PART 3
OTC Derivatives - A comparative analysis of regulation in US, EU, Singapore
FRM AIMs:
•Describe the characteristics and benefits of central clearing.
•Describe the function of a trade repository and explain the benefits of a trade repository to OTC market participants.
•Compare the regulatory requirements and regulatory authority in the United States, European Union, and Singapore with respect to: the central clearing of OTC derivatives, requirements of central counterparties, margin requirements for uncleared OTC derivatives, trading, and backloading of existing OTC contracts.
•Describe the requirements for reporting derivative transactions to trade repositories in the United States, European Union and Singapore.
Conclusion
This study compares clearing and reporting regulation of OTC derivatives in Singapore, the United States, and the EU on assets, institutions, and the timing of regulation. The United States and the EU require central clearing and trading of all asset classes. Singapore requires only central clearing but not trading of all assets except foreign exchange swaps and forwards. Further, only the United States has phased implementation for reporting; Singapore prioritizes foreign exchange derivatives, interest rate contracts, and oil contracts. As the United States is in the most advanced stages of implementation of OTC regulation, the phasing in will be only a marginal reprieve. Singapore’s clearing regulation is less stringent on foreign exchange derivatives but not on reporting.
Small nonfinancial companies in Singapore and the EU face no regulation of mandatory clearing and reporting. While smaller financial companies have no clearing requirements in Singapore and the United States, they do face reporting requirements (last to report). Hence, the bulk of the regulation is to minimize costs for nonfinancial companies, in particular, the smaller nonfinancial institutions.
Regulatory arbitrage is thus possible only based on the threshold used for clearing and reporting in each of the jurisdictions.
The United States is in the most advanced stages of the derivatives regulation. It has both adopted and implemented regulations on clearing and reporting. The EU has agreement among members on the OTC regulation but has not yet implemented the regulation. Finally, Singapore has not yet adopted nor implemented OTC regulation (Financial Stability Board 2012). Thus, it is the time to implement regulation that may lead to a regulatory arbitrage towards the EU and Singapore.
The main difference in the three regulatory jurisdictions is the non-requirement of trading of cleared derivatives in Singapore. This difference has the potential to provide substantial choices in trading venues for market participants.
A New Look at the Role of Sovereign Credit Default Swaps (IMF)
FRM AIMs:
• Explain the use of sovereign credit default swaps (SCDS) in hedging, speculating, and basis trading.
• Compare the economic factors that determine SCDS spreads with the factors that traditionally influence government bond spreads.
• Explain the mechanics of risk transmission from government bonds to SCDS and vice versa, and discuss empirical evidence of these transmissions, including the use of the Hasbrouck statistic and volatility decomposition.
• Explain the possible impact of the European Union ban on naked SCDS protection buying on the SCDS market; explain the motivations for this ban as well as its criticisms.
• Explain how the benefit of SCDS central counterparties can address the risks of naked short-selling without the need to limit short-selling.
Introduction:
· “With the growing influence of SCDS, questions have arisen about whether speculative use of SCDS contracts could be destabilizing” àEuropean authorities banned uncovered or “naked,” purchases of SCDS protection referencing European Economic Area sovereign debt obligations, (purchases in which there is no offsetting position in the underlying debt). The motivation was that in extreme market conditions short selling could push sovereign bond prices into a downward spiral leading to “disorderly markets” and systemic risks
· Empirical results from this paper don’t support the negative perceptions about SCDS. Spreads of SCDS and sovereign bonds reflect economic fundamentals and other relevant market factors in a similar fashion:
o SCDS spreads tend to reveal new information more rapidly during periods of stress
o The influence of the usage of SCDS on the propagation of contagion in credit markets is difficult to assess as the SCDS-embedded risks cannot be fully isolated from those in the financial system
o There are some signs that SCDS “overshoot” their predicted value for vulnerable European countries during crises, however there is little evidence that such excessive increases in countries SCDS’s spreads lead to higher sovereign funding costs
· The evidence highlighted in this paper does not underlign the need to ban purchases of naked SCDS protection, as such measures might reduce SCDS market liquidity to the point that these instruments are less effective as hedges and less useful as indicators of market-implied credit risk
· “Effortsto lower risks in the OTC derivatives market, such as mandating better disclosure, encouraging central clearing and requiring the posting of appropriate collateral, would likely alleviate most SCDS concerns.”
Conclusions and policy implications in the following areas:
· Role of SCDS as generally reliable market indicators. When examined relative to their comparable bond spreads, SCDS spreads are approximately equivalent as indicators of sovereign credit risk— reflecting the same economic fundamentals and other market factors. SCDS markets appear to incorporate information faster than bond markets during periods of stress, but this is not always the case at other times.
· Financial stability implications. SCDS can be used to hedge sovereign credit risks, thus enhancing financial stability. However, like other instruments, SCDS may be prone to spillovers during periods of stress (especially given their use as proxy credit hedges for other financial and nonfinancial institutions). Our analysis suggests that this threat is no more tied to SCDS markets than to the underlying bond markets; indeed, both may be destabilizing during periods of stress, as contagious forces are present across all financial market assets during these periods. We find evidence of overshooting using the model-based predicted values for some euro area countries’ SCDS spreads during the most recent period of distress, though the tendency was not widespread.
· Role of government and regulation. Governments and regulators have the opportunity to improve the functioning of SCDS and of CDS markets more generally.
o Cases in point are recent efforts, in line with the G20 regulatory agenda, to require counterparties to post initial margin on bilateral trades or move them to CCPs (where such margin requirements would be lower). While costly in the short term, such improvements in risk management could yield benefits in the longer term by lessening counterparty risks and reducing the potential for spillovers from sovereign credit events.
o The recent European ban on purchasing naked SCDS protection appears to move in the wrong direction. While the effects of the ban are hard to distinguish from the influence of other policy announcements, the prohibition may have already caused some impairment of market liquidity. And the ban may yet cause some important buyers of SCDS net protection, including those not targeted by the ban, to withdraw from the market; if so, SCDS market liquidity will likely be further reduced and hedging costs raised. The effects of the ban on speculation, hedging costs, and the information value of SCDS remain to be seen, but they bear scrutiny as evidence accumulates.
o More broadly, as an apparently permanent measure, the ban may fundamentally impair the functioning of the SCDS market by generating alternative trading schemes or the transfer of risk to other markets that may be less transparent. Even temporary trading bans have been found to be of only limited usefulness and to have many of the negative consequences of permanent ones.
o The concerns that SCDS can overshoot fundamentals or cause contagion in other markets would be better addressed by mechanisms to temporarily halt trading, such as “circuit breakers” with bright-line criteria for triggering and lifting such halts. Granted, imposing temporary trading halts in an OTC market, as opposed to an exchange trading environment, is particularly difficult, as there is no formal trading platform. But enforcing a ban, which requires identifying institutions that maintain uncovered short positions, is also quite difficult although upcoming reporting requirements for short positions should help.
· Data gaps. While it may be inappropriate to release detailed information about individual counterparty SCDS positions to the public, macro prudential supervisors should be able to access these data. Such information may enable them to assess risks to financial stability and circumvent, or at least anticipate, channels for contagion. To the degree that uncertainty about exposures and interconnections can be lessened through the public release of some aggregated or masked information, potential contagion and overshooting (among the motivations for the ban on uncovered SCDS protection) could be diminished.
Overall, SCDS markets help enhance financial stability by providing a mechanism to hedge sovereign risks. We find no evidence to support the concern that SCDS markets may be less effective than government bond markets in reflecting economic fundamentals, and we find little evidence that the SCDS market is any more destabilizing than other financial markets. That said, we find some evidence of SCDS overshooting in a few euro area countries during the most recent period of stress. Spillovers to other countries’ SCDS markets and the ongoing linkages between domestic banks and sovereigns also exist within the context of CDS markets, as they do more generally. Recent efforts to address the underlying, fundamental nature of these connections would be more productive than placing restrictions on the SCDS market that can limit and distort its role as “messenger.”
OTC Derivatives - A comparative analysis of regulation in US, EU, Singapore
FRM AIMs:
•Describe the characteristics and benefits of central clearing.
•Describe the function of a trade repository and explain the benefits of a trade repository to OTC market participants.
•Compare the regulatory requirements and regulatory authority in the United States, European Union, and Singapore with respect to: the central clearing of OTC derivatives, requirements of central counterparties, margin requirements for uncleared OTC derivatives, trading, and backloading of existing OTC contracts.
•Describe the requirements for reporting derivative transactions to trade repositories in the United States, European Union and Singapore.
Conclusion
This study compares clearing and reporting regulation of OTC derivatives in Singapore, the United States, and the EU on assets, institutions, and the timing of regulation. The United States and the EU require central clearing and trading of all asset classes. Singapore requires only central clearing but not trading of all assets except foreign exchange swaps and forwards. Further, only the United States has phased implementation for reporting; Singapore prioritizes foreign exchange derivatives, interest rate contracts, and oil contracts. As the United States is in the most advanced stages of implementation of OTC regulation, the phasing in will be only a marginal reprieve. Singapore’s clearing regulation is less stringent on foreign exchange derivatives but not on reporting.
Small nonfinancial companies in Singapore and the EU face no regulation of mandatory clearing and reporting. While smaller financial companies have no clearing requirements in Singapore and the United States, they do face reporting requirements (last to report). Hence, the bulk of the regulation is to minimize costs for nonfinancial companies, in particular, the smaller nonfinancial institutions.
Regulatory arbitrage is thus possible only based on the threshold used for clearing and reporting in each of the jurisdictions.
The United States is in the most advanced stages of the derivatives regulation. It has both adopted and implemented regulations on clearing and reporting. The EU has agreement among members on the OTC regulation but has not yet implemented the regulation. Finally, Singapore has not yet adopted nor implemented OTC regulation (Financial Stability Board 2012). Thus, it is the time to implement regulation that may lead to a regulatory arbitrage towards the EU and Singapore.
The main difference in the three regulatory jurisdictions is the non-requirement of trading of cleared derivatives in Singapore. This difference has the potential to provide substantial choices in trading venues for market participants.
A New Look at the Role of Sovereign Credit Default Swaps (IMF)
FRM AIMs:
• Explain the use of sovereign credit default swaps (SCDS) in hedging, speculating, and basis trading.
• Compare the economic factors that determine SCDS spreads with the factors that traditionally influence government bond spreads.
• Explain the mechanics of risk transmission from government bonds to SCDS and vice versa, and discuss empirical evidence of these transmissions, including the use of the Hasbrouck statistic and volatility decomposition.
• Explain the possible impact of the European Union ban on naked SCDS protection buying on the SCDS market; explain the motivations for this ban as well as its criticisms.
• Explain how the benefit of SCDS central counterparties can address the risks of naked short-selling without the need to limit short-selling.
Introduction:
· “With the growing influence of SCDS, questions have arisen about whether speculative use of SCDS contracts could be destabilizing” àEuropean authorities banned uncovered or “naked,” purchases of SCDS protection referencing European Economic Area sovereign debt obligations, (purchases in which there is no offsetting position in the underlying debt). The motivation was that in extreme market conditions short selling could push sovereign bond prices into a downward spiral leading to “disorderly markets” and systemic risks
· Empirical results from this paper don’t support the negative perceptions about SCDS. Spreads of SCDS and sovereign bonds reflect economic fundamentals and other relevant market factors in a similar fashion:
o SCDS spreads tend to reveal new information more rapidly during periods of stress
o The influence of the usage of SCDS on the propagation of contagion in credit markets is difficult to assess as the SCDS-embedded risks cannot be fully isolated from those in the financial system
o There are some signs that SCDS “overshoot” their predicted value for vulnerable European countries during crises, however there is little evidence that such excessive increases in countries SCDS’s spreads lead to higher sovereign funding costs
· The evidence highlighted in this paper does not underlign the need to ban purchases of naked SCDS protection, as such measures might reduce SCDS market liquidity to the point that these instruments are less effective as hedges and less useful as indicators of market-implied credit risk
· “Effortsto lower risks in the OTC derivatives market, such as mandating better disclosure, encouraging central clearing and requiring the posting of appropriate collateral, would likely alleviate most SCDS concerns.”
Conclusions and policy implications in the following areas:
· Role of SCDS as generally reliable market indicators. When examined relative to their comparable bond spreads, SCDS spreads are approximately equivalent as indicators of sovereign credit risk— reflecting the same economic fundamentals and other market factors. SCDS markets appear to incorporate information faster than bond markets during periods of stress, but this is not always the case at other times.
· Financial stability implications. SCDS can be used to hedge sovereign credit risks, thus enhancing financial stability. However, like other instruments, SCDS may be prone to spillovers during periods of stress (especially given their use as proxy credit hedges for other financial and nonfinancial institutions). Our analysis suggests that this threat is no more tied to SCDS markets than to the underlying bond markets; indeed, both may be destabilizing during periods of stress, as contagious forces are present across all financial market assets during these periods. We find evidence of overshooting using the model-based predicted values for some euro area countries’ SCDS spreads during the most recent period of distress, though the tendency was not widespread.
· Role of government and regulation. Governments and regulators have the opportunity to improve the functioning of SCDS and of CDS markets more generally.
o Cases in point are recent efforts, in line with the G20 regulatory agenda, to require counterparties to post initial margin on bilateral trades or move them to CCPs (where such margin requirements would be lower). While costly in the short term, such improvements in risk management could yield benefits in the longer term by lessening counterparty risks and reducing the potential for spillovers from sovereign credit events.
o The recent European ban on purchasing naked SCDS protection appears to move in the wrong direction. While the effects of the ban are hard to distinguish from the influence of other policy announcements, the prohibition may have already caused some impairment of market liquidity. And the ban may yet cause some important buyers of SCDS net protection, including those not targeted by the ban, to withdraw from the market; if so, SCDS market liquidity will likely be further reduced and hedging costs raised. The effects of the ban on speculation, hedging costs, and the information value of SCDS remain to be seen, but they bear scrutiny as evidence accumulates.
o More broadly, as an apparently permanent measure, the ban may fundamentally impair the functioning of the SCDS market by generating alternative trading schemes or the transfer of risk to other markets that may be less transparent. Even temporary trading bans have been found to be of only limited usefulness and to have many of the negative consequences of permanent ones.
o The concerns that SCDS can overshoot fundamentals or cause contagion in other markets would be better addressed by mechanisms to temporarily halt trading, such as “circuit breakers” with bright-line criteria for triggering and lifting such halts. Granted, imposing temporary trading halts in an OTC market, as opposed to an exchange trading environment, is particularly difficult, as there is no formal trading platform. But enforcing a ban, which requires identifying institutions that maintain uncovered short positions, is also quite difficult although upcoming reporting requirements for short positions should help.
· Data gaps. While it may be inappropriate to release detailed information about individual counterparty SCDS positions to the public, macro prudential supervisors should be able to access these data. Such information may enable them to assess risks to financial stability and circumvent, or at least anticipate, channels for contagion. To the degree that uncertainty about exposures and interconnections can be lessened through the public release of some aggregated or masked information, potential contagion and overshooting (among the motivations for the ban on uncovered SCDS protection) could be diminished.
Overall, SCDS markets help enhance financial stability by providing a mechanism to hedge sovereign risks. We find no evidence to support the concern that SCDS markets may be less effective than government bond markets in reflecting economic fundamentals, and we find little evidence that the SCDS market is any more destabilizing than other financial markets. That said, we find some evidence of SCDS overshooting in a few euro area countries during the most recent period of stress. Spillovers to other countries’ SCDS markets and the ongoing linkages between domestic banks and sovereigns also exist within the context of CDS markets, as they do more generally. Recent efforts to address the underlying, fundamental nature of these connections would be more productive than placing restrictions on the SCDS market that can limit and distort its role as “messenger.”
