Thursday, February 25, 2010

Asia launches reforms for OTC derivatives

Original posted in the Financial Times by Robert Cookson:

The US and Europe may be making the most noise about the need to reduce systemic risk in the over-the-counter derivatives markets but regulators in Asia – a region not known for trading in such opaque instruments – are starting to blaze their own trails.

Having witnessed the turmoil that gripped OTC derivatives markets in the west during the financial crisis, Asian regulators are keen to prevent the same problems from appearing on their own turf.

But there is also a concern that Asia does not get left behind in the race to reform the vast OTC derivatives markets as the US and Europe co-ordinate on reforms of their own.

The concern, say industry experts, is that as the big exchanges and clearers in the west start to gain traction with their new OTC clearing businesses, their momentum could crowd out Asian players from what is rapidly emerging as a ground-breaking business opportunity in global financial markets .

Japan, India, China, Hong Kong, Singapore, Korea and Taiwan have all created task forces to study setting up clearing operations for the opaque OTC markets, either by using existing clearing houses or by setting up clearers specifically for OTC derivatives.

Japan’s Financial Services Agency, the markets regulator, last month published the results of a consultation on the issue in which it recommended that more OTC derivatives be cleared and that improvements be made to clearing houses.

The moves are the latest phase of reforming zeal that has affected markets since last summer, when the Obama administration first insisted on sweeping reforms that aimed to bring greater transparency and safety to OTC derivatives .

So far US and European policymakers have agreed on a need to move as many OTC derivatives that are deemed eligible for clearing through clearing houses after they have been traded. A clearer stands between two parties to a trade, guaranteeing that a trade goes ahead even if one party defaults.

The aim is to prevent the default of one market participant from spreading “counterparty risk” throughout the financial system. A lack of such safeguards in OTC markets led to a dangerous ripple effect in 2008 when the Lehman Brothers default triggered widespread counterparty risk fears.

While Asia constitutes a small part of the global OTC markets – where notional outstanding volumes total $600,000bn, according to the Bank for International Settlements – trading volumes are rising fast and most international dealers have established footholds across in the region.

In Japan – the biggest market in the region – the notional outstanding amount of interest-rate swaps expanded by 47 per cent between June 2007 and June 2009, according to the Bank of Japan, reaching $27,100bn, or about 6 per cent of the global interest-rate swap market.

Yet some western policymakers believe that without a consistent global approach, market participants will pick and choose where to conduct their business – known as “regulatory arbitrage”.

In recognition of this, South Korea plans to follow the guidelines agreed by Group of 20 officials at their Pittsburgh summit in September.

Under the Pittsburgh agreement, all “standardised” OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through clearing houses, or “CCPs”, by the end of 2012 at the latest.

Although Singapore is not in the G20, it has endorsed its process. The local exchange, SGX, aims to become a regional hub for OTC clearing and is exploring the idea of joining forces with other clearers such as the UK-based LCH.Clearnet, already the world’s largest clearer of OTC interest rate swaps.

SGX already clears OTC oil, freight, and other commodity derivatives through its Asiaclear unit and plans to expand into OTC foreign exchange and interest rate products.

But as the push for OTC clearing gains momentum, there is some concern among the big OTC dealers at banks that a proliferation of CCPs could add to costs for some amid a proliferation of CCPs, forcing dealers to post margin in multiple places.

Keith Noyes, Asia head of the International Swaps and Derivatives Association, which represents the dealers, says: “There is a lot of potential risk that we get lots of ‘national champion’ CCPs that are very inefficient. From a practitioner’s standpoint, costs would go up dramatically.”

For its part, China launched the Shanghai Clearing House three months ago, although the country has not revealed what products would be included and when clearing would start.

The Clearing Corporation of India, which was established in 2002, has started clearing rupee foreign exchange derivatives and is moving towards the clearing of local interest rate swaps.

Japanese trading volumesIn Japan, the FSA has concluded that at least one CCP will be necessary for the clearing of straightforward interest rate swaps and credit default swaps of a certain turnover, such as iTraxx Japan index transactions.

For interest rate swaps, Japan’s FSA has said that, ideally, domestic CCPs should be used to reduce settlement risk swiftly and effectively.

But not all Asian countries are quite so gung-ho. While Taiwan is also considering setting up a national CCP, a central bank official says there is no urgency to do so because its OTC derivative market is relatively small.

For similar reasons, Australia says it is unlikely to build a domestic OTC clearer.

But there is another reason why some countries are hesitant about the idea of building their own clearing houses: the risk of getting it wrong.

“A CCP is the ultimate too-big-to-fail institution,” says one regulatory expert. “If a CCP goes down, you really are looking at financial armageddon.

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