Celent analyst Arin Ray explores the challenges Asia faces as the region moves toward adopting the G20 mandates for standardizing the OTC derivatives market including extraterritoriality and fragmentation/concentration risks.
The G20 countries addressed the problems in the OTC derivative market and came up with a set of mandates requiring standardized OTC derivatives to be traded on open platforms, and cleared through central counterparties (CCPs). Trade repositories would capture and maintain data on nonstandard transactions. Different Asian countries have agreed to adopt the proposals initiated by the G20 countries to different extents. The task is more onerous in Asia because the region is highly fragmented, consisting of multiple economies with independent regulatory and monetary regimes. There is no single regulator in Asia, so different countries are implementing these changes differently and in a timescale that is appropriate for each market. However, this gives rise to a number of issues that need to be addressed.
Extraterritoriality
Different clearinghouses in the Asian countries can create inconsistent or even conflicting rules. This not only applies to trades carried out between two counterparties in the region, but also to trades involving a counterparty in another part of the world. Under the Dodd-Frank regulations, US regulators may not recognize foreign CCPs if they think the foreign CCP does not have adequate supervision. Trades cleared at such CCPs would attract additional capital requirements, which would have to be borne by the counterparty in the US. This might discourage a lot of US banks in clearing at such CCPs in Asia.
This issue is of such importance that regulators from Australia, Singapore, and Hong Kong have expressed concern to the Commodities Futures Trading Commission (CFTC). They argue that they, along with other national regulators, are taking steps to match up to reform measures in line with G20 proposals. However, stricter supervision for cross-border transactions may create confusion, increase cost of compliance, and thereby disrupt liquidity in their domestic markets. Therefore the issue of harmonization of rules for cross-border transactions has become important for many regulators in Asia.
Most regulators in Asia have suggested that OTC derivatives in their countries should be centrally cleared; however, it is not clear if they can be cleared at any clearinghouses or only using domestic clearers. Given the low volumes in many countries, it is possible the country regulators force all derivatives to be cleared at domestic clearinghouses to justify the existence of local CCP. Countries like India, China, and South Korea are moving in this direction. Under this scheme a difficulty may arise from the fact that some of the US or European banks may not get approval from home country regulators to join local or regional clearinghouses if they have to assume unlimited liability in case of defaults. However, this will be a difficult proposition for the advanced countries like Australia, Hong Kong, and Singapore to implement, because it will force international market participants (e.g., CME, LCH-Clearnet) out of those markets. Not surprisingly, these countries have already indicated that they would leave this choice to the market participants to decide where they would want to clear.
One arrangement to resolve this issue could be to set up global standards by supranational bodies that would allow catering to local nuances while establishing minimum global standards. This would also reduce the risk of concentration on US-based CCPs. A coordinated Asian plan of action would help greatly in achieving this goal and protecting the interests of the countries in the region.
Fragmentation- Concentration Dilemma
Too many CCPs in the region (one or more per country) may result in fragmentation of the Asian OTC market. Similar to the possibility of fragmentation in clearinghouses, there is a possibility of data fragmentation as a result of having multiple trade repositories along jurisdictional lines, as many of the Asian countries propose to create trade repositories of their own. A consolidated single trade repository administered by a supranational body may solve this issue if there is political consensus.
A related issue is the size of clearinghouses vis a vis concentration risks. Having many clearinghouses in the region may make some of them economically unviable because volumes are not significant beyond top few products in most markets. Liquidity may be constrained if positions are dispersed over a large number of CCPs. It also takes higher initial investments and operating expense to build and run a large number of CCPs. Lack of harmonization in regulations pertaining to cross-border transactions adds to the difficulty.
On the other hand, smaller number of CCPs allows for more netting opportunities and thereby cost savings. However, having a single (or a few) pan Asian CCP would likely result in high concentration risk thereat. If or how the regional regulators would work together to strike right balance is something that still needs to be seen.
It can be said, while the intentions to bring changes in the OTC derivative market are right, it would take significant effort from regulators and market participants to avoid serious unintended consequences. Given that most of the Asian regulators have traditionally been conservative in nature, implementing significant changes is likely to take time.
