Derivatives have a long-standing history as financial instruments for managing financial risks stemming from changes in macroeconomic conditions. They thus represent important risk management tools for companies, authorities and financial institutions as they can be used to manage exposure to interest rate, currency, commodity price or other risks. Derivatives range from fully standardized to tailor-made products: fully standardised derivatives are usually traded on exchanges, whereas customised contracts are traded over-the-counter (OTC). Thus, as OTC derivatives markets are generally characterised by flexible and tailor-made products, satisfying the demand for bespoke
contracts customised to the specific risks that a user wants to hedge, OTC derivatives often compriseprivately negotiated contracts, with only the participants having access to detailed information.
In contrast, exchange-traded derivatives, which are by definition standardised contracts, leave a transparent trail in terms of positions, prices and scale of exposures while OTC derivatives markets have historically been largely unregulated with respect to the disclosure of information even though operations in these markets were executed by supervised entities. As a result, information available to market participants and supervisors has long been limited.
The financial crisis has brought to light many weaknesses in OTC derivatives markets, such as:
1 Greater standardisation of OTC derivatives contracts.
2 More robust counterparty risk management.
3 Consistent and high global standards for Central Counterparties (CCPs).
4 International agreement as to which products are ‘clearing eligible’.
5 Capital charges to reflect appropriately the risks posed to the
6 Registration of all relevant OTC derivative trades in a trade repository.
7 Greater transparency of OTC trades to the market.
8 On-exchange trading.
Uncertainty surrounding regulations and a decline in OTC derivatives notionally is causing market participants to reexamine the landscape to understand how they are being affected by recent and upcoming changes. Regulatory uncertainty has plagued us since the financial crisis. In reaction to the financial crisis, there has been an international effort to increase stability in financial markets – including OTC derivatives markets: In 2009, G-20 leaders agreed that
all standardised OTC derivative contracts should be cleared through Central Counterparties (CCPs) by the end of 2012 at the latest, while non-centrally cleared contracts should be subject to higher capital requirements. Furthermore, all OTC derivative contracts should be reported to trade repositories. These changes are set to improve the efficiency and transparency of OTC derivatives markets with a view to reducing counterparty and operational risk involved in these markets as well as overall systemic risk.
OTC Regulations As Per Different Geographies:
1) At the global level, OTC derivatives regulation is being undertaken by CPSS and IOSCO and focuses on efforts to update and strengthen standards for CCPs, CSDs, payment systems and the treatment of trade repositories.
2) At the national level, initial proposals regarding OTC derivatives market regulation have been initiated in 2010, especially in the US and in Europe.
3) OTC derivatives regulation in Europe is implemented through 4 different legislative initiatives:
-EMIR: The European Markets Infrastructure Regulation, constitutes
the main part of Europe’s OTC derivatives market reform.
-ESMA: The strengthened supervisor of market infrastructures, will
be responsible for the implementation of the new rules and the
supervision of OTC derivatives markets. Specifically, it will be
responsible for interpreting the new legislation and determining which
financial instruments and market participants will be covered.
-EMIR: The regulation includes reporting obligations for OTC
derivatives, clearing obligations for eligible OTC derivatives,
measures to reduce counterparty credit risk and operational risk for
bilaterally cleared OTC derivatives and rules on the establishment of
interoperability between CCPs. It also includes requirements for CCPs,
post-trade interoperability and requirements for trade repositories.
4) In US Market, Title VII of the Dodd-Frank Act, entitled the —Wall Street Transparency and Accountability Act of 2010, establishes a new framework for regulatory and supervisory oversight of the OTC derivatives market. Defining terms and establishing how these regulations are going to work in practice has been left to the CFTC and the SEC. However, the rule-making is well underway. Topics affecting OTC derivatives in the Dodd-Frank Act include:
— Registration of swap dealers and major swap participants;
— Push-Out Rule;
— Swap clearing and execution;
— Swap reporting;
— The Volcker Rule, which is in Title VI
5) OTC derivatives regulation elsewhere in the G20, In Canada and Asia, regulatory efforts are at an early stage with unofficial proposals published by the CSA (Canada) and initial public policy intentions and 2012 targets announced in several markets. Also,several new clearinghouse are in development for the clearing of derivatives. In General, the Asian derivatives regulations are more focused on clearing than on transparency.
Source : DB