Financial Regulatory Forum

COLUMN – OTC derivatives modernisation deserves support: John Kemp

October 9, 2009

U.S. Representative Barney Frank (D-MA), Chairman of the House Financial Services Committee, listens to a reporter's question during the Reuters Global Financial Regulation Summit in Washington, April 28, 2009.  REUTERS/Jonathan Ernst (UNITED STATES POLITICS BUSINESS HEADSHOT)  — John Kemp is a Reuters columnist. The views expressed are his own –

By John Kemp
LONDON, Oct 9 (Reuters) – Prominent banks and some business groups have warned policymakers their efforts to force standardised over-the-counter (OTC) derivatives transactions onto futures exchanges and into the clearing system will drive trading offshore and raise the cost of genuine risk-hedging for non-financial firms.
But scaremongering by the finance industry’s well-paid lobbyists about “unintended consequences” should not deter legislators from pressing ahead with a worthwhile reform.

While the status quo has proved immensely profitable for the banks, it is untenable from a public policy perspective. Large and poorly recorded exposures have heightened systemic risk and made it impossible to enforce sensible limits on market positions or counterparty exposure.

Draft legislation published last week by Representative Barney Frank, chairman of the Financial Services Committee of the U.S. House of Representatives, would bring real improvements in transparency and stability, without imposing undue burdens on corporations that rely on swap deals to undertake genuine commercial hedging.

At the moment, the debate over OTC derivatives reform risks being side-tracked by the question of whether transactions, particularly between banks and non-financial corporations, should be subject to the same margin regime as on-exchange futures and options deals. But margins are only one issue. The reasons for stricter regulations on OTC deals go much wider.

There is no comprehensive information about the size of the OTC derivatives markets. But the limited data on commercial bank exposures reported to the Bank for International Settlements (BIS) as well as that reported by U.S. commercial banks on their Form Y-9C statements of consolidated financial condition all show OTC positions are much larger than those on registered futures and options exchanges, and have been growing more rapidly.

Massive interbank exposures in OTC markets were not the prime cause of the banking system failure in 2007-2009. But they helped ensure that once a crisis developed in a few institutions it was propagated rapidly throughout the rest of the sector. OTC exposures were at the root of the “interconnectedness” problem, ensuring even peripheral institutions became “too big to fail”.

The risks were made worse by the poor record-keeping and reporting of OTC transactions endemic in the industry, which made it impossible for banks and regulators to monitor the build up of counterparty exposures properly, or plan for positions to be unwound as part of an “orderly failure”. Better control and reporting of OTC exposures is crucial to regulators’ hopes for implementing an orderly resolution regime for banks and other financial institutions in future.

In commodity markets, the explosive growth of OTC swaps has helped banks and institutional investors circumvent traditional position limits and accountability levels that apply to regulated exchanges, and also contributed to the lack of transparency because these deals have not been reported or captured in the weekly commitment of traders (COT) data published by the Commodity Futures Trading Commission (CFTC).

Bringing OTC swap transactions within the CFTC’s supervisory framework is essential to enforcing tougher position limits and stricter surveillance over the commodity markets. There is no point regulating the size of on-exchange positions if markets can be squeezed or distorted by substantially the same trades structured as OTC swaps.
While various objections have been raised to the reforms, none of them is intractable, and there is a suspicion that they are being raised simply to maintain the status quo. It is the industry’s usual counsel of despair, aimed at convincing policymakers almost any change will be too hard, have too many adverse consequences, or be rendered ineffective as financial institutions find new loopholes.

The first set of objections centres around the argument OTC derivatives can be tailored to meet the specific needs of each customer, unlike the highly standardised futures and options products available from exchanges. But while some OTC contracts are indeed customised, many are not, and are simply bilateral “lookalike” versions of existing on-exchange futures and options products. There is no real reason these contracts cannot be brought within the exchange and clearing system.

The second set of objections centres round the payment of margin. Cleared contracts are generally subject to a margining regime, where profits and losses on the position must be settled daily throughout the life of the contract. In contrast, OTC swap deals are generally not margined and any profits and losses do not need to be settled until the contract matures.

Corporate hedgers prefer un-margined lines since the timing of cash flows on the hedge and the underlying transactions are synchronised. By contrast daily margining can give rise to substantial margin calls on the hedge before revenues on the underlying transactions have been realised.

Corporations fear that margining will require them to set aside cash or obtain costly credit lines to cover margin calls, as well as introducing a new source of volatility into their published accounts, as margin calls have to be recognised in the income statement. By requiring OTC swaps to be cleared and margined, corporate hedgers fear their hedging costs will increase and force them to reconsider or even abandon worthwhile, risk-reducing strategies.

Despite the scare stories, the “Over-the-Counter Derivatives Market Act 2009″, published in draft form last week, is a carefully balanced reform that would reduce the risks associated with the growth of OTC swap markets while avoiding undue burdens on nonfinancial businesses hedging genuine commercial exposures (

The bill does not require OTC derivatives to be moved onto futures exchanges. Instead it stipulates that standardised swaps must be cleared (and margined), while non-standardised swaps must be registered with a (non-clearing and non-margining) swaps repository or directly with the CFTC itself. The bill’s clearing, margining and reporting requirements would reduce systemic risk among financial institutions and make it much easier to plan for an orderly failure.

Crucially, the reporting requirements will also enable the CFTC to monitor the build up of positions in specific commodities irrespective of whether the transactions occur on-exchange or off it. The bill specifically authorises the CFTC to publish aggregated data on OTC positions, and to enforce position limits on a consolidated basis across both exchanges and the OTC market.

At the same time, the bill contains an exemption from the clearing and margining requirements for non-financial businesses holding positions “primarily for hedging (including balance sheet hedging) or risk management purposes”, which would avoid a substantial increase in the cost of genuine physical and cash flow hedging.

The key will be to prevent financial institutions circumventing the clearing and margining requirements by establishing nonfinancial subsidiaries or claiming an exemption on the grounds they are also using swaps for risk-management purposes (in the same way swap dealers managed to circumvent commodity position limits in the 1990s and 2000s by claiming they were using on-exchange positions to manage risks in relation to their off-exchange swap contracts).

But the regulatory environment has changed significantly in the wake of the financial crisis. The CFTC is seeking to restrict the availability of hedging exemptions, and there seems little likelihood it will allow banks and swap dealers to frustrate the bill’s aims by taking advantage of the exemption for non-financial businesses.

Overall, the draft bill looks like a workable compromise that will bring greater transparency and stability to the OTC swap market without imposing an expensive burden on non-financial firms that want to continue undertaking genuine hedges.
(Edited by David Evans)
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