Regulatory frameworks for financial derivatives

US DERIVATIVES REGULATION

The Obama administration on May 13th unveiled a sweeping plan to regulate over-the-counter derivatives in an attempt to seize greater control over an opaque market that has been blamed for exacerbating the financial crisis.

The move is intended to increase transparency and reduce risk in a market that is worth more than $680,000bn but has so far been largely unregulated. Many problems like accounting rules for derivatives have to be solved.

The new government plan, presented by Secretary Geithner, would force all “standardized” OTC derivatives to be cleared through central clearinghouses, to reduce the risk of investors being dangerously exposed to a single counterparty. These types of derivatives, which are estimated to make up the bulk of the market, -in particular credit default swaps- would also have to be traded on regulated exchanges via electronic systems. Currently many trades are done over the phone, making them hard to track and record. The move to clearing and exchanges would not apply to non-standardized derivatives, but Mr. Geithner said such tailor-made instruments were “not a dominant part of these markets now”. However, dealers in those markets and firms with large exposures to them would become subject to greater regulation. Under the plan central clearers will be required to produce publicly available data on trading volumes under the plan, and reveal to regulators the trades of individual counterparties. Banks are pushed to increase price transparency by adopting electronic trading systems for over- the-counter derivatives. It would imply imposing price reporting and transparency requirements on all over-the- counter derivatives. This might be similar to Trace, a bond-price reporting system of the Financial Industry Regulatory Authority. Trace gives anyone with an Internet connection access to trading data for corporate bonds. The system, in full operation since February 2005, reduced the difference in prices that banks charge to buy and sell bonds by almost half.

THE EU DERIVATIVES FRAMEWORK

The proposed US reforms of the OTC derivatives market could accelerate similar changes in Europe, but are unlikely to change radically the direction in which the European Union was already travelling. The EU has already hammered out plans that should see centralized clearing of credit default swaps, one of the biggest classes of OTC derivatives, introduced this year. The industry agreed to a system for clearing most EU-based credit default swaps in Europe by end-July. European Union Financial Services Commissioner Charley  McCreeevy  is presssing dealers to safeguard trades by creating a European clearinghouse.
The European Union is presently informally consulting market parties the idea of broadening the range of OTC instruments that are subject to central counterparty clearing. The possibility of standardization of derivatives and other complex structured products is a major criterion. A report is to be released towards the end of June. It will explore appropriate initiatives to increase transparency and ensure financial stability. Probably the capitals which banks and others trading in complex products have to hold are to be changed.

DOUBTFUL CORPORATE APPETITE

While prior efforts to move credit derivatives to exchanges haven’t succeeded, the odds are currently much better, given the regulatory spotlight and upheaval in the financial markets.
The plans to move derivatives trading to exchanges could however end up hurting companies that use the products for two major reasons. The first is that accounting rules often make customized, off-exchange products a better choice for corporations. Many corporations typically enter into non-standardized trades with banks in order to get better accounting treatment for their transactions. If it became mandatory for most over-the-counter derivatives to move to an exchange risk management would become more difficult and in any case more costly. Moreover FAS 133 requires corporations to record derivatives on their books at fair value, with changes in the value affecting the company’s income. Many companies would not want the value of their derivatives to affect their earnings. The only way out would be to qualify for hedge accounting. But that requires that the companies can demonstrate that the derivatives they are using are designed to reduce risk rather than take risk. This implies that the derivative must match the original exposure very closely, which typically requires custom-tailored instruments. The second reason is that effective risk management requires tailor made solutions. This need stands in the way of moving to exchanges the interest-rate, currency, and commodity derivatives that companies and large institutional investors use.  Simple solutions in standardizing derivatives offered through exchanges could be attractive for businesses as counterparty risks are reduced but it could have a disastrous effect for the large majority of corporations if basic risk management tools would be taken away.
New regulatory measures should preserve the usefulness of derivatives as risk-management tools for companies. If there is to be a successful market for corporate derivatives going through the exchanges the US administration will have to press for new accounting rules for derivatives and likewise the EU. Moreover the administration has to allow the continued use of tailor made OTC instruments.

MAJOR CONSEQUENCES

The new system could affect the earnings of banks, energy companies and other large corporate users of derivatives as it would force them to set aside more capital to cover potential losses.
However on the other hand the new regulations, including the amended accounting rules  mentioned above could bolster the stability of financial markets, promote efficient and transparent pricing and help regulators stamp out fraud and abuse. This holds in any case for credit default swaps. In particular of importance are the reductions of systemic risk, of counterparty risk, and the possibility that owners of CDSses could profit from “credit events” not brought about by corporate management of companies on whose debt CDSses are written. Fighting fraudulent providers of default swaps and market manipulation is also in the interest of hedgers of risks and other genuine sellers and traders of protection. So it is evident that in the present circumstances ISDAwelcomed the recognition of industry measures to safeguard smooth functioning of privately negotiated derivatives. It also stated to be looking forward to working with policymakers to ensure these reforms help preserve the widespread availability of swaps and other important risk management tools.
As to the net costs of the new system, the costs of margining and capital allocation make for higher costs to users and sellers of CDSses. On the other hand there will be more transparency for the buy side and less spread for the sell-side. If the a buyer of protection through a credit default swap can save money by clearing credit default swaps through a clearinghouse then they’re going to trade through that clearinghouse. However if dealers are required to trade CDS on exchanges, transparency of trade volumes and pricing and increased competition imply that margins are going to get squeezed.  This could be reinforced by secondary trading.

Drs. Alphons P. Ranner is founder and director of Sovereign BV financial consultancy. His background includes many years of experience in strategic and financial management and consulting.

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