Ligia Catherine Arias-Barrera,Ph.D University of Warwick and Partner at Nalanda Analytica (Regulatory Consulting Firm) is author of the book “Regulation and Supervision of the OTC Derivatives Market,” which recently was added to the BookAuthority’s41 Best Banking Law Books of All Time. In this Q&A, Arias-Barrera offers highlights of the book and what she believes lies ahead for this market from her academic and legal perspective.
Q. In your book, you take a “normative risk-based approach’ to analyzing the regulation of the OTC derivatives markets in both the US and UK. Can you briefly explain this approach and why you adopted it in your analysis?
A. Professor Julia Black defines Risk-based regulation as a a general set of principles that seeks to find common and homogenous elements to rationalise the regulatory process. In particular, having assessed the risk that the regulated firms will present to the regulatory body achieving its objectives, it prioritises regulatory actions accordingly. This approach to regulation comprehends two stems: conduct of business and prudential regulation. It requires regulators to clearly define its objectives from the outset; therefore, regulatory agencies conduct a process of decision-making to determine how to address and when to prioritise risks.
The key question debated in the book is how risk-based regulation helps regulators to control the risk manufactured in the OTC derivatives market and thereby cope with the impact of innovation. In order to provide a ‘route map’ for regulation and supervision of the market, risk-based regulators should acknowledge the difference between risk and uncertainties, and understand that both -although at different levels- might inform and contribute to the process of regulation. The OTC derivatives market creates risks and accumulates uncertainties. These uncertainties in turn show the limits of the expertise and regulation of the market.
Risk-based regulation is a particularly useful approach because it exposes the reality that there might be a limit on the resources that can be spent on controlling certain types of risk. In addition, this method allows the observer to analyse how the regimes are satisfying expectations regarding transparency and accountability.
The risk-based approach is a particularly interesting way to analyse the regulation of central counterparties (CCPs). The idea, explored in the book, is to question the emphasis that has been placed on the regulation of CCPs in the UK and the US. Is the use of a risk-based approach restricting the UK and US regimes – rather than ensuring their focus on the safety and soundness of CCPs, both as individual sites, and by simultaneously promoting the stability of the OTC derivatives market? In other words, is risk-based regulation the appropriate approach for ensuring the effective management of systemic risk in the OTC derivatives market (OTCDM)? Does it need to be complemented with other strategies of regulation? If so, what are those strategies likely to be?
Q. You first published this book in 2018. What were the most significant shortcomings in regulation of OTC derivatives markets in both the US and UK at time of publication? And has any of the recent regulatory development, such as EMIR 2.2 addressed some of these shortcomings?
A. The introduction of mandatory central clearing through CCPs brings benefits to OTCDM supervision: CCPs act as co-regulators by imposing market discipline. Using this rationale, the Bank clearly stated that CCPs would become a forum for the vast majority of OTC derivatives transactions and, as such, CCPs can promote high levels of disclosure about market participants and transactions. However, as a result of the analysis of the UK and US regulatory reforms we identified some shortcomings.
In the UK:
Although we recognise the importance of the areas that have been regulated by the Bank of England, we must also be aware of other areas where supervision has not been sufficiently developed.
- The first abandoned area is the CCPs’ conduct of business regime. In pursuing this argument, we considered the misinterpretation of the UK regulators’ mandates. In 2013, when the UK introduced reforms to the financial regulatory architecture, the Bank was designated as the regulator and supervisor of financial market infrastructures, within them CCPs. This means that the Bank would perform macro- and microprudential regulation of CCPs and the OTCDM. It was also clearly stated that the Bank would work closely with the Financial Conduct Authority (FCA), reflecting the FCA’s responsibilities for trading infrastructure and market product. A systematic interpretation of the regulators’ mandates leads us to the conclusion that, while the Bank carries out the prudential supervision of CCPs, the FCA supervises the conduct of business. However, in practice, regulators and (CCPs authorised in the UK perceive that the Bank is the only CCP regulator. The consequence of this misinterpretation is that the current conduct of business rules, implemented by the FCA, do not apply to CCPs in the OTCDM. From this, we can see that CCPs’ standards of conduct are not a regulatory priority, because regulators do not consider this area to pose a significant threat to their regulatory objectives.
- Closely connected with the absence of conduct of business rules is the shortcoming concerning the insufficient legal framework underpinning CCPs’ operations – specifically, the imbalance affecting the contractual relationship between CCPs and their members. The CCPs’ rulebooks and complementary agreements exclusively regulate this relationship. The content of such rulebooks is exclusively and unilaterally drafted by CCPs; therefore, they have a limitlessly high level of discretion to draft contractual provisions, without considering the rights of their counterparties. Our concern should not be limited to the existence of abusive or unfair contractual terms – it also involves the clauses limiting the liability of CCPs to the detriment of clearing members’ rights. This issue reveals the need for a broader scheme of protection that would benefit clearing members and their clients. In particular, it calls for the recognition of a duty of care predicable of CCPs in the performance of their contractual obligations related to holding and managing clearing members’ assets and positions. We argued that the recognition of such a duty and standards of diligence would imply a regulatory reform of Section 291 of The Financial Services and Markets Act (FSMA) 2000 and could be constructed under the parameters of the common law.
- The Bank of England has developed loss-allocation and recovery rules to ensure that CCPs are sufficiently resilient. Nonetheless, the resolvability of a CCP needs to follow a comprehensive and pre-established regime that ensures that the core functions of CCPs are maintained during times of crisis. A Special Resolutions Regime (SRR) of CCPs should address the efficient allocation of losses, the mitigation of fire sales, and how to ensure the continuity of services. The novel contribution of this book in this area is to highlight the potential shortcomings of the resolution regime for CCPs. It is particularly challenging to build up an SRR that can be articulated with the exercise of termination rights in derivatives contracts allowed by the Financial Collateral Arrangements Directive (FCAD). The possibility of bailout CCPs and the role of clearing members as the ultimate underwriters of CCPs are also considered in this discussion. Moreover, one of the questions explored in this book is around the suitability of implementing ring-fencing for CCPs. In this regard, the central concern is whether ring-fencing – in essence, a territorial approach to insolvency – could be coordinated with cross-border policies. The argument is relevant because CCPs occupy a prominent and systemic position and provide services in more than one jurisdiction. The ring-fencing regime, if applicable, should consider the twin realities of cross-border arbitrage embedded in the interconnections between CCPs and other entities.
- We also explored the role of innovation and the risk it poses to the achieving regulatory objectives. The central argument is that CCPs are providing services in a market led by innovation. The regulated firms’ attitude towards risks and regulation is pivotal to anticipate whether they are willing to comply or if, alternatively, they will find innovative forms of compliance. The practice of creative compliance might frustrate the expected outcomes of the regime – the multiple edges of innovation challenge the role of regulators. However, understanding the dynamics of the OTCDM, the conflicting interests that converge within the CCPs, and the interaction between CCPs regime with other regimes are illustrative of how innovation poses a significant risk to the achievement of regulators’ objectives. As noted earlier, the regulatory solutions might be as diverse as the issues triggered by innovation. However, this book argued that the design and implementation of governance rules might contribute to solve, at least partially, the issues that stem from the conflicting interests converging within the CCP. The development of governance rules implies the adoption of standards of conduct. We could, therefore, question the importance of having in place an individual accountability regime. It’s not clear whether the new Senior Managers and Certification Regime (SM&CR) would be automatically applicable to CCPs by 2018; the Bank must clarify the applicability of the SM&CR and the role of the FCA.
In the US
The analysis of the Dodd-Frank Act highlights the failure of the US CCP regime in implementing a coherent risk-based approach to regulation. This lack of coherence is associated with flaws of the bifurcated regulatory structure. The divided jurisdiction between the Commodity Futures Trading Commission (CFTC) and the U.S. Securities and Exchange Commission (SEC) is problematic, not only in terms of the duality of regimes applicable to derivatives instruments and participants, but, also and perhaps more importantly, concerning the adoption of an amalgam of regulatory strategies. US regulatory agencies have adopted multiple strategies featuring elements of principles-based, rules-based, and risk-based approaches to regulation.
As in the UK regime, the US body of regulation is incipient when dealing with events of innovation risk, failing to deal with the unintended consequences of collateral transformation. The direct effect of the intersection between derivatives regulation and capital requirements for Bank’s members of CCPs is that the risks traditionally associated with the derivatives market are transferred to other markets (e.g. repo market). Similarly, the rise of FinTech, as a relatively new phenomenon, has emphasised the limits of regulatory agencies when prioritising the risks that will be controlled and managed through regulation. In particular, the status quo of the US regime fails to deal with the changes and risks posed by the use of Distributed Ledger Technology (DLT) and smart contracts in the derivatives market, especially in central clearing services.
Finally, the cross-border impact of the US regime for CCPs exacerbates extraterritorial issues affecting non-US CCPs providing clearing services to US market participants. Through our analysis of the phenomena of divergent rules on segregation, and the system of recognition and authorisation of CCPs, we see the importance of establishing an equivalence strategy that ensures different regimes – e.g. the US and UK – can find common principles to guide the implementation of cross-border rules. The key, however, is not to customise the rules to make them similar; instead regimes must move towards the implementation of an outcomes- or principles-based approach. Under such a regime, the coordination between national and third-country authorities would be more effective, because the supervision would be guided to achieve the same results, and not to comply with specific sets of rules.
About EMIR 2.2
What we have seen in terms of regulatory reform for CCPs in the OTC derivatives market are the amendments to two existing EU directly applicable regulations: EMIR and the regulation establishing European Securities and Markets Authority (ESMA). On one hand, the focus of these reforms is on strengthening the framework for authorisation of EU-based and third country CCPs ( basically as a response to Brexit). On the other hand, changes to the competencies granted to ESMA include extending ESMA’s decision-making and oversight powers to ensure consistency of EU-wide supervision of CCPs. At least, that’s the idea behind the reform. However, there is no clarity how the unified regulatory strategy will be. Until now, there reform considers a change in terms of regulatory architecture by setting up a new committee within ESMA to centralise the supervisory decision-making relating to CCPs. Also, there’s an increased role of central banks and the European Central Bank (ECB). Although these advances might be necessary to ensure the safety of the derivatives market after Brexit, non of the shortcomings we identified have been directly addressed so far.
Q. What do you think is the biggest risk to the OTC derivatives markets in the coming years that needs to be either addressed by regulation or market participants and why? Is there a solution?
A. One of the biggest risk to the OTC derivatives market is associated with relocation of CCPs.
Under the hypothesis of relocated CCPs, national EU regulators would be compelled to carry out the supervision of certain CCPs. It cannot be denied that, although subject to common principles and rules, not all EU national supervisors have the same level of expertise to deal with systemically important financial institutions. Thus, unless the place of relocation is in certain European countries, the shift of CCPs’ location will bring excessive burden on inexperienced EU national supervisors, increasing the risk of ineffective supervision, which might lead to inadequate management and prevention of systemic risk.
The political context of the EC’s reforms of EMIR is clearly coloured by individual EU Member States’ interest to undertake the supervision of CCPs currently based in London and to concentrate their market. However, the implementation of the CCPs’ location policy might undermine such purpose and the influence of the political forces behind the reform could backfire, affecting the European market. It is possible that CCPs end up relocated in different EU Member States, putting at risk not only the financial stability of the EU, but also triggering market fragmentation. The movement of CCPs from London to several European countries would ‘artificially split the Euro market into small pools of liquidity’. Along with the repercussions of a fragmented market associated with liquidity and increased costs for end-users, there is a possible backlash from market actors, affecting EU market competitiveness. It might be anticipated that the relocation policy of the EC will make split on-shore markets in the Eurozone less liquid than offshore markets outside the Eurozone. The impact might also be reflected on prices differences between EU and non-EU CCPs on the same products.
Thus, the issues triggered by such fragmentation do not only concern the EU and the UK, but international markets and regulators. Indeed, the European Commission (EC) reform seems to take a step away from the G20 principles, in particular, overlooking the commitment to avoid fragmentation, protectionism, and regulatory arbitrage. Moreover, the implementation of post-GFC regulatory reform emphasises the importance of the principle of deference and international comity in international forums.87 The G20 Pittsburgh Summit coined the concept of regulatory deference to ensure an efficient cross-border implementation of the OTC derivative clearing obligation. This notion embeds the commitment of ‘regulators to defer to each other when it is justified by the quality of their respective regulatory and enforcement regimes, based on similar outcomes, in a non-discriminatory way, paying due respect to home country regulation regimes’.
Notwithstanding the terms of the Brexit deal and the effects of a change of regime applicable to UK CCPs, UK regulators would benefit from the coherent adoption of a risk-based approach. The challenges of the after-Brexit period will require collaborative work between regulators and market participants to maintain the stability of the financial system and to safeguard the place of London as the largest market for OTCDM. We are not suggesting that regulators should lighten the regime – indeed Mark Carney has been clear in anticipating that London will not lower its requirements to retain investors after Brexit. Instead, we suggest UK regulators take advantage of the approach to regulation proposed in this book as a means to facilitate the process of design and implementation of post-Brexit rules. In the particular case of OTCDM and the rules applicable to CCPs, the cooperation should be not only with European Supervisors, but also with market participants to ensure no disruption is caused to the provision of central clearing services. A regime of incentives seems to be better suited to keep the OTCDM and CCPs as successful as they have been since 2013, when the current regime entered into force.
Q. Ongoing innovation in financial technology (FinTech) is changing the financial services industry generally. How do you think regulation and supervision need to evolve to keep up with these developments?
A. FinTech is an evolving almost daily and that is the key challenge for regulators. How to keep up with these developments. The best approach is to find the balance among the sometimes conflicting regulatory objectives: maintaining the stability of the market, protecting consumers and investors, promoting competition, and now facilitating innovation and technology. Although is not an easy goal, UK regulators work is a good example of how to approach the FinTech phenomena.
Regarding the derivatives market and its central clearing services, the developments so far are attributable solely to the industry, as a form of self-regulation. The International Swaps and Derivatives Association (ISDA) has led the discussion about the role of smart contracts in the context of OTC derivatives. In this context, the role of the distributed ledger in the negotiation of financial derivatives is mainly associated with the better management of operational deficiencies and reduction of transactional costs. The ISDA has developed a programme that seeks to identify the benefits FinTech might bring to derivatives trading and post-trading. The industry-led initiative aims at reducing cost and complexity, as well as at increasing efficiency. The new proposal is the implementation of the ISDA Common Domain Model (CDM). The benefits of adopting the CDM are related to a high aspiration of reaching efficient interoperability among execution and post-trade management of derivatives transactions.
Moreover, open or restricted access to a DLT providing clearing services would necessarily go beyond traditional concerns about cyber security. At the basic level, the need to restrict access to a DLT is justified, due to information security issues and scalability when access is granted to a large number of participants. However, when the discussion is brought to clearing services, we should consider the effects open or limited access might have for the stability of the clearing services. As explained earlier, CCPs are willing to comply with central clearing mandates and to clear those transactions that regulators determine need central clearing, understanding that such a determination would not pose excessive risks to the stability and functioning of the CCP itself
Against this background, we argue that a risk-based approach to regulation is central to the effective adoption of FinTech (e.g. DLT and smart contracts) in the OTC derivatives market, especially in central clearing services. Regulators are expected to move towards understanding FinTech developments, and to decide the role which regulation will have. That’s why having a broad strategy of regulation that facilitates early identification of risk and assessment of regulatory tools is essential to manage the new risks FinTech evolution might bring.
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