In a Q&A Mark Battistoni of Chatham Financial explains why the FSA’s approach to regulatory reform of the OTC derivatives markets is better.
Q. The FSA and HM Treasury issued a paper recently that called for changes to the OTC derivatives markets and warns that proposed changes from other jurisdictions may have a negative impact on the OTC derivatives industry. What were the most important takeaways from the FSA/HM Treasury paper?
More than 40% of the global OTC derivatives market is located in the UK. As such, the joint paper put out by the Financial Services Authority and HM Treasury represents an important marker in the ongoing debate over effective regulation of the derivatives market. In this paper, the UK authorities have clearly articulated their concerns over the negative unintended consequences that could arise from an overbroad and indiscriminate implementation of regulation in the OTC derivatives market. The paper distinguishes between market participants and the varying degrees of risk that they pose to the financial system, and then advocates for reforms that are proportionate to these different levels of risk. Specifically, the FSA and HM Treasury have demonstrated that they understand the concerns of the thousands of companies that use derivatives to manage business risk – the so-called corporate end users. As a firm that helps more than 1,000 companies with hedging strategies, we were pleased to see such an eloquent and well-reasoned argument in support of corporate end users.
Q. What is the difference between FSA and US/Europe approach?
The specific item that stands out the most in the FSA/ HM Treasury paper is the recognition of the end user issue. The UK regulators appear ready to go to bat for the corporate end user.
More generally, the FSA/HM Treasury approach is measured and proportionate, while the approach taken thus far by some policy makers in the US and Europe seems to be somewhat rigid and proscriptive. We should point out that the European Commission has indicated that they will do an impact assessment to evaluate the costs and benefits of proposed market reforms. In addition, Werner Langen, of the European Parliament’s Committee on Economic and Monetary Affairs, released a draft report last month that acknowledged that corporate end users did not cause the financial crisis and recognised the need to treat corporate end users with care. These are very encouraging signs and we would hope that policy makers in the US take notice. The OTC derivatives market is the world’s largest market and international regulators need to proceed very carefully or else they risk creating a disjointed patchwork of regulations that promotes regulatory arbitrage.
Q. What are top areas of concerns for the FSA? Why?
The approach proposed by the FSA and HM Treasury diverges from the European Commission’s October 20, 2009 proposal, and the proposals submitted thus far by the US Congress, in the areas of collateral requirements, capital charges and exchange trading.
With regards to collateral requirements, the FSA/HM Treasury report warns of the “unpredictable liquidity burden” that central clearing and margin mandates would impose on non-financial firms. The paper goes on to note that “not all firms have equal levels of financial and operational resource” and that any collateral requirements should be “proportionate to the risk of the users and the sector to the system as a whole.”
While noting that capital reserve requirements for derivatives may be increased, the FSA/HM Treasury paper argues that these charges should be “proportionate” and not used “as a tool to directly influence market structure.”
While proposals in the US and Europe have embraced the notion that much of the OTC trading should be moved to regulated exchanges and trading platforms, the FSA and HM Treasury appear to be unconvinced, noting, “At this stage [it] is unclear what additional benefits mandating trading of standardised derivatives on organised trading platforms will deliver and costs would likely be significant.”
Q. Why is the FSA’s approach a more reasonable one for better regulation of the OTC derivatives markets?
We recognise the enormous damage that was done to the global financial system over the last couple of years. We also know that certain actors in the OTC derivatives market played a role in exacerbating the financial crisis. But our role as consultant to companies across all sectors of the economy gives us a vantage point from which we can see the tremendous utility of derivatives as risk management tools. This appears to be the first instance in which a government regulator has given serious consideration to the practical implementations of proposed regulations. The FSA/HM Treasury’s proportionate approach is reasonable because it seeks to fix the parts of the market that are broken without breaking the parts of the market that work quite well.
*Since 1991, Chatham Financial’s mission has been to bring transparency and fairness to the OTC derivatives market. Chatham’s provides information and updates on the current regulatory reform of the OTC derivatives market via its company blog and information site – hedgingworks.com
