Market split over HK OTC derivatives proposals

The regulatory proposals for OTC derivatives from the Hong Kong Monetary Authority and Securities and Futures Commission are garnering a mixed response from market participants.

The regulatory proposals for OTC derivatives from the Hong Kong Monetary Authority (HKMA) and Securities and Futures Commission (SFC) are garnering a mixed response from market participants, with some broadly welcoming them and others doubting the practicality of crucial elements of the new regime.

Following a consultation at the end of last year, the HKMA and SFC published its conclusions earlier this month and announced a supplementary consultation on the changes would be held until the end of August.

“In general, the effect of current regulatory regime proposals in Asia is that Hong Kong, Singapore and Australia will come into line with most regulatory aspects of the G20 – which can be summarised as ‘Stage One’ swap execution facilities and clearing as per the Dodd-Frank regime [in the US] – with a second stage of detailed rule-making to follow,” said Michael Go, executive director of the Money Market and Debt eXchange (MMADX).

Hong Kong’s regulators are “liaising with the market comprehensively,” suggested Go, who stressed the importance of taking into account the practicalities of the proposed changes for participants and new electronic trading platforms.

Dr Alex Frino, professor of finance at the University of Sydney Business School and CEO at Capital Markets Cooperative Research Centre, said: “There are similar consultations going on in major markets around the world and they are centred on three points: centralised clearing, centralised reporting and the issue of trading OTC derivatives on exchanges.”

The HKMA/SFC consultation documents “lack specifics, and the devil will be in the details,” said Frino, who believed the proposals for shifting OTC derivatives on to electronic platforms will be the biggest stumbling block.

“There are good reasons why they don’t trade on exchanges. If there were good economic reasons for them to do so, they would be traded and the liquidity would be absorbed. I don’t think forcing them onto exchanges is going to work, it will diminish their value,” said Frino, who added the point of OTC instruments is that the specific terms and dates can be tailored to suit the parties involved and to defer the risk from those who are willing to pay for that. “They are so non-homogenous; how can you fit that onto exchange trading?”

Trading on exchanges would bring more transparency and create an audit trail, conceded Frino, but he believed the practicalities involved made it close to “impossible”.

“The trading technology will also struggle to handle the complexity of them; it already struggles with some of the more exotic instruments that are traded electronically now,” Frino said.

Similar considerations exist for centralised clearing and reporting, says Frino, “They are so heterogeneous that working out the risks for each one individually will be so difficult that the economies of scale for clearing houses won’t work, it will be very expensive. That would impose costs on OTC derivatives.”

He said reporting made perfect sense in a broad-brush sense. But OTC instruments are so specifically tailored and exotic that reporting is almost meaningless.

“What do you gain? OTC derivatives exist because two parties hammer out the details between them,” said Frino.

However, MMADX’s Go sees the shift towards automated trading and processing as unstoppable.

“With the SFC’s proposed regulations, G20 directives and Dodd-Frank all pushing, there is a lot of momentum behind OTC derivatives moving onto an electronic trading platform. There are also benefits for the market in pooling liquidity onto an exchange, efficiencies from straight-through processing and improvements to pre- and post-trade risk management,” said Go. “Therefore, it is MMADX’s view that this movement is inevitable, noting that virtually every other financial instrument trades electronically today.”

MMADX is currently looking at the feasibility of launching its platform in Asia after it becomes operational in Australia.