Thursday, December 17, 2009

Britain signals rift in OTC derivatives regulation

Original posted in the Financial Times by Jeremy Grant:

Divisions between global regulators over how to reform the vast over-the-counter derivatives markets started to emerge yesterday as the UK's financial watchdog said it opposed forcing "standardised" OTC contracts into clearing houses.

In a paper published with the UK Treasury, the Financial Services Authority supported the thrust of proposals to tame the OTC derivatives markets, including greater use of clearing. But it raised objections to forcing "standardised" OTC contracts into clearing houses, as well as mandating that they be traded on exchanges and other electronic platforms.

The development comes after repeated assurances by global watchdogs - reinforced at the recent G20 meeting in Pittsburgh - that regulators should agree on a joint global approach to cleaning up the financial system in the wake of the crisis. Last week, the US House of Representatives passed a bill to reform the financial system that included sweeping changes to the way OTC derivatives are traded.

That included requiring "standardised" OTC contracts to be processed through clearing houses to safeguard against the fallout from defaults by market participants.

The FSA and Treasury said they supported moves towards greater "standardisation" of OTC contracts, as well as greater use of clearing in such markets. A clearing house stands between parties to a trade, stepping in if there is a default.

The Obama administration and the House bill both call for mandatory clearing of "standardised" OTC derivatives, although lawmakers have yet to define what "standardised" means.

However, the FSA and Treasury said: "We do not support proposals to mandate CCP [central counterparty] clearing for all standardised derivatives. Mandating the clearing of all standardised derivatives could lead to a situation where a [clearing house] is required to clear a product that it is not able to risk manage adequately, with the potential for serious difficulties in the event of a default."

Alexander Justham, director of markets at the FSA, told the Financial Times that deciding what should and should not be cleared should involve more than an analysis of what OTC contracts were "standardised", and that what contracts were "clearing eligible" should also be assessed.

He said clearing houses were likely to become more systemically important as they cleared more trades. "The concern is that if you force things to go through CCPs that can't be risk managed, you create a new risk point."

The European Commission said in October that it intended to "propose making it mandatory to clear standardised derivatives through CCPs".

Non-financial users of OTC derivatives - such as ordinary companies - have been lobbying against moves to force certain OTC derivatives into clearing houses, arguing that it would cause a drain on cash .

The paper said: "If nonfinancial firms were forced to clear products, the requirement to post both initial and variation margin to the clearing house or their clearing member would increase costs and introduce an unpredictable liquidity burden."

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