In the heady rush of reforming fervor after the global financial crisis of 2007-08 it seemed to some that exchanges and central clearinghouses were the solutions, and that over-the-counter wheeling and dealing without the benefit of such reassuring institutions were the problems.
A Grand Scheme
Accordingly in 2009 the G-20 leaders committed themselves, at their Pittsburgh meeting, to reform the OTC derivatives market in order to improve transparency and crack down on market abuse. They said that standardized OTC contracts “should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest,” and that contracts that are not centrally cleared “should be subject to higher capital requirements” as a consequence.
The target year has arrived, and although some eyes still sparkle with the idea of “reforming” the OTC market, the central idea circa 2009, that of repealing its free-wheeling character, or tying it all down to exchanges and clearinghouses, seems to have faded, or to have re-defined itself into a more modest reform project.
Even the G-20 itself, one year after Pittsburgh, at the Toronto summit, spoke in far less sweeping tones. Yes, that summit’s declaration reaffirmed a commitment to “trade all standardized OTC derivatives contracts on exchanges or electronic trading platforms where appropriate, and clear through central counterparties by end-2012 at the latest,” but the emphasis seemed by then to be on a more piecemeal approach.
“[W]e agreed to pursue policy measures with respect to haircut-setting and margining practices for securities financing and OTC derivatives transactions that will reduce procyclicality and enhance financial market resilience,” the statesmen wrote, “We recognized that much work has been done in this area. We will continue to support further progress in implementing these measures.”
In October 2010, too, the Financial Stability Board published its report on Implementing OTC Derivative Market Reforms. The FSB tangled with an obvious but sometimes overlooked question: how determine whether an OTC derivative has become sufficiently standardized to be suitable for central clearing. The Board proposed that the determination must take into account the product’s contractual terms and operational processes, the “availability of fair, reliable, and generally accepted pricing sources,” and the depth of the market.
IOSCO, the international policy body for securities regulators, has this month published its own final report on international standards for the regulation of derivatives market intermediaries. This continues a course followed by international bodies ever since the G20 summit: the drift away from the grand idea of treating all derivatives in a standardized way, toward acceptance of the unharnessed character of the OTC world, though for all that a renewed insistence on regulating the particulars.
The report of IOSCO is intended in particular to promote cross-border consistency among regulators with regard to DMIs, in
- Registration/licensing standards;
- Capital standards and other financial resources requirements
- Business conduct standards
- Business supervision standards, and
- Record keeping.
The gist of the recommendations is that the regulatory systems that apply to DMIs should be well defined, though it might be best to lighten their touch from time to time. For example, DMIs “should be subject to registration or licensing” but “in certain limited circumstances full application of substantive regulations and/or requirements and standards may not be appropriate for certain types of entities.”
The registration requirement should, as a default rule, encompass those who are in the business of dealing, intermediating transactions, or making a market in OTC derivatives.
But the IOSCO task force did recognize that many jurisdictions have regulatory systems that include exemptions for certain intermediaries, such as those that intermediate only on a limited scale. Such exemptions should be “explained and clearly defined.” Also, a general exemption for DMIs who only transact with non-retail entities would be far too broad, since the majority of the market is aimed at non-retail entities.
IOSCO devotes a good deal of attention to the development of consistency in “business conduct standards,” the third item on the above list.
One guiding idea is that conduct standards that at present apply to other securities intermediaries, such as requirements about disclosure, the clarity and presentation of communications, and due diligence requirements, may and should be extended to DMI intermediaries as well.
Yet there are and should be other business conduct standards, IOSCO proposes, that are specific to DMIs. In most IOSCO jurisdictions, for example, DMIs that collect margin assets that belong to a client must segregate those amounts from the DMIs own assets.
On this issue of the segregation of collateral, the pertinent principle is simple. DMIs should segregate and should “employ an account structure that enables the efficient identification and segregation of positions and collateral belonging to DMI clients.”