icfr roundtable - the future of international otc derivatives regulation

8/8/2019 ICFR Roundtable - The Future of International OTC Derivatives Regulation

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The fu t ure o f int ernat iona l OTC

24 November 2009


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The ob jec t ives o f the sess ion :

.that have led to calls for greater regulation, centralised

clearing and exchange-trading

2. Determine potential effects of, and problems with,

outstanding and forthcoming regulatory proposals

3. Discuss alternatives

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Contents

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K ey ques t ions fo r t he debate

Why do legislators see a need for OTC derivatives specific regulation?

Where do EU and US proposals differ?

The corporate response

Clearing

Trade reporting and data warehousing

Exchange trading

Ca ital re uirements Product re ulationCentral

Underlying key aspects of the topic

Participant/ market

regulation

Accounting standards

implications

Counterparties: CCPs

Trading on exchanges

Risk management Prevention of fraudand market abuse

Standardisation

Transparency

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In t roduc t ion t o der iva t ives

from the value of an underlying asset

Two t es:

Traded on exchanges

Privatel ne otiated between two arties - the over-

the-counter (OTC) derivatives

OTC derivatives are not standardised but rather tailored to

meet a specific need

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A br ie f h is t ory of OTC der ivat ives

13th century

English monasteries

17th century

Forward contracts

Late 19th c

After financial futures

Late 19th- early 20th c

Exchanges

1865

Chicago Board ofso e r woo up o20 years in advanceto foreign merchants.

ex s e or u p u sin Holland and forrice in Japan .

Calculus introduced

an op ons wereintroduced, banned,and again introduced,

relevant derivativeson interest rates,

compe e or developing trading inspecific contracts.

ra e wascreated, introducingto-arrive contracts

for grain.

by Isaac Newton. equities,commodities andcurrenciesdeveloped in volume

1980s197519731972

.

1981

Birth of the interest rateswap: IBM and theWorld Bank worked out

an arrangement in

Beginning ofOTCderivatives tradingmostly starting with

currencyswaps.

CBOT creates firstinterest rate futurescontract.

Publication of theoption pricing modelof Fischer Black and

Myron Scholes.

Chicago MercantileExchange (CME)responded to new free

floating currencies,

borrowed dollars in theU.S. market andswapped the dollarpayment obligation to

orpora e nanc amanagers learned touse derivatives.

the Treasury Billcontract....as the firstsuccessful pureinterest rate contract.

Chicago BoardOptions Exchangeopens

International MoneyMarket, allowing thetrading ofcurrencyfutures (first contract

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IBM in exchange for

taking over IBM's Swissfranc and deutschemark obligations.

on non-physical

commodities) .


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A br ie f his to ry o f OTC der iva t ives - 2

1982

The London

1982

CME introduced the

1985

International Swaps

1987

ISDA published two

1982

Kansas City Board ofn erna onaFinancial Futuresand Options

Exchange (LIFFE)was established,

uro o ar con rac ,becoming the mostactively traded

contract.

an er va vesAssociation (ISDA)was formally

established andpublished the Code

sugges e s an ar forms of masteragreements for swaps

(the 1987 IDSA MasterA reements , one for

ra e aunc e efirst stock indexfutures contract (on

the Value LineIndex .

following the removalof foreign exchangecontrols in the UnitedKingdom.

of standard wording,assumptions andprovision of swaps.

USD interest rateswaps, one for interestrate swaps andcurrency exchange

CME quickly followedwith launching thecontract on the S&P

1994-1995199319901989

..

1997

1997 Credit DefaultSwaps had been inexistence from at least

the early 1990s, but the

Procter&Gamble,Metallgesellschaft,Orange County and

Barings Bank incurred

ISDA added masterdocumentation forcommodity

derivatives.

Created in the mid-1990s credit defaultswaps were used to

transfer credit

ISDA added masterdocumentation forcaps/floors.

1990 ISDA added

swaps were inventedin 1997 by a teamworking for JPMorganChase.

uge osses rougthespeculative/leverageduse of derivatives.

commercial loansand to free upregulatory capital incommercial banks.

documentation forswap options.

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A br ie f his to ry o f OTC der iva t ives - 3

1999

ISDA published the

2000

The International

2001

Enron, the worlds

2002

The purchase of LIFFE

2000

Euronext was formedre

DerivativesDefinitions, updated

in 2001.

ecur es xc ange(ISE), the first fullyelectronic derivatives

exchange in the US,started tradin in

arges energy ra er,went bankrupt afterattempting to conceal

huge losses.

y uronex wascompleted. LIFFEsfocus on short term

interest rate derivativesclosel com lemented

o ow ng a merger othe Amsterdam StockExchange, Brussels

Stock Exchange, andParis Bourse, in

May 2000. Euronexts expertise ina range of equityproducts.

order to takeadvantage of theharmonisation of theEuropean Union

2008200820052004

.

Lehman Brotherscollapsed, impactingthe OTC derivatives

market.

Societe Generale lostEUR 4.9 billion inunauthorised futures

trading.

The New York StockExchange (NYSE)and EURONEXT

merged.

China Aviation lost$550m in speculativederivatives

transactions.

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Why are der iva t ives a t issue?

The unintended consequences of derivatives use are at issue rather than the

1. Lack of centralized reporting on OTC derivatives made it difficult forcounter arties to know each others full ositions causin mistrust andfurther eroding market confidence.

2. Derivatives ermitted the build u of osition risks with a lower level of

capital than required when transacting in the underlying, effectivelyleveraging their positions.

3. Risks build up in good times and materialise in bad times.

4. Inter-bank business came to substitute for client business, particularlyamong financial institutions in search of yield (Landesbanks, for example).

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In t roduc t ion t o der iva t ives

How to encoura e innovation while maintainin some control

How to encourage diversity and liquidity

How to monitor (and control if necessary) systemic risks and pro-cyc ca ee ac e ec s

How to restore trust in the system:

Supervisory understanding

Counterparty risk)management

Market risks management

Timely/efficient derivatives processing and documentation.

e use o ncen ves vs, ru es

Equilibrium between risk control and economically viable derivativesrices.

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The in ternat iona l OTC der ivat ives mark et before

In terms of notional value, the OTC market was about 10 times

December 2006

gger t an t e exc ange tra e mar et.

Total OTC derivatives

11Source: BIS data

notional principal outstanding: $ 418,131 bn


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Impac t o f t he c r i si s on t he der iva t i ves m arke t

12Source: Bank for International Settlements


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Impac t o f t he c r i si s on t he der iva t i ves m arke t


notional principal outstanding :,

CDS trade volumes dipping atthe end of 2007 while overall

decline started in the middle of2008.


December 2008

$591,963 bn

13Source: Bank for International Settlements


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K ey st ak eho lders in the debat e

Counterparties in OTC derivatives markets in the world and the UK

The major feature of theglobal counterparty

breakdown was a further risein the share of other financialinstitutions to 44%, close tothe 46% share of reporting

ea ers. e g o a s are o

non-financial customers alsoedged up to 10%.

counterparty in the UK wasmore closely aligned with

previously.

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Corporate

der ivat ives

Source: ISDA survey report 23 April2009: Derivatives use by the worlds500 largest companies

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The Regula t ory Landsc ape

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Ex is t ing regula t ion w i th im p l ica t ions fo r der iva t ives

Global

ISDA rules on documentationIOSCO Principles and Multilateral

Memorandum of UnderstandingIFRS: International Financial reporting

Europe

Markets in Financial Instruments Directive (MiFID)

Standards vs. US GAAP

De Larosiere report

Market Abuse Directive (MAD)

Commodity Exchange ActCommodity Futures Modernization Act of 2002

CFTC RegulationsSEC Rules

Securities Exchange Act of 1934

Government Securities Act RegulationsExchanges manuals and internal rules

FSA HandbookBanking Act 2009Financial Services Act 1986 - Re ealed

The Code of Federal Regulation

Financial Services and Markets Act 2000Investment Exchanges and Clearing Houses Act 2006

Regulation of Financial Services Act 2005

SFC regulations

ChinaNAFMII *** Chinas inter-bank market of

financial derivatives transaction masteragreement (2009 version)

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* Directorate-General for Economic and Financial Affairs (DG ECFIN) andThe Internal Market and Services Directorate General (DG MARKT)

** ECON = Committee on Economic and Monetary Affairs and CRIS = Special Committee to tackle the Financial Crisis*** National Association of Financial Market Institutional Investors


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Docum enta t ion w i th po t ent ia l OTC imp l i ca t ions

1985

ISDA was created as

1987

CFTC proposed to

2000

The Commodity

2005

Timothy Geithner,

1993

G30 published a studypeop e wereconcerned aboutstandardisation of

swap documentation

move morederivatives ontoexchanges but

backed down in 1889

u uresModernisation Actbecame law, but

swaps wereexcluded.

pres en o eFederal ReserveBank, mentions in a

speech his concernsabout the backlo of

o er ngrecommendations onhow dealers, users and

regulators can managederivatives activitiesOTC derivativestransactiondocumentation.

and maintain anadequate financialinfrastructure. Nomentioning of CCP

Mar 2009

Global ChinaGlobalUS

Feb 2009Jan 2009

Global

Apr 2008

.

The NationalAssociation of FinancialMarket Institutional

Investors (NAFMII)

Report of theFinancial StabilityForum on addressing

pro-cyclicality arising

The House,AgricultureCommittee passed

H.R. 977, the

Group of Thirtyreport: A frameworkfor financial stability

Report of theFinancial StabilityForum on enhancing

market and

inter-bank market offinancial derivativestransaction masteragreement, namely

rom e an cap aframework

Transparency andAccountability Act of2009, which wouldenact mandatory

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The NAFMII MasterAgreement (2009version)

central clearing of

OTC derivatives andsuspend "naked"CDS trading.


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Doc um enta t ion w i t h pot en t ia l OTC im p l ica t ions-2

The US TreasuryEuropeanAPRA: Survey of theG 20 LondonESCB and CESR

EU USEU AUS EUMay 2009 Jun 2009Apr 2009Mar 2009

Department releasedits white paper:Financial regulatory

Reform - A newfoundation -

Commission:Consultation:Possible initiatives to

enhance theresilience of OTC

OTC derivativesmarket in Australia

Communiqueconsultation on DraftRecommendationsfor Central

Counterparties Revised for CCPs

Rebuilding financialsupervision andregulation

Derivatives Markets

clearing OTCDerivativesResponses by 17April 2009

Jun 2009

US USUS

In the Senate,Agriculture CommitteeChairman Tom Harkin

(D-IA) introduced S.

Legislation introduced by Energy andCommerce Committee Chairman HenryWaxman (D-CA) and Rep. Ed Markey (D-

MA), the American Clean Energy and

Today the Treasury announced that theObama Administration proposed a billnamed the Over-the-Counter Derivatives

Markets Act of 2009. The bill proposes to

most OTC derivativesonto CFTC-regulatedexchanges. TheAgriculture Committee

, . . ,provisions concerning the regulation ofOTC derivatives. That legislation wasmarked up and reported by the committeeon May 21, 2009 and approved by the

(including the Commodity Exchange Act,the Securities Act of 1933 and theSecurities Exchange Act of 1934), toregulate the OTC derivatives markets. A

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has not yet acted onthis legislation.

House of Representatives on June 26,2009.

summary of the release is reprinted below.


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Report of theCESR-ESCBCESR consultationCESR consultationBasel Committee:

Global GlobalEU EU EUJul 2009

Financial CrisisAdvisory Group toadvise the IASB and

the US AccountingStandards Board

recommendations forsecurities settlementsystems and

recommendations forcentral

paper: Classificationand identification ofOTC derivative

instruments for theur ose of the

on MiFID complexand non-complexfinancial instruments

for the purposes ofthe Directives

Enhancements to theBasel II frameworkand guidelines for

computing capital forincremental risks in

about the standard-setting implications ofthe financial crisisand potential

counterparties in theEuropean Union

exchange oftransaction reportsamongst CESRmembers

appropriatenessrequirements:CLOSED 17 July2009

the trading book

Aug 2009

regulatoryenvironment.

US UKUK US

Joint UK FinancialServices Authorityand HMT Treasury

response to the EU

The HouseAgriculturecommittee held

hearings to review

The FSA haspublished version 2of its Transaction

Reporting User Pack

Today the Treasury announced that theObama Administration proposed a billnamed the Over-the-Counter Derivatives

Markets Act of 2009. The bill proposes to

document: Possibleinitiatives to enhancethe resilience of OTCderivatives markets.

by the U.S.Department ofTreasury regardingthe regulation of OTC

.is a consolidatedpoint of reference totransaction reportingobligations. The

(including the Commodity Exchange Act,the Securities Act of 1933 and theSecurities Exchange Act of 1934), toregulate the OTC derivatives markets. A

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derivativesmarkets. Testimonyby CFTC and bySEC

revised TRUP waseffective from 21 Sep2009 and includesOTC derivatives.

summary of the release is reprinted below.


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Rep. Barney FrankCESR consultationCESR consultationG20 PittsburghImproving financial

Global USGlobal EU EUOct 2009

(D-MA), Chairman ofthe House FinancialServices

Committee, releaseda discussion draft of

on classification andidentification of OTCderivative

instruments for theur ose of the

on TradeRepositories in theEuropean Union":

DEADLINE 6November 2009

communique -leaders statement

regulation - FinancialStability Board:Report to the G20

Leaders

legislation to regulateOTC derivatives.

exchange oftransaction reportsamongst CESRMembers :

Nov 2009Oct 2009

US USEU EU EU

2009

National Conferenceof InsuranceLegislators (NCOIL)

is drafting model

CESR: Waivers fromPre-TradeTransparency

Obligations under the

CESR statement -Application ofDisclosure

requirements related

EuropeanCommission:Ensuring efficient,

safe and sound

Over-the-counterderivatives marketsact of 2009; House

Agriculture

subject credit defaultswaps to regulationas insurance andprohibit such

Instruments Directive(MiFID) - Update

Instruments in the2008 FinancialStatements

Future policy actions

Collin Peterson (D-MN) releaseddiscussion draftlegislation to regulate

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transactions that arenot undertaken forhedging purposes.

the market for OTCderivatives.


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Overview o f t he k ey regula to rs invo lved

Global

Euro eEuropean Systemic

Risk Board

EBA

EIOP ESFS

Federal

AESMA

USregulators

UK

China

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CESR = The Committee of European Securities SupervisorsFSA = Financial Services AuthorityFINRA = Financial Industry Regulatory AuthoritySFC = Honk Kong Securities and Futures Commission


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Issue date Authorit Le islation/re ulation Submission

Timel ine o f c onsul t a t ions

deadlineApril 2010 European Commission Draft legislation available for consultation

9 October House Agriculture Committee Over-the-counter derivatives markets act of 2009 Closed2009 Chairman Collin Peterson

29 September2009

CESR CESR consultation on Trade Repositories in theEuropean Union":

Closed6 November 2009

23 Se tember IOSCO IOSCO consultation on trans arenc of structured Closed2009 finance products 13 November 2009

25 September2009

European Commission Public consultation: Derivatives in Crisis:Safeguarding financial stability

25 September 2009

OTC derivative instruments for the purpose of theexchange of transaction reports amongst CESRMembers

1 October 2009

22 Jul 2009 CESR CESR consultation a er: Classification andidentification of OTC derivative instruments for thepurpose of the exchange of transaction reportsamongst CESR members

CESR Consultation on MiFID complex and non-complex Closedfinancial instruments for the purposes of theDirectives appropriateness requirements

17 July 2009

3 July 2009 Commission of the EuropeanCommunities

Consultation document: Possible initiatives toenhance the resilience of OTC DerivativesMarkets

ESCB and CESR ESCB and CESR consultation on DraftRecommendations for Central Counterparties Revised for CCPs clearing OTC Derivatives

Closed17 April 2009

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G20 t arget s for OTC der ivat ives regu la t ion

Leaders statement, the Pittsburgh summit, 25 September 2009

1. All standardised OTC derivatives contracts should be traded on exchanges orelectronic trading platforms, where appropriate, and cleared through central

counterparties by end-2012 at the least.

2. OTC derivatives contracts should be reported to trade repositories.

. -

requirements.

.and whether it is sufficient to improve transparency in the derivatives markets,mitigate systemic risk, and protect against market abuse.

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What a re the k ey i tem s addressed by the c ur rent

.

EU and US proposals to tighten regulation of the OTC derivatives markets areconsistent at a high policy level.

1. Closer supervision and regulation of OTC derivative markets

. rea er s an ar sa on o con rac s

3. A much greater degree of multilateral clearing of contracts through central

4. Enhanced transparency and information collection

5. Comprehensive reporting of all OTC derivative transactions to theauthorities

6. Overall two complementary regulatory regimes will be required: One forthe dealers and one for the markets themselves (exchanges, clearinghouses tradin s stems

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.

Main tool to manage counterparty risk: All standardised derivatives contracts

Europe US

European Commission wants to see thebroadest possible use of CCP clearinghouses considering incentives for using

CCPs or making use mandatory for

exchangesto be cleared through well-regulatedcentral counterpartiesAll executed either on a regulatedexchange or regulated electronic

standardised contracts.Commission to analyse further theimpact of moving derivatives tradingonto organised trading venues onto

trading platform . Regulated financialinstitutions will be encouraged to makegreater use of regulated exchange -traded derivatives.

ability of some market participants to

hedge risks effectively.

More standardisation: Standardised OTC derivatives will be1) Contract specifications2) EC focus on legal terms of the

contract (while allowing flexibility in

the s ecifications

pre-defined and the definitions will beupdated to match evolving markets.

Regulators will monitor productdevelopments for customisation withthe sole ur ose of avoidin central

Productregulation

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clearing and exchange trading


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.

Europe US

Participant/marketregulation

other major OTC derivatives marketsparticipants will be constrained by

regulation, supervision, a capital

proposing legislation to establishcommon safety, regulatory and

operational standards for central,

business conduct rules and tighteningof standards of who may participate inthose derivatives markets

Capital regime,

collateralisation of bilaterally-clearedcontracts, (iii) substantially raisingcapital charges for bilaterally-cleared

-

transactions, and on top of this (iv)mandate CCP-clearing forstandardised contracts;

in the CRD to prompt standardisationof contracts and electronic processing

Widening the use of central datarepositories (already in use for CDS)on number of transactions andoutstandin ositions

TransparencyTransparency of OTC derivativesmarkets enhanced through recordkeeping and reporting requirements

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.

Europe US

Prevention of Regulators will have clear authority toEnhance market integrity and oversightfraud and marketmanipulation

act against fraud, market manipulationand other abuses.

by clarifying and extending the scopeof market manipulation as set out in theMarket Abuse Directive (MAD) to

derivatives and by giving regulators the

European Commission will continue towork closely with the US to ensure

Global standardsand regulation

Tim Geithner: US administration willwork with its international partners to

possibility to set position limits.

global consistency of policy

approaches and to avoid any risk ofregulatory arbitrage.

ensure that its strict regulatory regime

for OTC derivatives is matched by asimilarly effective regime in othercountries.

Local standardsand regulation

The idea of merging the two regulatoryagencies overseeing derivativesmarkets (SEC and CFTC) has been

In Europe the definition of the roles ofCESR and its local counterpartiesregarding OTC derivatives regulation

interests opposing the merger.

finalised.

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icfr roundtable - the future of international otc derivatives regulation

Documents