G20 leaders met regularly since 2008 to discuss the global economic and the financial challenges. They have in the past agreed that financial stability is necessary to support a sustainable economic recovery. The Financial Stability Board (FSB), successor of the FSF, is trying to rectify the severe failures related to financial regulation.
The FSB works in collaboration with international standard setting bodies and national authorities. In agreement with the Basel committee (BCBS), the FSB is elaborating the Basel III rules. The over-the-counter (OTC) derivatives’ markets exacerbated financial instability during the last episode of financial crisis. Experts identified a mismanagement of counterparty risk. Therefore, lack of transparency regarding credit exposure along with an interconnection between all OTC derivatives’ participants led to a loss of confidence and a fall of market liquidity. Experts propose to introduce Central Counterparties (CCP). The CCPs help to: “mutualise” the risk in OTC derivatives’ markets; move from a bilateral risk exposure model to a centralized risk exposure management; and disclose details about risk exposure in OTC derivatives’ markets.
The FSB’s main objective is that the clearing of OTC derivatives should be mandatory by the end of 2012. To guarantee good implementation of CCPs, the FSB made four recommendations:
- First, a standardization of financial instruments leads to higher clearing possibilities. More precisely, operational standardization means a comparable life cycle (trade process) for derivatives’ contracts. The legal standardization, however, indicates similar legal contract specifications. Nevertheless, it is impossible to standardize all OTC derivatives because investors need bespoke contracts. The challenge for market regulators is to distinguish between contracts created to respond to investment needs (hedging) and those created to circumvent standardization.
- Second, to clear the standardized contracts, markets participants’ must have direct or indirect access to CCPs. There should be also a real interconnection between CCPs. International and national authorities should ensure that the non-cleared products don’t enclose bilateral risk.
- Third, experts criticize OTC derivatives’ markets opacity. Transactions prices and volumes are rarely disclosed. Therefore, the FSB recommends trading on exchange or electronic trading platforms to guarantee transparency.
- Finally, the FSB recommends the creation of trade repositories (TRs). The data help local and international authorities to identify OTC contracts’ risk. Simultaneously, TRs help investors to properly price contracts and help authorities to oversee the implementation of regulation.
Progress and challenges in Implementing OTC’s new regulation
Many developed countries (e.g. U.S, Japan, EU and Hong Kong) are implementing reforms related to FSB recommendations regarding OTC derivatives. More precisely, the OTC derivatives’ clearing is contained in the Dodd-Frank Act in the U.S. The European market infrastructure regulation (Emir) and the markets in financial instruments directive (Mifid) are in charge of implementing OTC derivatives reforms. None of these mechanisms has yet been finalized. Hong Kong is committed to OTC derivatives reforms, but it is not clear if they will be able to comply with the 2012 deadline.
In other markets (e.g. Korea, Canada), there has been considerable policy analysis; however, regulatory amendments have yet to be taken. Australia, India, Mexico, Saudi Arabia, South Africa, and, Switzerland decided to assess their OTC markets and implement changes throughout 2011.
Whereas China and Russia agreed to the implementation of FSB OTC commitments but no clear timetable is presented. The FSB admits that: “While recognizing the implementation challenges and the complexity of the needed laws and regulations ... jurisdictions should aggressively push forward to meet the deadline in as many reform areas as possible”.
Add this to the list of many challenges facing leaders in Cannes this week.
Badye Essid is an Economist at CIGI.