP) and have these transactions reported to trade repositories. These commitments are reflected in the United States' Dodd-Frank Act and the European Market Infrastructure Reform legislation.

Currently, any end-user wanting to enter into an OTC derivative will transact directly with a dealer under private contacts (e.g. ISDAs) between both parties. The end-user and the dealer maintain a bi-lateral relationship for the life of the derivative trade and, accordingly, each faces counterparty risk. For centrally cleared transactions, once the deal has been struck, both parties 'give up' the transaction to a CCP, meaning that the end-user and the dealer both face the CCP for the life of the trade and have no direct contractual relationship with each other. This reduces the counterparty risk and impact to the market in the case of a default because the CCPs maintain margin on all contracts and hold a default fund with contributions from all members.

Well intentioned, but not without potential concerns

Several G-20 member Asian countries have announced initiatives to create home country CCPs. Outside the G20 members, Singapore has announced intentions to become a 'multi-asset class clearing hub' for OTC derivatives in Asia and has already started clearing Singapore dollar interest rate swaps. Hong Kong has also announced their intention to require locally incorporated financial institutions to adhere to clearing requirements. Several other Asian countries have initiated task forces to evaluate the issue.

However, these well intentioned reforms could also lead to unintended consequences. Firstly, the proliferation of too many CCPs may be a problem in itself. As a general rule, a small number of well capitalised CCPs are preferable to a large number of smaller ones as it enables increased netting benefits across counterparties, currencies and products. Fewer CCPs may also lead to lower liquidity if positions are too dispersed across many CCPs. Also, the high start up costs of a CCP and on-going running costs may be passed on to end-users.

Secondly, having each local CCP design its own unique platform, rules and technology infrastructure may hinder cross border trading and hedging activity. As many market participants (both end-users and banks) are already and, increasingly, seeking to operate in multiple jurisdictions (particularly in Asia), having common platforms and reporting requirements across CCPs will facilitate such activity.

Thirdly, Dodd-Frank rules may lead to US regulators not recognising foreign CCPs if they are not of 'comparable comprehensive supervision'. For example, if a US bank operating in Country A (which mandated local clearing) transacting in a swap which was cleared through a CCP that was not recognised by the US regulator, then additional capital requirements may be imposed on the US bank. Accordingly, there is little incentive for this trade to take place. In many Asian jurisdictions, US banks provide substantial liquidity to OTC derivatives and losing this liquidity would be undesirable.

There is no doubt that increased regulation of OTC derivatives is here to stay. The full implications of such reforms still require further analysis given that rules are not yet in final form. However, it is certain to have implications on Asian markets, particularly given the increasing connectivity between Western and Asian markets participants. To reduce risk of unintended consequences, a coordinated response across Asian industry bodies would be helpful. This response could entail agreeing minimum standards, common platforms and reporting requirements. In this case, more coordination would likely lead to greater liquidity and lower costs for all involved- surely a positive outcome for all.

Keith De Vaz is a senior executive vice president , Financial Market, Standard Chartered Bank (Thai).