Dealers are getting used to the slow drip of national over-the-counter derivatives regulations, but the publication of Singapore’s proposed rules in February triggered a level of enthusiasm that is perhaps at odds with the size of its local currency derivatives market. The reason? Simply, because the Monetary Authority of Singapore decided not to propose that trades be cleared locally, and instead opted to give market participants a choice in their clearing arrangements. That stands in stark contrast to other markets, including Australia, Canada, Hong Kong and Japan, which are all considering – or have already decided – to impose location requirements on certain domestic derivatives trades.
The motives are obvious – regulators want their domestic banks to access clearing services directly, and are keen to retain oversight of local currency derivatives trades. But there are downsides, say dealers: it could lead to the fragmentation of liquidity and break-up of netting sets, which would eliminate efficiencies and lead to higher costs for end-users. In the worst case, it may be all but impossible to transact cross-border trades given competing and contradictory clearing requirements in some markets.
“The real issue people would find particularly troubling is if you have a US bank doing a Japanese yen-denominated trade with a European bank, and you could have regulators in all three jurisdictions demanding you have to clear that trade through a local central counterparty (CCP). Then you would have a really untenable situation where you couldn’t do that trade,” says Bob Pickel, chief executive of the International Swaps and Derivatives Association in New York.
It shouldn’t come to that – but there are plenty of examples of inconsistencies in the various OTC regulations. In some cases, they relate to the instruments that must be cleared; in others, to the entities that would qualify for an exemption to the mandatory clearing requirement. Even where the various national rules agree, they are unlikely to be implemented at the same time in every market.
“Ideally, what the industry would like is for all of the various jurisdictions to have the same rules and implement all the rules on the same day, at the same time – but we don’t enjoy the luxury of that ideal world,” says Stephen O’Connor, New York-based chairman of Isda and global head of OTC client clearing at Morgan Stanley.
The timings in the US and Europe are a case in point. The Dodd-Frank Act was passed into law in July 2010, and regulators have been working to draw up detailed rule-makings covering everything from swap dealer registration to the segregation of client collateral. While implementation has been delayed once already, dealers expect the mandatory clearing requirement to come into force – at least to some extent – this year. In Europe, however, the final version of the European Market Infrastructure Regulation (Emir) was only agreed by the European Commission, European Parliament and the Council of the European Union in February. The European Securities and Markets Authority was initially required to draw up a series of technical guidelines by the end of June – a deadline that was extended to September. But many market participants think it unlikely the rules will be fully implemented by the end of 2012 – the date set by the Group of 20 nations in September 2009.
“Looking at Europe and the US, it appears the US is going to go first and there’s a timing difference there,” says O’Connor.
Another potential issue is where trades that meet the mandatory clearing obligation will actually clear. Under the Dodd-Frank Act, clearing houses need to register with the Commodity Futures Trading Commission (CFTC) as a registered derivatives clearing organisation (DCO), requiring them to meet standards set by the regulator. The CFTC can exempt a clearing house from having to register, as long as it meets comparable rules in its own jurisdiction. However, many participants think it is unlikely the CFTC will provide an exemption for every CCP that springs up – meaning many foreign clearing houses will need to register in order to clear trades for counterparties subject to the Dodd-Frank Act.
“As it currently stands, a CCP would be a bilateral counterparty if it is not recognised as a DCO. If it trades with a US swap dealer as a bilateral counterparty, the US swap dealer would have to demand margin from the CCP. Clearly, that’s not the way CCPs work,” says Keith Noyes, Asia-Pacific regional director at Isda in Hong Kong.
This could be a particular problem in Japan, one of the largest local currency derivatives markets. The Japan Securities Clearing Corporation (JSCC), a Tokyo-based CCP, started clearing Japanese index credit default swap (CDS) trades in July 2011, and plans to start clearing yen interest rate swaps in October this year, but is not currently registered as a DCO. Conversely, any foreign CCP that wants to offer clearing services for domestic firms needs to be approved by the Japanese Financial Services Agency (JFSA). While the regulator has suggested it will authorise foreign CCPs to carry out clearing business, it has yet to do so.
This may not present too many difficulties for trades between two local counterparties. The current thinking is that Japan’s mandatory clearing obligation, due to come into effect in November, will only apply to domestic dealers in the first phase. Those firms will be required to clear Japanese CDS contracts through a domestic CCP, and yen interest rate swaps through a domestic or authorised foreign CCP – although, in reality, choice is limited to the JSCC at the moment.
Much less clear is the treatment for cross-border trades – those involving a domestic counterparty and a foreign bank. The JFSA has stated it will tackle this after the first phase, but dealers are concerned about the lack of clarity. As it currently stands, a Japanese bank would only be able to clear yen interest rate swaps through the JSCC. The overseas bank, however, may be required to clear elsewhere – either due to a domestic clearing requirement, or because the JSCC is not recognised by the bank’s regulator as an authorised clearing house. In other words, Japanese dealers may not be able to trade with foreign banks in certain circumstances. Given the fact that cross-border transactions account for around 50% of the volume in yen interest rate swaps, this could have a major impact on liquidity, dealers claim.
“The volume of trades between domestic and overseas firms is not small – it is larger than for domestic versus domestic trades. That gives Japanese banks access to liquidity. So, if domestic versus overseas transactions cannot clear through a Japanese CCP, we cannot trade,” says Yutaka Nakajima, senior managing director and head of trading for fixed income in Japan at Nomura Securities in Tokyo, and an Isda board member.
There is time for this to be sorted out. In fact, London-based clearing house LCH.Clearnet was working with the JSCC in a joint venture to develop a yen interest rate swap clearing service, but the initiative was abandoned last September, when it became clear the JFSA would only require mandatory clearing for domestic dealers in the first phase – a decision that meant the cost of the venture outweighed the opportunity, according to LCH.Clearnet (Risk December 2011, page 8). Dealers say the JFSA understands the issues, and hope it will be amenable to future applications from clearers like LCH.Clearnet.
Either way, dealers have been calling for greater clarity on the issue. “A local Isda working group strongly argued that the regulations in each country have to be consistent, clear and transparent in terms of cross-border transactions,” says Yasuhiro Shibata, joint head of the fixed-income group at Mizuho Securities in Japan, and an Isda board member. “Regarding the clearing obligations, it will be physically impossible to clear in multiple locations. The issue is really crucial in Japan, because roughly half of the major players in yen swaps and Japanese CDSs are non-Japanese. That means very close to half of the derivatives transactions traded here are booked somewhere outside the country.”