A discussion of regulatory reform in the OTC derivatives market
The 2008 financial crisis made policymakers and legislators around the globe deeply concerned about the complexity and opacity of the OTC derivatives markets. The major impact of the OTC derivatives on the global economy is beyond any doubt. Their volumes are staggering and keep growing every year. This paper argues that the recent regulatory reform makes the OTC derivatives market safer. First, it will briefly explain the role of OTC derivatives in the 2008 financial crisis and the need for reform in its aftermath. Secondly, the key changes introduced by reform in the EU and the USA will be discussed. Thirdly, the idea of ‘too big to fail’ and its possible relevance to the central counterparties (CCPs) will be analysed. Finally, this paper will consider factors that insure the safety and resilience of CCPs, thus, proving the abovementioned statement highly doubtful.
Originally designed for risk-hedging, nowadays derivatives are widely used for speculation, but unregulated speculation of highly sophisticated financial instruments poses a threat to the stability of the financial markets. In the early 2000s, the investor Warren Buffett characterised them as ‘financial weapons of mass destruction’ (BBC News, 2003). That turned out to be prophetic, and in 2008 the world saw an ‘explosion’. The complexity and opacity of the structured credit and derivatives system and credit default swaps’ (CDSs) contribution to hard-wired procyclicality of the market are named among the main reasons of the 2008 crisis, according to the Turner Review (FSA, 2009). The systemic risk has become simply too high to be ignored; this led to an agreement on the international level that there was urgent need for the regulatory reforms.
The sweeping reforms
The G20 in 2009 decided that standard OTC derivative contracts should be cleared through a CCP. (The European Association of CCP Clearing Houses, 2013). From a legal point of view, three basic concepts constitute the essence of CCPs: novation, netting and set-off. Basically, the use of the CCP transforms multilateral contracts into several bilateral contracts, thus mitigating risk and adding transparency. In the EU this idea was implemented in EU regulation No, 648/2012, more commonly known as EMIR. The USA adopted similar policies with the Dodd Frank Act in 2010.
How has the recent regulation affected markets? EMIR imposes requirements on the parties to report every one of their derivative contracts to a trade repository. In addition to this, they have to meet the new risk management standards, including, but limited to, margining and operational processes for all OTC derivatives that are not cleared by a CCP. Finally, those OTC derivatives that are subject to mandatory clearing must be cleared via a CCP (FSA, n.d.).
Similarly, the Dodd-Frank Act introduced the mandatory use of the derivatives clearing houses for financial firms. The traders post capital here to cover potential losses that may be caused by an open contract. The larger the position firms have, the more capital they must post. This requirement is explained by the higher systemic risk posed by the firms with large open positions. The Dodd-Frank Act mandates that most derivatives cleared through a CCP are to be traded on a trading platform that satisfies certain criteria or through a regulated exchange. This also makes pricing more transparent (Markovich, 2013).
Mandating the use of CCPs for the OTC derivatives appears to have been controversial and has generated lively debate. On the one hand, the benefits seem to be obvious: CCPs can mitigate credit risk through intermediation between OTC derivatives counterparties (‘a buyer to every seller and a seller to every buyer’). They assist safe and effective clearing, reducing the disruptive effects of the default of a clearing member, thus acting as ‘shock absorbers’. CCPs make it easier for regulators access valuable market data, making markets more predictable and controllable (Pirrong, 2011). On the other hand, CCPs concentrate too much risk within themselves, potentially creating great difficulties in their operation during times of financial turmoil. Besides, a number of the legal problems that are vital for CCPs’ functioning (e.g. enforceability of netting and effective collateralisation in cross-jurisdictional transactions) still remain unsolved.
‘Too big to fail’ vs ‘too safe to fail’
The near failure of the American International Group, largely due to its transactions with CDSs, made regulators and academics think about the ‘too big to fail’ problem. Indeed, if in order to reduce and better manage systemic risk, regulators concentrate it within one institution, the effect may be just the opposite of that desired. Failure of such a giant, if not rescued, is sure to launch a chain reaction that will make the whole market crumble. ‘Putting all the eggs in one basket’ is said to be the main danger of relying too much on CCPs.
The most likely reason for a possible default of the CCP is the default of one or more of its members and subsequent lack of liquidity. In order to meet a margin settlement obligation, the CCP may use its own resources, if posted collateral is not enough, or borrow. After all its resources are depleted, the CCP goes bust. In his paper for ISDA, Pirrong (2011) notes that default is unlikely for strong CCPs, but that ‘the nature of CCPs makes them most vulnerable to default at the times that they are most needed as a systemic bulwark’. Of course, the regulators were aware of that risk when drafting EMIR. Creating a set of ‘too big to fail’ institutions that actually would be likely to fail could amount to transferring credit risk from financial institutions to tax payers. That is hardly aligned with societal interests, and EMIR clearly states that CCPs must have strong risk-management strategies in order to avoid this (The European Parliament and Council on OTC derivatives, central counterparties and trade repositories, 2012). Therefore, a number of measures were taken to ensure the safety and resilience of CCPs. These measures include the new rules about organisational arrangement, authorisation, separation of different assets, control mechanisms and capital requirements (Barker 2012).
Basically, there are several lines of defence that can protect CCPs from collapse: high initial capitalisation (7.5 million Euros), high entry requirements for clearing members and their contribution to the default fund, regulatory requirements for conducting business and prudent oversight of CCP activities. The Basel Committee has named the three most effective risk-mitigation techniques in the financial market: netting, collateralisation and segregation of client assets. CCPs are expected to use all these and more (Bank for International Settlements, 2010). If all the above mentioned requirements are met, it seems reasonable to support the use of CCPs. In this, most of state regulators are unanimous. For example, the FSA and HM Treasury (2009) have stated that they ‘strongly support the use of central clearing for clearing eligible derivatives through robustly managed clearing houses that meet a uniform set of high standards’.
In an attempt to reduce systemic risk, the new regulation has significantly increased the importance of CCPs for the OTC derivatives market. Despite all the measures to ensure the safety and resilience of CCPs, the risk of their collapse still cannot be ruled out completely. However, one may argue that the increased transparency brought to the OTC derivatives market by the recent regulatory reforms does make these markets safer and more controllable, so in the long-term, this will hopefully contribute to market sustainability and efficiency. Besides, CCPs have high safety standards in place that make the possibility of their collapse extremely remote. An unlikely public bailout seems less trouble than the more realistic frequent small or medium failures of market participants that disrupt the markets. In this case, such concentration of risk and heavy reliance on CCPs may be considered to be justified. Going back to the ‘all the eggs in one basket’ metaphor…well after all, it is probably safer to have all eggs bubble-wrapped and counted in one basket than to leave them scattered all around the kitchen.
Bank for International Settlements (March 2010) Report and Recommendations of the Cross-border Bank Resolution Group. Basel Committee on Banking Supervision Available at: http://www.bis.org/publ/bcbs162.pdf?noframes=1 [Accessed 3 March 2014].
Barker, M. (2012) Ireland: EMIR: Regulation on OTC Derivatives, Central Counterparties And Trade Repositories. Mondaq Business Briefing
BBC (March 2003). Buffett warns on investment ‘time bomb’ Available at: http://news.bbc.co.uk/1/hi/2817995.stm [Accessed 3 March 2014].
FSA and HM Treasury, (December 2009). ‘Reforming OTC derivative markets: A UK perspective’ Available at: http://www.fsa.gov.uk/pubs/other/reform_otc_derivatives.pdf [Accessed 3 March 2014].
FSA, (March 2009). The Turner Review: A regulatory response to the global banking crisis. Available at: http://www.fsa.gov.uk/pubs/other/turner_review.pdf [Accessed 3 March 2014].
FSA, (n.d.). European Market Infrastructure Regulation (EMIR) – what you need to know. Available at: http://www.fsa.gov.uk/about/what/international/emir [Accessed 3 March 2014].
Markovich, S. J. (December 2013) The Dodd-Frank. Available at: http://www.cfr.org/united-states/dodd-frank-act/p28735?cid=ppc-google-grant-dodd_frank&gclid=CJmmuIDIhb0CFYQfwwod1SYAqA [Accessed 3 March 2014].
Pirrong, C. (May 2011). ‘The Economics of Central Clearing.’ ISDA discussion paper. Available at: http://www2.isda.org/functional-areas/research/discussion-papers/ [Accessed 3 March 2014].
The European Association of CCP Clearing Houses, (2013) Responses to the Discussion Paper on the Clearing Obligation under EMIR, ESMA/2013/926 Available at: http://www.esma.europa.eu/system/files/gfxd_response_esma_discussion_paper_on_clearing_esma_2013_925_submission.pdf [Accessed 3 March 2014].
The European Parliament and Council on OTC derivatives, central counterparties and trade repositories, (2012). Regulation (EU) No 648/2012 of the European Parliament and Council on OTC derivatives, central counterparties and trade repositories (EMIR). Available at: http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32012R0648 [Accessed 3 March 2014].