Very recently CME shared a paper on the famous OTC derivatives and their treatment under Extraterritoriality. Due to the role of unregulated over-the-counter (OTC) financial derivatives in the 2008 financial crisis which began in the U.S. but whose influence was felt globally, the G-20 agreed in its Pittsburgh meeting in 2009 that “all standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012, at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”
The members of the G-20, in varying degrees and at different speeds, have embarked in their own jurisdictions to reform the OTC derivatives market. Given the interconnected nature of these markets, international cooperation has very much been part of crafting derivatives financial regulation.
According to the Bank for International Settlements, at the end of 2012, total global derivatives markets were about $633 trillion in notional amounts. U.S. participants, with about $223 trillion in notional exposure, account for over a third of the aforementioned global amount; this is a 270% rise in just one decade. The data go a long way to explain the desire of U.S. regulators such as the CFTC and the Securities and Exchange Commission, along with bank regulators, the Federal Reserve, the Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency, to see that derivatives markets are not only better regulated but also well supervised. The disproportionate amounts of derivatives transactions are between dealers; end-users such as commodity companies are incredibly small in comparison.
In the U.S., 80% of financial derivatives are interest rate derivatives, 12% are foreign exchange derivatives, about 6% are credit derivatives, with the remainder being equity and commodity derivatives.
The majority of U.S. players, to no one’s surprise, are banks. According to the OCC, while over 1,350 insured U.S. commercial banks and savings associations reported derivatives activities at the end of the fourth quarter 2012, derivatives activity in the U.S. banking system continues to be overwhelmingly dominated by a small group of large financial institutions.
Specifically, JPMorgan, Citibank, Goldman Sachs, and Bank of America represent 93% of the total banking industry derivatives notional amounts and 81% of industry net current credit exposure. What many may not know, however, is that the top U.S. banks’ derivatives portfolios are about 96% OTC, which until 2010 were unregulated, and only 3-4% are exchange traded.
For the banks to transition from OTC to clearable derivatives is requiring a massive change in risk management culture, not to mention business strategy and significant overhaul of how data are collected, verified, and reported to comply with Dodd-Frank. Moreover, U.S. regulators like CFTC and SEC, which had minimal exposure to OTC derivatives, have had to upgrade significantly their knowledge not only about these derivative notionals by Type of users.
Total derivative notionals are now reported including credit derivatives, for which regulatory reporting does not differentiate between trading and non-trading.3 instruments but of how international banks like JPMorgan and Bank of America conduct their derivatives business across multiple legal entities and geographies.
Also extremely important, these entities often book their derivatives in multiple legal entities in the U.S. but also abroad. Just because financial book trades are booked offshore does not mean that risk stays offshore, as has been seen with JP Morgan’s “London whale” scandal, Citibank, AIG, Lehman, Long Term Capital Management and Bear Stearns.
It is precisely because of the interconnectedness of derivatives markets that the CFTC cannot afford to assume that other supervisors are properly monitoring the derivatives of U.S. participants offshore or foreign entities in the U.S. Substituted compliance is an invitation for significant regulatory arbitrage.