The Bilateral World vs The Cleared World

As the OTC derivatives industry moves forward towards implementing the clearing mandate, it is becoming increasingly apparent that there is a need to maintain consistency between the bilaterally transacted OTC derivative world and the newly emerging cleared world. Failure to maintain consistency could prove problematic for all involved, including hedgers, market makers and CCPs. This might ultimately undermine the objective of policymakers and market participants: the creation of a safer, more robust system.

Regulators are creating another set of market rules which may or may not be consistent with the set of OTC derivatives market practices that have been developed over the past 30 years. Some concrete examples of this potential inconsistency include:

  • In the bilateral world, collateralization of exposures is the norm. But posting of initial margin is optional subject to one counterparty’s credit view of another. In the cleared world, initial margin is mandatory, irrespective of the quality of the counterparty. The result is different quoted prices based on whether initial margin is posted, its level (when posted) and how it is calculated and traded off against default fund contributions.
  • In the bilateral world, all aspects of an agreed trade — legal, credit, market and operational risks — are dealt with directly between the two transacting parties. In the cleared world, as many as four additional counterparties are potentially being inserted between the two transacting parties (a SEF, an FCM, a CCP and another FCM). Some of these parties are pure pass-through parties when it comes to risk, but some are not. Worse, one agreement is replaced potentially by a number of agreements, and apart from the increased complexity (always a red flag), there is an increased likelihood that the sum of this process is not comparable to or consistent with the initial contract.
  • In particular, in the bilateral world, counterparty risk is all aggregated in the ISDA Master Agreements between the parties. Considerable effort has been spent to ensure legal enforceability of this agreement (and associated CSA) around the world through the netting and collateral opinions. In the cleared world, this is substituted with a set of agreements involving CCPs and in some cases other parties (FCMs). These agreements, apart from being inconsistent among CCPs, typically only cover a single product. Even in the best case of a single CCP per product (which is clearly not where we are headed), there is a considerable loss of netting efficiency. These agreements are asymmetrical (one way) and it remains to be seen to what extent these agreements are enforceable in a variety of jurisdictions. Worse, because of the above, these transactions are no longer fungible with their bilateral counterparts, giving rising to a host of unexplored risk, legal, accounting and capital considerations. Again, all these factors translate to different quoted prices.
  • Bilateral OTC derivative portfolios are subject to elaborate capital requirements that have evolved. As transactions are moved to CCPs, capital is released but since CCPs are now taking up these risks, they have to put up capital which, in turn, determines clearing charges. Guess what? The methodology proposed for calculating required capital for the CCPs for these trades (the outdated current exposure method) is different from those for bilateral transactions. In fact, the charges are much higher than those prevailing for bilateral trades, acting as a disincentive for clearing as they make it too expensive, but also leading to inconsistent treatment of identical risks.

We’ll stop here as the purpose of this note is meant to be illustrative of the kind of inconsistencies that are emerging. The consequences from such inconsistencies are significant. Given the fact that a fair amount of OTC derivative business will continue to trade bilaterally, even after the clearing mandate is fully in place, inconsistency in practices between the bilateral world and the cleared world is likely to give rise to market fragmentation, lack of fungibility between cleared and uncleared products (with all the consequences for risk management) as well misguided incentives as to where to do business.

Regulatory Arbitrage: No Fork in the Road

Are some Asian jurisdictions venturing down the path of “regulatory arbitrage” in order to lure derivatives business away from the (supposedly) more strictly regulated US and Europe? Some observers think so. But if you kick the tires on this claim by considering observable facts and actions, you will see this claim isn’t going anywhere.

The September 2009 G20 Summit in Pittsburgh laid out the path for OTC derivatives:

“All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”

The APAC G20 signatories – Australia, China, India, Japan and South Korea – are all on track to meet their mandatory clearing and reporting requirements. Hong Kong and Singapore are not G20 members and could have chosen the other path by not adopting G20 standards, but they’re opting in to G20 principles, not staying out. (For an update on Singapore’s thinking see a recent Asia Risk piece by our colleague, Cindy Leiw. Registration for free trial required.)

With the exception of Japan, APAC regulators have chosen not to address the G20 plank on exchanges or electronic trading platforms at this time. This makes sense given how much less liquid APAC derivative markets are than those in the west, and the “where appropriate” language in the G20 commitments, in our view, allows for this. The drafters of Dodd Frank and EMIR have chosen to make electronic trading platforms an important part of their regulatory reforms, but that does not mean that APAC jurisdictions should have to do so or stand accused of regulatory arbitrage. Asian jurisdictions will abide by global consensus reforms, not US or European domestic regulations.

Asian regulators have energetically participated in all global regulatory coordination bodies, including the Basel Committee, CPSS/IOSCO, ODRF, and the Financial Stability Board. They are actively engaging with US and European regulators on a bilateral basis to harmonize regulation and deal with extraterritorial issues. At ISDA we work with regulators one-on-one and also organized two regulator forums in 2011. APAC jurisdictions have all committed to adoption of Basel 3 standards, and in some cases such as China and Singapore, have even called for more stringent capital standards than those prescribed by Basel 3. Contrast this with the US, which never implemented Basel 2 and and has yet to decide whether to adopt Basel 3 standards.

Another fact not considered in the debate is that prior to the financial crisis, Asian derivative markets were already much more stringently regulated than western markets. CDS were not allowed onshore in China or India at that time and, even now, are only allowed in a controlled manner that has led to minimal volume. China, India and Korea also control the amount of leverage banks are allowed to offer to clients for hedging products which also puts a damper on trading volume. China and India are also likely to mandate clearing of FX forwards while the US and Europe will likely exempt them. This hardly smacks of regulatory arbitrage to us.

The final charge against Asian jurisdictions is that much is still pending. But that’s understandable given that the FSB has not finalized standards on mutual recognition of third country CCPs or LEI standards, CPSS/IOSCO has not finalized CCP risk management standards and rulemaking under Dodd Frank and EMIR remains a work in progress. Asian regulators are wary of enacting legislation before global standards are set as it could be difficult to amend legislation once passed. Their intention is to harmonize with global regulation, not to create arbitrage opportunities.

Regulatory arbitrage is easy to assert and hard to prove. All the more reason to keep our eyes on the road and focus on the facts.