Securitisation, Swaps and the Regulatory Imperative: A Look at the Role of OTC Derivatives Market Reform in the G20 Agenda

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By Megan Bowman, UNSW

SYDNEY: 30 October 2014 – Australia is set to host the G20 Leaders Summit in Brisbane from 15-16 November 2014. George Gilligan, CLMR Senior Research Fellow, noted last week that key reform pathways for the G20 under the Australian Presidency coalesce around two core priorities: stimulation of economic growth and strengthening economic resilience. This two-fold program of reform is laudable and also challenging due to the inevitable tension between financial innovation (which requires risk) and regulatory stability (designed to mitigate risky behaviour).

Items on the G20 agenda include regulatory reform of over-the-counter (OTC) derivatives and shadow banking. Moreover, there is growing international concern about equity or asset bubbles. This piece comprises the first of three articles exploring some contemporary concerns and international efforts in those respective areas.

The Derivatives Market: Background, Statistics and Contemporary Trends

The OTC derivatives market is an important source of tradeable securities for the purposes of the hedging of risk, speculation and capital (often for the purpose of leveraged acquisitions). The exponential growth in the market has been described by the IMF as one of the main drivers in the modernisation of banking and the globalisation of finance.

Twinned sources of market statistics and trends are the International Swaps and Derivatives Association, Inc (ISDA) and the Bank of International Settlements (BIS). Indeed, the ISDA produces a semi-annual OTC Derivatives Market Analysis to correspond with the statistical releases of BIS. In May 2014, BIS estimated that the notional volume of outstanding derivatives contracts totalled US$710 trillion at end-2013, which is a significant increase from $693 trillion only six months earlier and $633 trillion the year prior. However, BIS also estimates that the market value of outstanding derivatives contracts declined, as based on market prices. At end-2013, the gross market value of all contracts stood at US$19 trillion, which is a decrease from $20 trillion at end-June 2013 and $25 trillion at end-2012.

Specifically, the global OTC derivatives market is comprised of five segments:

  • the interest rate segment, which comprises the majority of OTC derivatives activity (being 82% of the market or US$584 trillion at end-2013);
  • foreign exchange derivatives, being the second largest market segment at approximately 10% of OTC derivatives activity or US$71 trillion at end-2013;
  • credit default swaps (CDS) which accounted for $21 trillion by end-2013;
  • equity-linked derivatives, which stood at $6.6 trillion end-2013; and
  • commodity derivatives at $2.2 trillion by end-2013. 

BIS notes that the recent global market trend of increasing notional amounts but declining market values has been driven by developments in the interest rate segment. Importantly, there has been a shift towards central clearing (through central counterparties or CCPs) and away from derivatives dealers. Indeed, the concentration of interest rate derivatives activity among dealers as at end-2013 had fallen to levels close to or below those reported prior to 2008. As at end-2013, Herfindahl indices for the US dollar and euro interest rate swap (IRS) markets had fallen back almost to 2007 levels. However, concentration remained well above 2007 levels in the sterling, Swiss franc and Swedish krona IRS markets.

In contrast, market inter-dealer contracts in the foreign exchange segment continued to account for nearly as much activity as contracts with other financial institutions. The notional amount of outstanding foreign exchange inter-dealer contracts totalled US$31 trillion at end-December 2013, which is almost equal to contracts with financial counterparties. Nicholas Vause demonstrates that inter-dealer activity is especially significant in the yen and US dollar markets, where it accounted for 52% and 47%, respectively, of notional amounts at end- 2013.

Structural Design Flaws: Lessons from the Financial Crisis

These market developments have important implications for regulators. Specifically, the gross market value represents the maximum loss that market participants would incur if all counterparties failed to meet their contractual payments and the contracts could be replaced at current market prices. The notional value of outstanding contracts at $693 trillion is approximately ten times the size of global GDP. Although the value at risk is much less at$19 trillion, Justin O’Brien points out that reserves for major banking entities that are systemically important institutions have increased by only some $500 billion in the same period. The numbers tell a vital story.

Structural flaws in OTC derivatives markets were highlighted starkly by the 2008/2009 financial crisis. Leading up to the financial crisis, the lack of transparency and market regulation had caused a build-up of risky investments. Bilateral relationships underpinned by derivatives trading linked to securitised mortgage loans had given rise to significant credit exposure. Yet, as noted by William Dudley, President and CEO of the Federal Reserve Bank of New York, these activities were highly profitable for financial institutions. When the crisis occurred, the depth of excessive risk-taking was revealed, showing how reliant the market had become on certain financial institutions, and how interconnected these institutions had become with each other. For example, OTC derivatives such as mortgage-backed securities that were secured by poor-quality mortgages compounded the downside risks and subsequent losses throughout the financial system. Concomitantly, other traded securities through the OTC derivatives markets such as Credit Default Swaps (CDS), that were based on the credit exposure of mortgage-backed securities, further contributed to those losses.

Importantly, Priya Nandita Pooram highlights that against the exponential growth of OTC derivatives markets, regulatory bodies had not kept up with the pace of change that ultimately permitted these trades to take place. Eventually, the level of interconnectedness, hidden behind the lack of transparency, set risk levels well above reason. Specifically, there were three inherent design flaws in OTC derivatives markets revealed by the financial crisis.

First, a defining feature of OTC derivatives segments were that parties dealt directly with each other, in contrast to formal exchanges where standardised securities are traded through a centralised system. By implication, this bilateral relationship meant that finding counterparties and negotiating prices could take considerable time. However, akin to the way that mortgage owners switch between banks in search of better interest rates, market participants often switched between counterparties. In particular, this occurred if market participants thought that the financial health of their counterparty had diminished such that they would not be able to deliver on the contract. Not only was this process inefficient, it meant that when the need for liquidity did arise, it was not available as dealers had gone looking elsewhere for fear of their counterparty’s risk of insolvency.

Second, while this system worked during periods of economic stability, the financial crisis showed the inherent flaws of bilateral dealing and its profound consequences in times of uncertainty. O’Brien notes that ‘[b]ilateral contracts negotiated out of sight of the market have created tightly connected webs that span the globe’, which prima facie seem problematic. However, when Lehman Brothers collapsed under the weight of its credit exposure from mortgage-backed securities, it left its counterparties in positions where they were unable to access their frozen funds. Without being able to move trades, the counterparties thus remained exposed to the sharp rise in volatility of financial markets. This outcome also showed how the mutual reliance of financial actors became a primary driver in the sudden increase in market volatility, which helped to bring the liquidity of financial markets to a standstill. The fear held by market participants that this would happen to their counterparties only exacerbated the liquidity problem as financial dealers redirected their trades away from troubled financial dealers, leaving them with little liquidity with which to perform trades.

Third, underpinning the problems arising out of the OTC derivatives markets was the lack of transparency which set the scene for suboptimal market conditions. The privately negotiated derivatives agreements traded via the OTC market were often referred to as ‘opaque’, ‘shady’ and ‘murky’. Not only did the lack of transparency impair price discovery, it also effectively limited the scope of review into the financial health of market participants. Indeed, while market participants could measure the value of their relationship in terms of risk, the lack of transparency prevented market participants from understanding their level of interconnectedness. Crucially, many market participants did not know their exposure to other seemingly unrelated market participants throughout the financial system via their derivative trades and open positions. The complexity of the financial system as a contributory factor to the financial crisis has been well covered by scholars such as Aviv Pichhadze. In short, the OTC derivatives markets allowed the sort of behaviour where, taken in isolation, the counterparty risks could be limited; however, dealers would often offset those risks by contracting with other parties, eventually producing a situation where risks were embedded throughout a web of dealers. Of course, once the economic climate did turn sour, the level of mistrust among market participants essentially became the catalyst for the freeze in liquidity.

Contemporary International Reform Efforts

Since the 2008/2009 financial crisis there has been much regulatory activity regarding reform of OTC derivatives markets.

At the national level, a prime example is the work of the US Commodity Futures Trading Commission (CFTC) regarding implementation of the recent swap execution facility (SEF) regime. From 2 October 2013, electronic trading platforms that provide access to US persons were required to register as SEFs with the CFTC and comply with strict new rules. The first OTC derivatives products were subsequently mandated for trading from 15 February 2014. This process, termed ‘made-available-to-trade’ (MAT), legally requires all US persons to trade MAT instruments on SEFs or designated contract markets. However, the problem is that similar rules are not yet in place widely in other jurisdictions such that the same requirements do not exist for non-US persons. In January and July 2014 the ISDA published empirical reports on the topic of market fragmentation in order to characterise cross-border pools of liquidity since the implementation of the SEF regime. It found that, in the relatively short time since the SEF regime began, derivatives markets have fragmented along geographical lines. This has been particularly apparent for euro interest rate swaps whereby European dealers have opted to trade with other European parties such that ‘the market for euro interest rate swaps is now clearly split between US and non-US counterparties’.

Indeed, such developments highlight inevitable inter-jurisdictional tensions in regulation of the OTC derivatives market. The combined elements of risk, complexity, and lack of transparency in OTC derivatives markets requires global coordination. Specifically, O’Brien highlights that global coordination is necessary for credible reform given that: (a) the ‘global reach of major banking entities and their counterparties provides multitudinous transmission channels for contagion’; and (b) 90% of the global derivatives market is driven by 12 banks. The challenge, he notes, is that market participants and regulators alike remain unclear as to the size, nature and direction of risk profile in the derivatives markets despite reform proposals since the 2009 G20 Leaders Summit in Pittsburgh. Nicholas Dorn similarly contends that reform will not be a simple task. He writes that making the market more transparent and mitigating institutional interconnectedness will involve ‘austerity, political dissent and significant reform to avoid the deepening moral hazard.’

Nonetheless, an international and centralised reform agenda is not only plausible but underway. There is international consensus for centralised infrastructure as a means to provide more granular data on how the market is operating. In this way, centralised infrastructure can perform both monitoring and accountability purposes. Moreover, O’Brien writes that the reform agenda:

also involves commitment to develop trade repositories, centralised clearing and, where appropriate, subsequent trading on exchanges. In order to incentivise progress towards standardisation, derivative contracts not centrally cleared are proposed to be subject to higher capital charges. The primary justification for such an approach is, on the face of it, justified.

Specifically, in this and other regulatory reform arenas, the G20 has been prominent through the activities of the Financial Stability Board (FSB), which was established in 2009 as an international coordinative body for the work of national financial authorities and international standard setting bodies .On 8 April 2014 the FSB delivered its Seventh Progress Report on Implementation of OTC Derivatives Market Reforms. In those pages it reported that international policy standards have been finalised in most of the five commitment areas being: trade reporting; central clearing; capital requirements; margin requirements; and exchange and electronic platform trading. The FSB states that outstanding work is on track to be finalised by the November 2014 G20 Leaders Summit in Brisbane.

Most jurisdictions have completed necessary reforms to legislative frameworks and are developing or bringing into force detailed rules where required. Specifically, there has been much progress in implementing higher capital requirements for non-centrally cleared derivatives, and most jurisdictions have committed to implementation of margin requirements for those derivatives consistent with the internationally agreed start of phase-in during 2015. Yet the FSB notes with some caution that ‘[w]ithin this overall picture of progress, unevenness remains with respect to particular commitment areas’. Specifically, it notes that implementation of trade reporting, capital requirements, and central clearing have progressed while implementation of reforms to promote trading on exchanges or electronic trading platforms ‘is taking longer’.

These reform efforts mirror inevitable inter-jurisdictional tensions experienced by the CFTC. Indeed, the FSB notes that national authorities continue to identify implementation concerns particularly as they relate to satisfactory resolution of cross-border regulatory issues. Issues remain of overlap, duplication, inconsistencies, conflicts and gaps in regulatory requirements that apply in cross-border contexts. To this end, G20 Leaders agreed in their September 2013 Summit in St Petersburg that ‘jurisdictions and regulators should be able to defer to each other when it is justified by the quality of their respective regulatory and enforcement regimes, based on similar outcomes, in a non-discriminatory way, paying due respect to home country regulation regimes.’

Moreover, the FSB accentuates positive progress in this area:

Regulators…have made good progress identifying and working through regulatory issues in this area and have established a number of understandings on how to resolve issues. The Regulators Group will continue its work to resolve cross-border issues and will report for the November 2014 G20 Leaders’ Summit how it has resolved or intends to resolve identified cross-border issues.

Looking Forward

The G20 summit in November will hopefully provide more robust steps towards curbing the risk of complex financial products traded in risky environments through increased compliance and accountability, while mitigating the development or deepening of future risks. Clearly, a crucial but not necessarily inevitable step along the path of reform is for jurisdictions to implement regulation in a prompt and flexible fashion that can respond to issues in cross-border consistency.

The author wishes to thank Joe Shin, CLMR intern, for additional research assistance.