12 September 2012

Help or Hinder?: are new OTC derivative regulations worsening the problem?

The Sibos Colloquium will examine the OTC derivative clearing regulations and their effects on market infrastructures.

The newly-created SWIFT Institute will be showcasing a new format, a Sibos Colloquium, at Sibos in Osaka in October 2012.  In a previous article we announced a debate on the anticipated OTC Derivatives clearing regulations.  In this second in a series of four articles, we examine the at times conflicting perspectives (which our next article will explore even further) of the potential impact of the imminent regulations on market infrastructures.

Recent regulations in both Europe and the U.S. mandate that certain OTC derivative products will need to be cleared through a Central Counter Party (CCP).  In his paper, “Making OTC Derivatives Safe – A Fresh Look”, Manmohan Singh, Senior Economist at the International Monetary Fund argues that a single CCP would ideally provide the best solution and the proposed regulations do not adequately address the “tail risk “of derivatives carried by financial institutions (measured via the bank’s residual derivative liabilities).  Mr Singh foresees that the exemption of certain parties (for example, sovereigns) and products (foreign exchange swaps) implies the regulators are only moving part-way to a “first-best solution” which could actually worsen the problem of under-collaterisation.  In addition, Mr Singh suggests that lack of CCP interoperability will result in a demand for increased collateral, implying that institutions will not put forward all of their derivative positions and this will have a negative impact on market liquidity. Furthermore, banks may skirt the definition of “standard” contracts requiring CCP clearance in order to maintain their bundled “netted” positions.

Godfried De Vidts, Director of European Affairs at ICAP plc, agrees that the exemptions offer constraints and despite the fact that comprehensive bilateral netting will be broken, the regulations will not take the risk out of the system.  He remains opposed, however, to Mr. Singh’s belief in the creation of further regulations, questioning the need for additional measures:  “The G20 regulatory reform will encourage greater central clearing of derivatives and the Dodd Frank/EMIR mandate risk mitigation for non-cleared trades.  As portfolio risk exposures arise across bilateral counterparties and CCPs, and netting opportunities reduce, further requirements should not be necessary.”

The next article in the series will examine the issue from the taxpayer’s perspective, the creation of CCP’s “too big to fail” and Mr. Singh’s proposal of a derivative liabilities tax.  We invite you to attend the Colloquium, to listen to the debate in person and have the opportunity to participate in the subsequent discussion.

 


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