Despite all negativity, collapses of financial institutions and overly lengthy recession, the 2008-2010 financial crisis did have something good coming out of it. Governments and regulators finally decided to establish limitations on financial activities which brought in all that chaos and despair. This is our silver lining: financial system reform. The price of this lining however, is not quite clear yet. Being mostly concerned about energy and commodities markets, we are looking at the pending impact from all those restructuring efforts.

One of the recommendations from 2009 Pittsburgh G20 summit on the topic of strengthening the international financial regulatory system was improving over-the-counter derivatives markets. It was stated that 1) all standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms and cleared through central counterparties by end-2012; 2) OTC derivative contracts should be reported to trade repositories; 3) non-centrally cleared contracts should be subject to higher capital requirements. The summit established Financial Stability Board (FSB) to coordinate and monitor progress in strengthening financial regulation. FSB was directed to assess implementation and sufficiency of transparency in the derivatives markets.

After the summit closed, nations went their own ways in developing regulatory frameworks and implementation. While they are currently in different stages of progress (e.g., European market infrastructure regulation is way ahead of the US Dodd-Frank act), they are setting the global stage to harmonize swap markets to avoid arbitrage opportunities.

The US and European reforms have been discussed widely in media. So we decided to have a look at the Asian efforts in this direction. In February, 2012, the Monetary Authority of Singapore (MAS) published a paper on an over-the-counter (OTC) derivative reform. It has been a general consensus that while the Asian framework may appear lax compared to the firm structures emerging in the US and Europe, MAS strikes the balance between meeting the G20 objectives and the needs of the local market. To begin with, OTC trades comprise a tiny fraction of global volumes (~7%) with Japan outweighing all other nations in the region. Thus, the impact from their reform cannot have any significant global impact. Nevertheless, let’s look at the similarities and differences between counterparties.

Similarities

  • Central clearing of all standardized OTC derivatives: criteria to determine whether products should be centrally cleared are largely in line with those proposed elsewhere and include level of systemic risk, depth of liquidity, level of standardization, availability of reliable pricing.
  • All instruments will have unique identifiers. All transactions will carry details including economic terms contained in agreements, execution data, counterparty information, underlier information etc. This information must be updated throughout the lifecycle of the transaction.
  • The initial list of cleared OTC derivatives includes interest rates, FX products and oil derivatives. Eventually cleared will be all contracts traded or booked in Singapore in all asset classes, including current transactions with one year or more to expiry.
  • The mandate will apply to all financial institutions; to what extent non-financial institutions will be affected is still a matter of debate. One thing for sure: central clearing will apply to non-financial institutions above certain yet-to-be-determined thresholds in terms of derivative exposure and asset portfolio size.
  • Derivatives used for hedging will be excluded from the exposure threshold. It is likely that most industrial entities will be largely unaffected by the new regulation as single-sided reporting will be introduced (e.g.: when financial firms trade with non-financial firms, the financial firms do the reporting).

Differences

  • OTC derivatives don’t have to be traded on exchanges or electronic trading platforms in order to avoid increased costs to the participants and allow for more flexibility.
  • Central clearing is not limited to domestic central counterparties (CCPs): foreign CCP’s offer a “choice model” for market participants;
  • Some Trade Repositories (TRs) will be locally incorporated in Singapore; however, the regulator will allow reporting to “recognized” overseas TRs.

MAS took on an approach of avoiding a European / US path of prescriptive regulations. Clearing obligations will be phased in by having the reporting obligation being prioritized by product and asset class based on the significance to Singapore. The regulator intends to monitor and adjust the policy when needed and this makes it market participants friendly.

Arnaud de Herrypon, a ZE Director of Asian Markets, has been following developments of the OTC derivatives reform in Singapore. He will comment on the impact from the reform on the Singapore market participants in his later blog posts.