TWN Info Service on Finance and Development (Oct11/04)
17 October 2011
Third World Network 

Slow pace in implementation of OTC derivatives reforms
SUNS #7238 dated 13 October 2011
 
Geneva, 12 Oct (Kanaga Raja) - With only just over one year until the end-2012 deadline for implementing the G20 commitments with respect to over-the-counter (OTC) derivatives market reforms, few Financial Stability Board (FSB) Members have the legislation or regulations in place to provide the framework for operationalising the commitments.
 
This is the assessment of the FSB in its second six-monthly progress report on implementation of OTC derivatives market reforms, released on 11 October.
 
The report concludes that jurisdictions should aggressively push forward to meet the end-2012 deadline in as many reform areas as possible.
 
The FSB, whose secretariat is hosted by the Basel-based Bank for International Settlements, was established to coordinate at the international level the work of national financial authorities and international standard setting bodies to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies in the interest of financial stability.
 
According to the FSB, in September 2009, G20 leaders agreed in Pittsburgh that, by end-2012, all standardised OTC derivative contracts be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counter-parties (CCPs); that OTC derivative contracts be reported to trade repositories; and that non-centrally cleared contracts be subject to higher capital requirements.
 
The G20 leaders had asked the FSB and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.
 
In June 2010, said the FSB, G20 leaders reaffirmed their commitment to achieve these goals. In its October 2010 report on "Implementing OTC Derivatives Market Reforms", the FSB had made 21 recommendations addressing practical issues that authorities may encounter in implementing the G20 leaders' commitments.
 
In its first implementation progress report, published in April 2011, the FSB said it had expressed concern regarding the likelihood of many jurisdictions meeting the end-2012 deadline set by the G20.
 
In this first progress report, the FSB further said it had warned that in order for this target to be achieved, jurisdictions needed to take substantial, concrete steps toward implementation immediately.
 
The current progress report comes nearly two years after the Pittsburgh G20 leaders' summit and just over one year from the end-2012 deadline, the FSB said.
 
The FSB report recognizes that the needed laws and regulations are complex and have the potential to result in significant changes in market structure. They must be developed with due care and analysis so as not to compromise the objectives for derivatives market reform set by the G20 of improving transparency in the derivatives markets, mitigating systemic risk, and protecting against market abuse.
 
Nonetheless, the report adds, legislative and regulatory frameworks need to be put in place expeditiously to establish the parameters and requirements for the full set of practical actions that firms, markets, infrastructures, and authorities need to take.
 
"In the interim, it is critical that market participants continue efforts to reform the trading, clearing and reporting of OTC derivatives."
 
According to the FSB, its second progress report provides a more detailed assessment of progress toward meeting the G20 commitments relating to central clearing, exchange and electronic platform trading, reporting to trade repositories, capital requirements, and standardisation.
 
The FSB said that for each of the G20 commitments, the report provides an assessment of progress in the three key steps that need to be taken: the development of international standards and policy; the adoption of legislative and regulatory frameworks; and actual implementation through changes in market practices.
 
With respect to the issue of central clearing, the FSB report notes that Members remain committed to changing legislative and regulatory frameworks, as needed, by end-2012 to achieve the G20 commitment to central clearing.
 
Some jurisdictions have indicated that they are waiting for the United States and European Union regulatory frameworks to be finalised before acting.
 
The report emphasizes that consistency in implementation across jurisdictions is critical, and it is understandable that smaller markets want to see what frameworks the United States and the European Union put in place when developing their own frameworks.
 
For instance, some smaller markets want to consider factors such as oversight arrangements and the availability of infrastructure for indirect clearing (i.e. clearing for market participants who are not members of the CCP) before deciding whether to rely on global infrastructure or promote local clearing infrastructure.
 
Nevertheless, the report stresses, it is important that all jurisdictions advance development of needed legislative and regulatory frameworks as far as they are able even before finalisation of the United States and European Union regimes, to be in a position to act expeditiously once rules are finalised in these two largest OTC derivatives markets.
 
Increasing the central clearing of OTC derivatives in practice is showing some progress both in higher volumes and expanded products, particularly in the interest rate and credit asset classes.
 
Nevertheless, taking this into account together with the pace at which various jurisdictions are implementing central clearing mandates, the FSB believes that the target of having all standardised OTC derivatives contracts centrally cleared will not be fully met by end-2012 in all FSB member jurisdictions.
 
"Therefore, the FSB believes that jurisdictions should aggressively push forward to meet the central clearing deadline for as many standardised OTC derivatives contracts as practicable."
 
On exchange and electronic platform trading, the FSB report finds that the establishment of legislative and regulatory frameworks to implement the commitment to trading standardised derivatives on exchanges and electronic platforms, where appropriate, is markedly behind the progress made toward other commitments.
 
Only the United States has enacted legislation and is actively working on the detail of the implementing regulations.
 
While the European Union (through pre-legislative consultation) has set out the direction of its regulatory framework, it does not anticipate having legislation in place before 2013.
 
Most other jurisdictions have not yet made basic decisions about regulatory measures, including whether any regulatory action will be taken.
 
The report notes that efforts to set an international standard for what the organised platform trading commitment means in terms of policy recommendations culminated in the International Organisation of Securities Commissions (IOSCO) Report on Trading of OTC Derivatives, which was published in February 2011.
 
Although IOSCO is conducting a further detailed stock-take on market use of multi-dealer versus single-dealer platforms, no further international policy guidance is anticipated.
 
Until more is known, the FSB said it is unable to assess whether the G20 commitment to organised platform trading will be fully achieved in practice in all FSB member jurisdictions.
 
"Based on the slower pace of basic decision-making in most jurisdictions, progress certainly does not appear to be on track across jurisdictions to meet the G20 commitment to exchange or electronic platform trading, where appropriate, of all standardised OTC derivatives by end-2012. Jurisdictions therefore should accelerate decision-making in this area."
 
On the issue of reporting to trade repositories, the FSB progress report notes that Members remain committed to putting in place by end-2012 the legislative and regulatory frameworks for achieving the G20 commitment to reporting to trade repositories (TRs).
 
However, it underscores, there are a number of implementation issues that need to be resolved around ensuring the suitability of the data collected in TRs for meeting different regulatory mandates (including financial stability) and authorities' effective access to data stored in TRs relevant to their respective mandates.
 
Actual reporting of OTC derivatives contracts to TRs is showing progress in the interest rate, credit, and equity derivatives asset classes. Currently, TRs are not operational for the commodity and foreign exchange asset classes, although infrastructure is under development.
 
Based on the current state of implementation, the FSB believes that, as is the case with central clearing, the target of having all OTC derivatives contracts reported to TRs will not be fully met by end-2012 in all FSB member jurisdictions.
 
"Nonetheless, the FSB believes that jurisdictions should aggressively push forward to meet the TR reporting deadline for as many OTC derivatives contracts as practicable."
 
With respect to capital requirements, the report finds that Members remain committed to putting in place by end-2012 the legislative and regulatory frameworks to achieve the G20 commitment to higher capital requirements for non-centrally cleared derivatives.
 
It notes that the Basel III capital framework, which strengthens the requirements for counter-party credit risk exposures, will take effect on 1 January 2013. Some aspects of that framework, in particular as it relates to banks' exposures to CCPs, are still being finalised.
 
At present, the FSB said it lacks information on capital requirements for non-bank regulated entities. Going forward, the FSB said it intends to focus on gathering this information.
 
According to the FSB report, standardisation is a core element for meeting the G20 commitments relating to central clearing, organised trading, and reporting to TRs.
 
To date, it notes, coordinated industry action led by the OTC Derivatives Supervisors Group (ODSG) has been the main driver of increased standardisation through a series of quantitative and qualitative commitments.
 
The industry's strategic roadmap delivered to the ODSG as part of the commitment letter published in March 2011 (Strategic Roadmap) establishes a framework for managing continued improvements in process and product standardisation by the G14 dealers and other major market participants.
 
"As establishment of legislative and regulatory frameworks to implement the G20 commitments progresses, authorities expect the industry to continue to increase standardisation of OTC derivatives products."
 
According to FSB, most jurisdictions believe that the proportion of OTC derivatives that are standardised will have substantially increased from pre-2009 levels by end-2012.
 
Approximately half the jurisdictions surveyed have adopted or plan to adopt legislative and regulatory measures to increase the use of standardised products and processes, while some other jurisdictions with markets that are already highly standardised expect to maintain these levels.
 
The FSB said it has been aware from the outset that there is a risk that overlaps, gaps, or conflicts in legislative and regulatory frameworks, if not addressed, could compromise achievement of the G20 objectives. This could occur if an overlap, gap, or conflict leads to an increase in systemic risk, or places inconsistent requirements on market participants that cannot be effectively implemented in practice.
 
The FSB pointed out that a number of potential overlaps, gaps, or conflicts have been identified and authorities are working on solutions.
 
Examples include issues concerning legislative and regulatory frameworks for regulation and oversight of CCPs and TRs, the application of central clearing requirements, and requirements by some jurisdictions that clearing occur in their respective domestic (or domestic-registered) CCPs.
 
"Work is needed to assess whether the issues that have been identified imply material problems for implementation at a global, systemic level."
 
One potential gap, which the FSB said it has identified, concerns the applicability of the G20 commitments to standardised derivatives that are moved onto exchanges or electronic trading platforms (and therefore no longer traded "OTC").
 
According to the FSB report, survey responses indicate some jurisdictions continue to review whether to mandate central clearing for these standardised derivatives.
 
The FSB said it believes that any interpretation of the language of the G20 commitment, which refers only to standardised "OTC" derivatives, to create a loophole so that such derivatives once moved onto organised platforms do not need to be centrally cleared or reported to trade repositories is clearly contrary to the spirit of the OTC derivatives reforms which are aimed at mitigating systemic risk.
 
The FSB recommended that all jurisdictions should confirm that standardised derivatives of the types which used to trade OTC should be centrally cleared and reported to TRs, irrespective of whether they continue to trade OTC or are moved onto organised platforms.
 
As to the next steps, the FSB said that a clear challenge going forward is to effectively monitor implementation through changes in actual market practice toward achieving the G20 commitments.
 
"Although improvements already can be seen, the scale of improvements is difficult to measure because today's OTC derivatives markets have not yet reached the substantially increased levels of transparency envisioned by the G20."
 
In the interim, until reporting to TRs and other reforms have been fully implemented, the FSB said it needs to identify alternative sources of data and metrics for tracking progress toward achieving the G20 commitments.
 
Presenting useful and comparable data tracking actual market changes is a priority for the FSB monitoring efforts going forward.
 
In its overall conclusions, the FSB said that it believes that the highest current priority in implementation of OTC derivatives markets reforms is to increase the pace of legislative and regulatory action to ensure that frameworks are in place as soon as possible.
 
"Jurisdictions should aggressively push forward to meet the end-2012 deadline in as many areas as possible, including accelerating jurisdictional policy decision-making with regard to organised platform trading."
 
The European Union and the United States, the jurisdictions with authority over the largest and most developed OTC derivatives markets, are well into the process of establishing legislative and regulatory frameworks.
 
Many jurisdictions have indicated that final decisions on domestic legislative frameworks will look to the international baseline established once European Union and United States' legislation and implementing regulations are in place and international standards are finalised.
 
Only a small minority of jurisdictions either have pre-existing frameworks or have adopted legislative reforms and are working on implementing regulations.
 
To meet the end-2012 deadline, the FSB stressed that it is important that all jurisdictions do as much as they can without waiting for finalisation of approaches in the largest markets.
 
To ensure consistency in implementation, and avoid overlaps, gaps, and conflicts in legislative and regulatory frameworks that may risk compromising reform objectives, specific overlaps, gaps, and conflicts should continue to be discussed, as a matter of priority, bilaterally between or multilaterally among jurisdictions.
 
Solutions also should come through consistency across jurisdictions in application of international standards that either address such issues directly or set out processes and expectations for international cooperation between authorities, says the FSB report.
 
The FSB said that as a key element of its work going forward, its OTC Derivatives Working Group will continue to actively monitor the consistency of implementation across jurisdictions and bring to the attention of the FSB any overlaps, gaps or conflicts that may prove detrimental to G20 reform objectives, particularly if there seems to be a risk that they will not be satisfactorily resolved through existing bilateral or multilateral channels.