Piloting policy

The privately negotiated derivatives industry congregated in Beijing last month for the International Swaps and Derivatives Association's annual general meeting. Top of the agenda were efforts to formulate a strategic response to calls for more regulation. Christopher Jeffery reports

The over-the-counter (OTC) derivatives industry has come in for its share of blame for fostering the development of the individuals, instruments, financial engineering techniques and conditions that lie at the heart of the global financial crisis. Some of this criticism has come in the form of attacks from parties with a vested interest in fanning the flames of discontent. Some of it has been more measured.

Barclays' chairman and chief executive for Asia Pacific, Robert Morrice, told delegates attending the International Swaps and Derivatives Association (Isda) annual general meeting (AGM) in Beijing on April 22 that "weak credit standards, too much leverage and too little transparency" were widespread in the financial markets and a "lack of market liquidity" was a key driver of contagion that led to a "severe loss of confidence around financial institutions' legacy asset exposures, creating a funding crisis".

While derivatives professionals were keen to stress that OTC instruments were not the underlying cause of the financial crisis, industry professionals attending the AGM appeared to be under no illusions about the seriousness of the threat to their business from policy makers. "Industry participants will need to recognise that the regulatory environment is going to change," said Morrice. "We all need to respond positively in partnership with regulators."

The result is a two-pronged effort by the industry to actively engage in discussions on the formation of policy while at the same time bolstering efforts to clean up the creaking derivatives infrastructure. "Our goals in these discussions are clear: separate myth from reality, underscore the risk-transfer benefits that derivatives offer and work together with policymakers to address the very real concerns that have been aired in recent months," said Robert Pickel, Isda chief executive, during his opening address.

Isda and its member institutions have already moved to deal with a number of infrastructure issues. The trade body has played a central role in improving derivatives operations, including eliminating backlogs of trade confirmations, dealing with novation concerns and, most recently, handling credit events.

Isda is now making efforts to improve its credit derivatives determinations via new committees, which are an important part of making new centralised counterparty credit clearing services viable - although there are concerns its determinations committee may face legal challenges to rulings on credit default triggers in Asian jurisdictions.

Morrice believes increased transparency, more capital and a reduction in bank leverage will be demanded by supervisors. But derivatives officials are concerned the increase in capital requirements may stifle genuine hedging activity. "In the effort to increase capital, we must not disadvantage tools that are essential to effective risk management," said Pickel.

It was a theme picked up by Eraj Shirivani, Isda's chairman and head of fixed income for Europe, the Middle East and Africa at Credit Suisse, who introduced the keynote speaker, China Banking Regulatory Commission (CBRC) chairman Liu Mingkang, on the second day of the conference. "Derivatives help companies manage their foreign exchange, interest rate and commodity exposures," said Shirivani. "They protect a company's financial health and its ability to meet its financial obligations by enabling it to transfer risks to other businesses that are set up to deal with that risk."

His comments coincided with the release of an Isda survey of Fortune Global 500 companies that found 94% of the world's largest corporates use derivatives to hedge their business and financial risks. Foreign exchange derivatives were the most popular type of contract (used by 88% of respondents), followed by interest rate derivatives (83%), commodity derivatives (49%), equity derivatives (29%) and credit derivatives (20%).

Asian corporates showed a lower level of derivatives use - 87% of South Korean corporates and 62% of Chinese corporates. But some corporates are clearly not happy with their exposures. One of the main topics of conversation on the sidelines of the event was the ongoing legal spat between corporates and banks in South Korea over the use of knock-in, knock out foreign exchange derivatives (see cover story, pages 16-19). There have also been problems flaring up in Indonesia.

Chinese state-owned enterprises (SOEs), asset managers and individuals, meanwhile, have lost billions of dollars on derivatives trades that have gone awry. As a consequence, Wu Xiaoling, vice-chairman of the finance and economic affairs committee of the National People's Congress, told delegates SOEs would be required to meet new guidelines on derivatives usage.

Wu added there needs to be more regulatory co-ordination between government agencies responsible for supervision of banks, securities dealers and insurance companies in China, and said government officials are assessing whether or not to move towards a centralised clearing system for trades rather than the current "scattered" approach. She also indicated that more disclosure would also be expected regarding derivatives transactions moving forwards.

"There is no doubt that we will have more complicated products for hedging and managing risk," said Yi Gang, deputy governor of the People's Bank of China. "The People's Bank of China and all the regulatory bodies ... have studied how to develop the future derivatives swap market. It will take time to do the co-ordination and also assess the potential risks. But if you look at the past few years, especially after 2005, derivatives swaps have developed fairly rapidly."

Liu at the CBRC, however, expressed serious misgivings about the use of derivatives and challenged one of the core benefits claimed by the industry: that derivatives have facilitated the transfer of risks from institutions that do not wish to hold them, to institutions that are best placed to understand and tolerate such risks. "That is not the reality," said Liu. "Risk was transferred to the parts that understand the risks the least."

Liu called for more "sociably responsible" use of derivatives to better develop the market, and said the Chinese banking industry will be closely monitored in its derivatives activities. "The CBRC opposes the use of high leverage, overly high bonuses, lack of transparency and derivatives structures that are not aimed at dealing with real issues," said Liu. "Know your customer, know yourself and know your counterparty."

While Liu accepted the useful role financial derivatives can play in risk sharing, he urged banks to "provide the right product to the right customer at the right time" and to "educate the customer about the risk inherent in the product".

The CBRC's message appears to have sunk in. Lili Wang, senior executive vice-president at International Commercial Bank of China (ICBC) in Beijing, indicated major Chinese banks such as ICBC may no longer be comfortable acting solely as a distributor of derivatives instruments. Wang said it is "not appropriate" for officials at banks to sell a product that the officials themselves "do not fully understand" to "people that understand it even less".

Liu, meanwhile, criticised both the practice of self-regulation and the prevalent incentive structure in the financial sector. "There is still an overreliance on self-regulation and not enough prudential regulation," he said. "Financial regulators need to change their mindset - it would be a big mistake to simply allow extreme freedoms for markets as it often leads to careless behaviour."

Market participants attending the event, however, called for greater consistency and co-ordination among regulators, saying regulatory and legal certainty is a vital component for the smooth functioning of markets. "There is a real collective action problem, not just among market participants, but also among regulators," said Theo Lubke, senior vice-president at the Federal Reserve Bank of New York. "As a regulator, you don't want to be out in front putting in place additional costs and restrictions within your jurisdiction if market participants can simply move somewhere else to trade."

CBRC chief slams 'piecemeal' supervision

Liu Mingkang, chairman of the China Regulatory Banking Commission (CBRC), who also sits on the monetary policy committee of the People's Bank of China, issued a broadside at what he termed "piecemeal" regulation of financial institutions and markets across the globe. In doing so, he took a swipe at the manner in which the global bilateral derivatives business is overseen.

Liu, a former chairman and president of the Bank of China, said the failure of financial markets around the world has challenged the assumption that globalisation is really a force for good. The CBRC head identified a number of failings in the global financial system, including the integration of banking and capital markets activities following the repeal of the Glass-Steagall Act; too much attention paid to innovation and reliance on the 'invisible hand' of free markets at the expense of prudential regulation; overuse of leverage; investments sold to investors by institutions that do not shoulder their responsibilities after selling instruments to third parties; and a piecemeal rather than a building block approach to supervision.

Liu said regulators need to have a comprehensive view of the whole market instead of looking at matters in isolation. He called for supervisors to adopt a "broad vision". "Governments around the world need to have a building-block approach rather than a piecemeal approach," said Liu, who added that efforts to use a 'piecemeal' approach to resolving the problems in the global financial system are destined for failure. And this has serious implications. "If we can't deal with these issues, we can't really embrace globalisation," Liu said.