The UK financial regulator, the Financial Services Authority (FSA), has laid out a vision for trading over-the-counter (OTC) derivatives in which standardisation and centralised clearing are preferable, but not mandatory.
Released this week by the FSA and HM Treasury, ‘Reforming OTC derivative markets – a UK perspective’ is less fulsome in its embrace of standardisation than legislation currently being considered in Europe and the United States.
The paper agrees that firms in the financial sector should be made to clear ‘eligible’ products via central counterparties (CCP), but says that the industry and regulators should acknowledge that exceptions would continue. The FSA recommends that trades which are not centrally cleared should be subject to “robust bilateral collateralisation arrangements and appropriate risk capital requirements” and allows for alternative approaches for non-financial firms “given the different nature of the risks they pose to the financial system”.
On the question of eligibility of OTC derivatives for CCP clearing, the FSA paper said the degree of standardisation should be considered in parallel with other factors such as regular availability of prices, depth of market liquidity and risks that cannot be mitigated by CCPs. To take on their added responsibility in limiting systemic risk, the FSA said CCPs must meet high regulatory standards “consistently applied in the major jurisdictions” and reiterated UK government calls for a clearing directive in Europe.
In October 2009, the European Commission published its proposals for reforming the OTC derivatives markets. A number of draft bills are currently under consideration by the US congress. A communiqué issued by the political leaders of the Group of 20 economies following their meeting in the US on 29 September 2009, included a commitment to the trading of standardised OTC derivative contracts on exchanges or electronic trading platforms by end-2012 “at the latest”.
The FSA warned that some of the existing legislative proposals could be “damaging” to the financial markets. In particular, it said that mandated CCP clearing for all standardised derivatives “could lead to a situation where a CCP is required to clear a product that it is not able to risk manage adequately, with the potential for serious difficulties in the event of a default”.
The UK regulator also sounded caution on mandating targets for CCP clearing of eligible products. “There may be some circumstances in which the more appropriate risk management approach is to manage a clearing eligible position alongside a non-clearing eligible position with the same counterparty outside of the clearing house,” it explained.
The FSA suggested that standardisation of OTC instruments could only go so far and that a proportion of the OTC derivatives market would always reflect demand for bespoke products that achieved a specific desired risk profile.
According to the FSA, the steps outlined in its paper, which also included higher capital charges for non-centrally cleared trades and registration of all relevant OTC derivative trades in a trade repository, would avoid the need to force standardised OTC trades on exchange. “Regulatory objectives of reducing counterparty risk and improving transparency can be achieved by other means,” the regulator asserted.
Nevertheless, the document confirms the willingness of the UK authorities to “work with international regulators and the industry to take steps to identify and agree which products can be further standardised … and ensure that this is implemented on a timely basis.”
According to research by International Financial Services London published in November 2007, 43% of the global OTC market is located in the UK.