Given regional differences, the pace of derivatives reform implementation is uneven but Asia is slowly progressing through the different deadlines. Lynn Strongin Dodds reports
Although Asia is making progress in implementing derivative reforms, there is not the same urgency that drove European and US market participants. For one thing the backlash against the banking community was not as harsh but also the landscape is much more fragmented and OTC trading volumes are a fraction of the other regions’ financial centres.
The result is that the status of clearing, central counterparty (CCP) recognition, trade reporting, electronic platform trading and non-cleared margin rules across the region are moving at different paces. “One of the biggest challenges in the region is that the markets are significantly smaller and meeting the rules is much more complex because of the multiple jurisdictions,” says Rory Baldini, APAC Sales Executive at Linedata. “Countries have had to figure out how to build and synchronise their local regulations into a global framework.”
Keith Noyes, regional director of Asia Pacific at the International Swaps and Derivatives Association (ISDA), adds, “If you look at the clearing and trading mandates they require a fair amount of liquidity. The US and Europe account for the bulk of the global derivatives market with Asia’s share being no more than 10%. Japan accounts for around 4% of that.”
Japan is leading the pack
Not surprisingly perhaps, Japan as the largest Asian derivatives market, is leading the pack. The country was not only the first in the region to launch a clearing mandate but it also leapfrogged the US and Europe. It adopted a phased in approach starting with the clearing of yen-denominated interest rate swaps and Japanese index credit default swaps in November 2012.
Two years later, Japanese financial institutions with derivatives notional outstanding volumes of over ¥1 trillion ($8.9 billion) started clearing followed by those with more than ¥300 bn in December 2015. The end of this year should see insurance companies and trust accounts join the fray.
China, India and South Korea have followed suit while the clearing mandates are expected to come into force in Australia, Hong Kong and Singapore over the next year or so. “Japan has often been the first mover, being the first jurisdiction to implement an OTC clearing mandate,” says Christian Lee, Head of Clearing, Risk, and Regulatory Practice at consultancy Catalyst. “However, many other jurisdictions such as Australia and Hong Kong have taken a lead from Europe and later the US with their DCO (derivatives clearing organisations ) exemption scheme to look at regulatory equivalence and ensuring that CCPs (central clearinghouses) meet the minimum standards specified in the PFMI(Principles for financial market infrastructure).”
“Japan has often been the first mover, being the first jurisdiction to implement an OTC clearing mandate,” says Christian Lee, Head of Clearing, Risk, and Regulatory Practice at consultancy Catalyst.
DCO exemption enables a CCP to clear the proprietary swaps of US clearing members but not their US client trades. To date, only Singapore Exchange (SGX) has registered with the Commodity Futures Trading Commission (CFTC) as a DCO, while the Australia Stock Exchange (ASX), Hong Kong Exchanges and Clearing (HKEx), Japan Securities Clearing Corp (JSCC) and Korea Exchange have all gained DCO exemptions.
The JSCC had initially applied for full DCO registration but differences between the country and the US over asset segregation led the group to opt for an exemption instead. This is because Japanese law does not allow for client assets to be segregated, while it is the requirement for DCOs under the CFTC.
Asia/Europe – Gaining Equivalence
Gaining equivalency in Europe has been a relatively easier process. Singapore, Japan, Australia and Hong Kong were recognised in the first wave of the European Union’s so-called “equivalence assessments” in 2013. Meanwhile South Korea and India are waiting in the wings for approval while China’s Shanghai Clearing House has not yet applied to the European Securities and Markets Authority (ESMA) for recognition.
The benefits are relatively straightforward in that it adds cache to the international status of the region’s financial hubs. Without it, for example, European banks would be unable to use a CCP for products mandated for clearing under EMIR, while any products cleared through the CCP by European banks or their affiliates would face higher capital charges under the EU’s capital requirements regulations.
Equivalency though is a two way street with Australia being the first Asian jurisdiction to fully recognise overseas CCPs. Most recently, the Hong Kong Securities and Futures Commission (SFC) granted LCH.Clearnet approval to become a CCP and provide automated trading services while the US based CME and JSCC were given the green light to offer clearing in mandated interest rate swaps (IRS).
“Japan is taking a slower approach with LCH.Clearnet now the only overseas CCP authorised to offer OTC clearing to domestic Japanese banks,” says Lee. “However, this is limited to non-JPY denominated IRS, so JSCC remains the sole CCP authorised to clear the JPY IRS market to domestic Japanese entities.”
Lee notes that the main challenge for CCPs looking to do business in Asia, particularly the smaller regional ones, is the high cost of preparing and filing the applications with multiple regulators, as well as to meet the individual reporting requirements of each jurisdiction. For example, Hong Kong has some specific reporting requirements that require relatively significant investment from each CCP.
“It gives a huge advantage to the likes of LCH and CME, who can use their larger size and scale to meet the various regulatory requirements of operating in multiple jurisdictions,” he adds. “This is the case with trade reporting to local trade repositories.
Dr Anshuman Jaswal, senior analyst at Celent’s Securities & Investments group, also highlight that the international nature of many OTC derivatives transactions can be a stumbling block. “The reporting requirements can overlap and sometimes conflict across jurisdictions,” he says. “Similarly, it is important for the leading markets to recognise the CCPs in other jurisdictions. The main challenge comes when the regulators do not try to align their rules with those in other jurisdictions.”
Trade Execution
While strides, albeit uneven at times, are being made on central clearing and CCP recognition, the same cannot be said for trade execution. One of the reasons is down to the wording of the text in the recommendations. “The G20 proposals required trade execution ‘where appropriate’ according to Jaswal. “As a result, many Asian regulators have determined that the volumes are not sufficient to justify OTC derivatives on exchanges or electronic platforms.”
Lee also notes that it is difficult for the smaller and less active domestic Asian markets to invest in the requisite new infrastructure, or to attract international electronic trading platforms to launch domestically.
Again Japan is a forerunner although it is taking small steps in this direction, according to Lee. “The initial scope of the trade execution mandate has been very narrow, with the scope broadening in the future phases,” he says.” The Japanese market is sufficiently large and has attracted a number of international players to setup Electronic Trading Platforms (ETPs), which is facilitating a slow migration away from voice broking.”
There are seven registered ETPs which made their debut last September for financial institutions with derivatives notional outstanding of more than ¥6 trillion. Initially, only yen-denominated IRS with a maturity of five, seven or 10 years are required to trade on the platforms. It is still early days and given the narrow thresholds, trading volumes are modest with only a handful of trades reported each day.
Non-cleared Margin Requirements
Another area of uneven development is the implementation of non-cleared margin swaps. Under the original timetable, the largest derivatives dealers were required to post initial margin from 1 September with others being brought into the fold in yearly waves. The final group – derivatives users with exposures of less than €750bn – is set for September 2020. Variation margin, which must be exchanged daily to reflect changes in valuation of swaps contracts, will be required to be posted by all participants from March 2017.
While US, Canada and Japanese have ploughed ahead with the original deadline, the European Commission announced in June that it was still reviewing the draft regulatory standards submitted by the European Supervisory Authorities and that it would not be ready for the target date. Regulators in Hong Kong, Singapore and Australia also chimed in due to fears that their financial institutions would also not be prepared.
Lee notes that there was a view that Hong Kong was ready to meet the 1st September deadline, but (based on the Monetary Authority of Singapore press release), decided instead to coordinate with Singapore in delaying. “MAS said in its press release that it had consulted with HKMA to delay implementation of the uncleared margin rules, to “avoid unintended disruptions to financial markets,” he says.
Noyes adds, “I do not think it was a coincidence that Australia, Hong Kong and Singapore announced at the same time that they were going to delay implementation. They were driven by a couple of things, the first being that they rely on liquidity provided by global market players and they did not want to be subject to a conflict of interest between local and global firms.”
Baldini also notes that overall delays are not uncommon. “Deadlines creep up and are not always met,” he adds. “One of the reasons is that volumes are low and the resources have not always been there. In some cases, they do not have the infrastructure and things are done on a manual basis.”
