26 June 2012

FSA/Lawton: Derivatives reform – Regulatory update

OTC derivatives are, and will remain, an important part of global financial markets. They provide financial and non-financial firms with tools for risk mitigation and transfer that are more bespoke than those available in the exchange-traded world.

However, before the crisis, the OTC market grew rapidly without appropriate regulatory scrutiny, posing problems of inadequate counterparty risk management and lack of transparency.

These two issues are clearly interconnected. Improvements in managing counterparty risk should also lead to improvements in transparency and vice versa. Operational effectiveness can also create significant problems when done poorly, but is similarly reinforcing when in good order.

Recognising these problems, in late 2009 the G20 concluded that four changes to such markets were needed:

• all standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate;
• all standardised OTC derivative contracts should be cleared through central counterparties by end-2012 at the latest;
• OTC derivative contracts should be reported to trade repositories; and
• non-centrally cleared contracts should be subject to higher capital requirements.

Outstanding issues

Work on many of the components is well advanced. But as I noted at the start, there are four areas where further progress needs to be made.

Bilateral collateralisation of uncleared trades

While not specifically referenced by the G20, we outlined in 2009 the principle that bilateral collateralisation should be required for uncleared trades in order to mitigate counterparty risk and reduce incentives to evade the clearing obligation.

This principle is broadly agreed, but details around which participants and products the obligation should apply to, and how they should calculate margin, remain open at the EU and international levels.

A Working Group on Margin Requirements (WGMR) consisting of the principal prudential, markets and payment system regulators has been formed to consider creating standards for margining as a tool to mitigate the risks in the non-cleared part of the market, and is due to consult in June with final proposals by end-2012.

Simultaneously, the ESAs are considering the collateral requirements under an EMIR Regulatory Technical Standard also due end-2012 and the Commission expects this standard to be compatible with the output of the WGMR.

Tools to assist the recovery or resolution of CCPs

Mandatory clearing will significantly increase the amount of risk concentrated in CCPs. This highlights the importance of effective recovery and resolution planning.

This is the subject of a forthcoming consultation by CPSS-IOSCO, with the proposals based on the FSB’s Key Attributes of Effective Resolution Regimes for Financial Institutions, which were published in October 2011.

Application of requirements cross border

One of the most difficult, but also most important, aspects of this reform programme is ensuring international consistency.

While every national regulator must ensure that its national markets are stringently and appropriately regulated, we must also recognise that derivatives markets cross national borders, and that regulatory intervention which fragments the global market could impose huge costs without necessarily reducing risk. 

The FSA operates to a long-standing principle that we seek to avoid extraterritorial application of our regulatory rules outside the UK, and instead place reliance on the application of regulation that achieves equivalent regulatory outcomes by overseas regulators in their domestic jurisdictions, where that exists.

In our view, this is the best way of reducing the potential for conflicts of laws, and also unnecessary duplication of similar regulatory requirements in relation to the same activity. It also avoids creating a situation in which our or other regulators' rules cannot be enforced effectively, owing to lack of jurisdiction.

Readiness of firms, both financial and non-financial, not currently clearing

As the legislative and rulemaking process draws towards its conclusion, so the onus shifts onto firms to step up preparations for compliance.

EMIR is unusual in the huge range of firms to which it applies. There are carve-outs, including a temporary exemption for pension funds from the clearing obligation, and an exemption from clearing and bilateral collateralisation obligations for non-financial firms hedging business risks. However, the headline is that EMIR affects all participants in derivatives markets, from the largest bank to the smallest investment fund.

We recognise that the implementation timetable is challenging. We recognise also that uncertainty around some rules makes timely preparation harder. However, waiting for certainty is not a realistic option. Firms will need to be ready to comply with much of EMIR from January 2013, with the rest of the rules coming into force later in the year.

The FSA is doing what it can to support industry preparation. We recently ran a series of workshops for affected firms, attended by nearly 400 people from across the markets. We will continue to provide information and guidance as gaps in the rules are filled in.

Full speech

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