Asia’s OTC derivatives markets have been both blessed and cursed by the fact they have implemented the structural reforms demanded by the Group of 20 in the wake of the larger European and US markets.
Blessed, in the sense that they can learn from the mistakes and experience of those countries that went before.
Cursed, because the rules already laid down in the west are having a profound and not wholly positive impact in the east.
Rebecca Terner Lentchner, head of policy and regulatory affairs for the Asia Securities Industry & Financial Markets Association (ASIFMA), says that differing policy priorities, legal frameworks and implementation timelines in Europe and the US have made it hard both for global market participants and other less-developed jurisdictions to comply with the principles laid out by the G-20 in 2009. “Different experiences of the crisis have led to serious divergences between Europe and the US in the implementation of those reforms, which may create an unequal playing field for large globally active banks and asset managers,” she says.
The G-20 plan for reducing systemic risk in the global derivatives markets centres on the migration of standardisable instruments to central reporting and clearing and trading on exchange-like platforms.
Non-standardisable instruments face higher margins and capital charges. Necessarily, the largest jurisdictions were the first to pass and implement new legislation.
Asia’s OTC markets are smaller, less diverse and built on different legal frameworks than those in Europe and the US. This has influenced the pace and detail of regulatory reform, as have other local factors, such as currency controls in some jurisdictions and the varying volumes of trading in particular instruments across the region.
While interest rate swaps (IRS) are the biggest class of OTC derivative globally, FX derivatives dominate the Asian landscape. Hong Kong is the biggest single equity-linked OTC derivatives market in Asia ex-Japan, but does very little trading in IRS, a market dominated by Australia and Singapore.
The G-20 requirement to report OTC derivatives trades to a trade repository is still being rolled out in Asia. In Japan – which accounts for roughly half the region’s OTC derivatives trading volumes – reporting rules came into force in parallel with those imposed by the US Dodd-Frank Act. And while the European market infrastructure regulation (EMIR) went for a big bang approach in February 2014, requiring both buy- and sell-side firms to report OTC and listed derivatives transactions, Australia, Hong Kong and Singapore are taking a more gradual approach.
These three finance hubs have woven global standards into their reporting requirements, but China, India, Indonesia, Malaysia and South Korea have tended to adopt new rules in line with their own domestic priorities.
Japan did not initially include legal entity identifiers (LEIs) – unique codes that identify counterparties to financial transactions – because it introduced its rules before the global governance framework for LEIs was finalised. But the Tokyo Stock Exchange began issuing LEIs last August following amendments to Japan’s Financial Instruments and Exchange Act.
As well as coordinating on reporting rules and fields, Australia, Hong Kong and Singapore have approached implementation schedules in a similar fashion by targeting primary dealers first – equivalent to US swap dealers – followed by other financial institutions such as foreign bank branches and major investment managers in a second wave and end-users such as pension funds and corporates in the third wave, with inevitable exemptions.
Similarly, these markets are reporting the highest volume instruments first, typically tackling interest rate swaps, credit default swaps and non-deliverable FX forwards before moving onto other instruments.
In September, the Australian Securities and Investments Commission (ASIC) and the Monetary Authority of Singapore (MAS) displayed further coordination by entering into the first ever agreement to allow trade repositories licenced in one jurisdiction to provide relevant data to regulators in the other, following the licensing by ASIC of DTCC Data Repository (Singapore).
Faced with a flurry of deadlines, derivatives market participants including major buy-side firms are rethinking their back-offices’ processes. “For buy-side firms, meeting the new reporting requirements is a lot easier if your derivatives trading process is automated further upstream. Many of the confirmation system providers are offering reporting as an added-value feature of their platforms,” says Peter Tierney, regional head of DTCC in Asia.
Buy-side firms operating in Asia are also looking to their sell-side counterparts for support in complying with the new rules, especially for less frequent users of OTC derivatives. Banks and brokers offered delegated reporting services in Europe with mixed results, some under-estimating the cost of the work involved and at least one subsequently withdrawing the service. And while some brokers are adding reporting to their Asian suite, others worry about the liability aspect of reporting on behalf of clients.
“Some banks saw a marked uptick in business from offering delegated reporting services in Europe. And although volumes might be lower in Asia, I’d expect them to cater for clients’ reporting requirements in that region too, subject to local rules on agency reporting,” says Cian O’Braonain, director of regulatory reporting practice at Sapient Global Markets.
In part because their financial markets are dominated by global institutions headquartered elsewhere, many of the deals ‘traded’ in Australia, Hong Kong and Singapore and are actually booked elsewhere. An HSBC swap trade with a local client denominated in sterling could be booked in London and does not need to be reported in Hong Kong for systemic risk supervision purposes.
However, in common with other Asian finance hubs, the Hong Kong authorities have decided to regard trade repositories as market conduct tools, and as such are requesting that ‘nexus’ trades that originate in their jurisdictions are reported locally, regardless of where they are booked.
This often requires firms to upgrade or implement new systems or workflows as the confirmation systems used to generate trade repository reports don’t necessarily identify the trader with whom the transaction originated. In Hong Kong, LegCo is allowing a six-month grace period after it has passed the new law requiring reporting of all locally originated trades, which means banks can send reports in arrears. But because some firms will not sign off budget for IT spend until the legislation is passed, their operations staff must find a way to report those trades before the investment can be made in new technology.
“Following years of dialogue around nexus, regulators would like to see an expedited implementation schedule while banks are still building the necessary systems architecture. Nevertheless, overall the dialogue between the industry and the regulators has been healthy,” says Keith Noyes, regional director, Asia Pacific at ISDA.
Although there remains much work to do in terms of completing the reporting mandate, the attention of many Asian OTC derivatives traders will focus on clearing in 2015.
While Japan is widening the range of instruments that must be cleared centrally, Singapore could still launch mandatory clearing before the end of the year, but Hong Kong and Australia are still consulting the market.
With voluntary volumes residing largely in LCH.Clearnet’s SwapClear, at least for IRS, the proxy battle for OTC derivatives clearing market share is most evident in the international positioning of central counterparties (CCPs) in Asia’s major hubs.
The CCPs of the incumbent exchange groups of Australia, Hong Kong and Singapore have invested to gain qualified CCP (QCCP) status under the principles for financial market infrastructures (PFMI) laid out by the Committee on Payment and Settlement Systems and the International Organization of Securities, but that doesn’t guarantee the right to compete globally.
“EMIR legislation is very prescriptive about some of the risk management practices of CCPs,” explains ISDA’s Noyce. “To be recognised in Europe as a QCCP, foreign CCPs must apply for recognition to the European Securities and Markets Authority (ESMA), which involves determining country equivalence by the European Commission, an assessment of compliance with regulations and law that are ‘equivalent’ to EMIR, and the signing of a MoU between ESMA and the local competent regulatory authority. If they cannot be recognised as a QCCP, they will be subject to a higher set of capital charges under Capital Requirements Directive IV.”
These extra costs of compliance with different jurisdictions’ legislative routes to the same global goal are a source of frustration, but progress has been made in recent months. EMSA has adopted equivalence decisions for the regulatory regimes of CCPs in Australia, Hong Kong, Japan and Singapore.
The US Commodity Futures Trading Commission recently gave approval for US market participants to trade directly on three Asian derivatives exchanges: Singapore Exchange Derivatives Trading; Bursa Malaysia Derivatives; and the Tokyo Commodity Exchange.
The US derivatives regulator has also granted temporary relief from registration to clearing houses in Australia, Hong Kong, India and South Korea where clearing for US persons is limited to clearing members and their affiliates, and intends to have permanent exemptions in place before the end of the year.ASIFMA has nevertheless voiced its concerns over the long-term effects of forcing Asia’s derivatives markets to meet the letter of the law of larger and more sophisticated jurisdictions. “Asia may well need more complex regulation as they develop, but that should be an iterative process. It makes no sense to saddle Asian markets with the same level of regulation as more advanced markets at their current stage of development,” says Terner Lentchner.