The Regulation of OTC Derivatives:

Minimising Systemic Risk

Presenter: Roy Havemann| National Treasury |10 September 2014

Outline

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1. Role of the financial sector in the SA economy

2. Post global financial crisis reform

– Twin peaks

– G20 commitments

3. Legislative reform for OTC derivatives

4. Challenges

a) Domestic Harmonisation

b) International harmonisation and equivalence

c) Lack of local FMI and extra-territoriality

A safer financial sector to serve South Africa

betterUpdate

Roy Havemann | National Treasury | 15 August 2013

A stable financial

system is a necessary

condition for growth…

…but not sufficient…

Costs, transparency,

efficiency, effectiveness,

savings

Financial Markets Act of 2013 (FMA)

• Chapter on Independent Clearing Houses *new

– But central clearing counterparties (CCPs) not defined (s107(1))

– “to clear” includes underwriting, i.e. the balance sheet underwrites

transactions cleared

– s48 Ministerial regulations: assets and resources

– FSB licensing and supervisory authority

• Chapter on Trade Repositories *new

– s54 - s56, s58 Ministerial regulations: licensing, assets and resources,

central reporting obligations

– FSB licensing and supervisory authority

• Recognition of external FMI

– s5 Ministerial regulations: security services to be provided

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OTC Derivative Providers not defined in FMA

• Regulations issued by Minister of Finance

• S5(1)(a): requirements for the regulation of unlisted securities

• s5(1)(b): a category of regulated person other than specifically

regulated under the Act

• s5(1)(c): functions and duties of external CCPs and TRs

• Registrar of Security Services (FSB-SA)

– Board Notices to be issued by the Registrar in terms of s6(7) & (8), s58, s74

• Definition and categorisation of OTC derivatives

• Definition and categorisation of OTC derivative providers (ODPs),

counterparties and clients

• Requirements to be authorised as an ODP

• Code of conduct for ODPs

• Reporting and clearing obligations on ODPs5

Ministerial regulations - definitions

• “OTC derivative”

– Means an unlisted derivative instrument categorised and prescribed as such by the

Registrar excluding

a) insurance contracts

b) forex spot contracts; and

c) physically settled commodity contracts

– Registrar to prescribe in line with ISDA taxonomy

• “OTC Derivative Provider” (ODP)

– Issuer or market maker

• “counterparty”

– another authorised ODP; an authorised user of the exchange; a bank; a long-term or

short-term insurer; a person outside the Republic rendering a service similar to an

ODP; a central bank; a private equity fund/hedge fund.

• “client”

– means any person, other than a counterparty

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ODPs – Requirement to be authorised

• The following requirements must be met:

I. Prudential requirements for all ODPs – bank vs. non-bank

II. Fit and proper requirements

III. Compliance function

IV. Internal control and risk management

V. Business continuity plan

VI. Record keeping and data retention requirements

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ODPs – code of conduct

• The code of conduct covers the following:

I. General principles

II. Categorisation of clients and counterparties

III. Disclosure to clients

IV. Appropriateness for clients (knowledge and experience)

V. Client and counterparty agreements

VI. Timely confirmations (best efforts, T+1 or T+5)

VII. Portfolio reconciliation (frequency depends on size of portfolio)

VIII.Dispute resolution

IX. Portfolio compression (not mandatory but explanation to Registrar required)

X. Safeguarding of collateral and margin

XI. Confidentiality and privacy

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Reporting framework aligned with larger jurisdictions

• Mandatory reporting of all derivatives to a Trade Repository

– T+0, Executed, whether confirmed or not

– Daily reporting

– UTIs, UPIs and LEIs mandatory

– Reporting obligation falls on ODP

– Fields to be reported align with EU and US requirements and take into

account current reporting requirements

• Obligations on the TR aligned with international requirements

• Outstanding issues

– Aggregating data across TRs

– POPI Act, blocking statues in other jurisdictions- confidentiality provisions

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Clearing - "carrot-and-stick" approach

• Incentives to Clear

– Netting benefits

– Requirements to clear if counterparty in US or EU

– CVA but banks temporarily exempt from holding capital for CVA risk on

derivatives denominated and transacted solely in ZAR, as well as for all OTC

derivatives entered into bilaterally between local counterparties – this

expires 31 Dec 2014

• Clearing not yet mandatory

– Too early to tell how local incentives/international requirements will work

– Need to understand market better (PWC DATA EXERCISE)

• Asset classes (mostly IR swaps and FRAs)

• Counterparties (type, local, offshore)

– Need to review exclusive reliance on incentives

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Challenge 1: Domestic harmonisation

• Bank/ Non-Bank/ FMI overlap

• Twin peaks

– ODPs under FMA and Conduct authority as “lead” regulator

– Most trades are inter-bank, which fall under the Banks Act and SARB

regulation

– Prudential regulation of non-bank ODPs – regulatory arbitrage

– FAIS Act: covers ALL product providers

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FINANCIALMARKETS

ACTFAIS BANKS ACT

FSB supervision Reserve Bank supervision

Challenge 2: International Harmonisation

• Balance harmonisation with disruption to market

• Understanding how equivalence will be assessed

– “Line by line” vs. “outcomes based”

– Having our “hands forced”

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Challenge 3: Concentration abroad

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Assumptions:

• FX spots/forwards exempt

from clearing

• Trades with int’l banks

assumed to clear off-shore

• Within IR, only swaps and

FRAs deep enough markets

to support clearing

• Within swaps and FRAs, only

include those with sufficient

liquidity (tenor, currency,

size)

• Includes large corporates

PwC Study 2012

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Cleared trades

Notional outstanding

(R’ Billion)

% of OTC

market

Local interbank only 3,810 14%

Local large corporates* only 5,614 20%

Local interbank and large corporates 9,424 34%

Range 3,800 – 9,400 14% - 34%

• Large corporates defined as top 10 other financial institutions and corporates

• Assumed to have the required trading and operational sophistication to clear

• Comprise hedge funds, asset managers and insurance companies

• Account for 91% of the local non-bank Swap and FRA notional outstanding

balance

Exemptions and the clearable market

PwC Study, 2012

OTC Derivatives Markets Composition

As at June 2012:

• R27 trn (US$2.5trn) notional outstanding (around 6 x GDP)

• >85% of market attributable to vanilla IR derivatives

• 59% inter-bank trades

• Around 60% of inter-bank IR trades are with international banks

-

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

Commodities Credit Equities Forex Interest rates

Notional outstanding - Interbank

Notional outstanding - Other FI

Notional outstanding - Corporates

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Study by PwC confirms the cross-border and inter-bank-dominated nature of the

South African derivatives market

PwC

Interbank trades mostly with foreign counterparties

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• 61% interbank interest rate

trades (notional outstanding) are

executed with international

banks

• 42% of interbank interest rate

trades (volume) are executed

with international banks

Notional balance outstanding (R’ billion)

-

2,000

4,000

6,000

8,000

10,000

12,000

Commodities Credit Equities Forex Interest rates

Local interbank Foreign interbank

-

20

40

60

80

100

120

Commodities Credit Equities Forex Interest rates

Local interbank Foreign interbank

Notional average monthly volume (R’ billion)

PwC Study, 2012

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Local notional

outstanding

Foreign notional

outstanding

Local notional

average monthly

volume

Foreign notional

average monthly

volume

Commodities < R12.5 m < R12 bn R0 < R200 m

Credit < R2.5 bn < R20 bn R0 < R150 m

Equities < R4.5 bn < R8.5 bn > R300 m < R300 m

Foreign exchange > R300 bn > R750 bn < R9 bn > R15.5 bn

Interest rates > R6 trn > R9.9 trn > R100 bn > R75 bn

Notional outstanding are executed with international banks

PwC Study, 2012

Type Potential Options

1. LOCAL CCP • Must be licensed as a clearing house by the Financial

Services Board

• Must demonstrate sufficient assets and resources,

however not required to be “in the Republic”

• Perform the functions of a licensed clearing house in

terms of the FMA

• Meet the requirements of and perform the functions

outlined in the draft Ministerial regulations

2. GLOBAL CCP

Clearing services to local dealers

and operating in South Africa as a

branch or subsidiary of the global

CCP

• Must be licensed as a clearing house by the Financial

Services Board

• Must demonstrate sufficient assets and resources

however, not required to be “in the Republic”

• Must perform the functions of a licensed clearing

house in terms of FMA

• Meet the requirements of and perform the functions

outlined in the draft Ministerial regulations

3. GLOBAL CCP

No local operations, or limited local

presence e.g. a Rep office

• Must be supervised by a foreign supervisory authority,

subject to a regulatory framework equivalent to that

established in the FMA

Off-shore vs domestic clearing and transaction typesC

urr

en

cyCOUNTERPARTIES

Domestic to Domestic Domestic to Foreign

ZAR Pros

• Netting benefits are realised leading to

optimal savings by banks

• Better protection due to greater oversight

and supervision by local regulators

• ZAR will be clearable

• Advantages in default situations & Less

exposure to global contagion

Cons

• Split book between local vs global CCP-

reduces netting efficiencies

• Less diversification and difficult to attract

international clearing members

• Limited number of participants

Pros

• Liquidity provisions

• Greater netting benefits are realised due to

larger number of clearing members

• Larger default funds mean lower DF

contribution and therefore cost

Cons

• Foreign CCPs not clearing ZAR transactions -

requires back to back hedging transactions

that add to risk and cost

• Global contagion effects due to increased

exposure

• Difficult for domestic regulators to have

greater oversight over foreign CCPs

• Default situations – ZAR based transactions

not prioritised

USD N/A • Multilateral netting benefits

Impact of global clearing on SA banks

• Foreign counterparties demand off-shoring clearing of ZAR derivatives, even without

mandatory requirement from SA regulators

• Derivative pricing differences between internationals and SA banks due to:

– Introduction of OIS discounting requirement to incorporate collateral in pricing

calculations

– CVA

– FVA - the cost of converting ZAR to dollars is expensive

• No ability currently to pay IM in preferred transaction currency i.e. ZAR which makes

funding IM sub-economic (even non-sensical)

• Reduced liquidity as Swap Dealers lose appetite for OTC transactions

• Dislocation between short and long dated swaps (currently clearing only available out

to 10year for ZAR IRS). Reduced liquidity over 10 year / pricing dislocation all feasible.

• Change in country risk pricing. CCP equivalent is covered via initial margin – only 1

CCP currently and a handful of clearing members, therefore no ability to control Initial

margin costs

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Domestic to Domestic Clearing (ZAR)

Domestic

CCP

ClientClientDomest

ic Bank

ClientClient

ZAR

ZAR

ZAR

As at June 2012:

• >85% of market attributable to vanilla IR derivatives

• 59% interbank trades

• Around 60% of inter-bank IR trades are with international banks

Domestic to Foreign Clearing (USD)

Counter

party

Counter

party

Domestic

Bank

US

D

USD

ZA

R• As indirect clearers, domestic

banks ODPs (clients) will be charged a clearing fee by foreign clearing members , e.g. Barclays Capital Inc

• Foreign clearing member novatetrades to global CCP

• For every trade cleared with the CCP, banks will be required to post initial margin (collateral) with the CCP

• Foreign CCPs do not accept ZAR IM, would require back-to-back trade to hedge out position

• The cost of converting ZAR to dollars is expensive

• Costs are passed onto clients

Counter

party

Counter

party

Counter

party

Foreign

clearing

member

Global CCPU

SD

International vs Domestic Clearing

Domestic

Bank

US

DZ

AR

If the derivative banks

clear through multiple

CCPs

• will have to contribute

to multiple default

funds if clearing

members

• will incur multiple sets

of clearing fees

• portfolios would be

split across the CCPs

• netting efficiencies

limited and increasing

collateral requirements

Domestic

Counter-

party

Domestic

Counter-

party

Foreign

counter-

party

ZAR

USD

Foreign

clearing

memberGlobal CCP

USD

Local CCP

ZAR

ZAR

Counter-

party

Trade 1 Domestic to

Domestic (ZAR)

Trade 2 Domestic to

Foreign (USD)

Trade 3 Back to back

ZAR hedging

trade

Summary and Challenges

• Twin Peaks implementation

• Harmonisation with other domestic regulation like FAIS

• International harmonisation (our progress depends on rest of world)

• Extra-territoriality

• Access to services concentrated in larger markets where we do not have the

infrastructure

• Pricing disparities and changes

• Regulating the unknown takes time

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QUESTIONS

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