The UK Financial Services Authority (FSA) has adopted a different stance on over-the-counter derivatives reform to other global regulators, by claiming in a report published last month that some standardised OTC derivatives may not be suitable for central clearing. The comments highlight the confusion over the definition of ‘standardised trades' in different regulatory jurisdictions.
The report, Reforming OTC derivative markets: a UK perspective, published jointly by the FSA and the UK Treasury on December 16, also diverges from regulatory proposals in the US and the European Union (EU) by rejecting the notion that standardised trades should be executed on organised trading platforms.
The UK authorities said they would not support proposals to mandate central clearing because "the clearing of all standardised derivatives could lead to a situation where a central counterparty (CCP) is required to clear a product it is not able to risk manage adequately, with the potential for serious difficulties in the event of a default".
The paper argues clearing eligibility should not be based solely on whether a product is ‘standardised', as it could leave CCPs and the market as a whole exposed to a number of risks. "There are benefits from pursuing greater standardisation in itself, irrespective of whether these products are then cleared or traded on an exchange. This may result in products that may be considered to be standardised, but are still not suitable for CCP clearing as they do not meet other necessary criteria," says the report.
Regulators should decide whether CCPs are able to effectively risk-manage individual products based on criteria including availability of prices, depth of market liquidity and whether the product contains inherent risk attributes that cannot be mitigated by the CCP, the report continues.
However, international regulators have yet to agree on the definition of a standardised trade - a key concern of the FSA and Treasury. "Standardisation will mean little if definitions and practices are applied in one jurisdiction and not another. In order to maximise the possible benefits from standardisation, it is essential that an international agreement between regulators and market participants is reached as to what standardisation means and what is realistically achievable on an asset class by asset class basis," they write.
The FSA and Treasury's definition of a standardised trade appears to contradict current thinking by the European Commission (EC). In its communication, Ensuring efficient, safe and sound derivatives markets: Future policy actions, published on October 20, the EC stated its intention to make central clearing mandatory for standardised derivatives.
In the US, all standardised swaps are required to be centrally cleared. But under the Wall Street Reform and Consumer Protection Act of 2009, passed by the House of Representatives on December 11, a swap will only be considered standardised if a CCP accepts it for clearing and the regulator determines the swap is required to be cleared. The regulator is required to review each swap, or any group, category, type, or class of swaps to determine whether they should be cleared.
The FSA and Treasury's definition implies trades can still be considered standardised even if they are not centrally cleared, whereas the US will only consider a trade standardised if it is centrally cleared. The EU has not come out with any clear indication as to how it will define a standardised trade, although it did state in its October communication that it will work with its partners in the Group of 20 to define which contracts can be regarded as standardised for central clearing.
The FSA and Treasury state their intent to push for the establishment of an international working group comprising regulators and industry participants, with the aim of agreeing consensus on products that are eligible for central clearing.
The report also focuses on other issues, such as whether non-financial firms should be included in the regulation. Corporate end-users of derivatives have been lobbying for months for exemptions from proposed legislation, which they argue will hamper their ability to hedge and put strain on working capital.
The report accepts that if non-financial firms were forced to clear products, the requirement to post both initial and variation margin would increase costs and introduce an unpredictable liquidity burden.
Similarly, it recognises that a non-financial firm's ability to collateralise exposures in non-cleared trades relies upon its capability to support the operational aspects of the collateral management processes, as well as its ability to meet unpredictable margin requirements. "Not all firms have equal levels of financial and operational resource to dedicate to this function. Therefore, plans for improving the robustness of bilateral collateralisation processes should be structured to ensure any changes are proportionate to the risk of the users and the sector to the system as a whole," says the report.
But it goes on to say regulators cannot be indifferent to the risks posed by non-financial firms, and, as such, a blanket carve-out from the requirements to mitigate counterparty risk within the financial system does not seem appropriate.
This point, in general, tallies with the EC's stance on the matter. The EC made an effort in its October communication to allay the concerns of corporate end-users, but stressed any significant carve-out for non-financial firms could create regulatory loopholes.