When G20 leaders set the broad reform agenda to be implemented by the end of 2012 to reduce systemic risk and increase transparency in the OTC derivatives markets, they might not have anticipated the complex nature of the instruments they are dealing with. Although these regulatory efforts have intensified in the last year, as pointed out by the Financial Stability Board (FSB), clear signs have emerged that substantial differences exist across multiple countries in the pace of implementation as well as in some rule‐making areas that could lead to regulatory arbitrage. In this case, market participants will seek out jurisdictions with less strict regulations, thereby shifting the risk rather than mitigating it. Greater international coordination is needed to ensure more consistent and effective oversight in OTC markets.
Previous issues of the Oil Market Report (OMR) and the Medium‐Term Oil & Gas Markets (MTOGM) reports extensively analysed US and EU proposed regulations on over‐the‐counter derivatives markets. Although there are differences between these two regulatory frameworks in clearing, membership of central clearing houses, margin requirements, swap execution facilities and position limits, a working group has already been set up to harmonise these regulations. Without consensus, some policy makers in the US already raised the probability of revisiting proposed rules and how to meet Dodd‐Frank Act requirements for improved prudential safety. Apart from different proposed rules, a recent ruling by the federal appeals court against the so‐called proxy access process on the basis of flawed economic analysis will potentially force regulators to revisit some of their proposed rules. For example, as the February OMR suggested, the CFTC did not provide a cost‐benefit analysis for its proposed speculative position limit rule, which the Commission is planning to take up in September. We anticipate that some of the rules may be challenged on the basis of a lack of cost‐benefit analysis, as well as inadequate consideration of public comments, which could lead to further delays in the implementation of the rules.
Of course, any legal challenges risk further difficulties and delays in reaching international consensus among regions, especially in Latin America and Asia. Traditionally, both regions had much smaller derivatives markets than those in the US and Europe. However, given the nature of global OTC markets, they have already either started implementing their own financial regulatory reforms or have been waiting to see the changes in the US and Europe before finalising their own rules. Given the slow progress in the US and Europe, it might be very challenging for some of these countries to meet the deadline of end 2012.
In Latin America, both in Brazil and Argentina, most derivatives are traded on exchanges (estimated at 90% and 70%, respectively). Brazil has only one central clearing house where all futures are traded and some OTC derivatives are cleared. Furthermore, derivatives that have not been cleared must be reported to a local trade depository. Likewise, exchange traded derivatives in Argentina are all centrally cleared and the Central Bank requires all financial institutions to provide quarterly statements about their derivatives activity. Neither country is planning to introduce mandatory clearing, a key measure in both US and Europe regulation for financial entities according to the Financial Stability Board’s OTC Derivatives Market Reforms Report on Implementation, dated April 2011. This might raise the question whether financial market participants in the US and Europe are likely to migrate their OTC transactions to these countries.
Although most Asian countries support the G20 commitments on OTC markets regulations, legislators have taken a wait‐and‐see approach as rules are being finalised in the US and Europe. According to the International Swaps and Derivatives Association (ISDA), Asian countries might not be able to meet the G20 deadline of end‐2012 to implement OTC market regulations. However, there is substantial variation in the speed of implementation across countries. Japan already enacted legislation requiring mandatory clearing and is working on its regulatory implementation and reporting rules to trade repositories. In Korea, the government finalised its plan for mandatory clearing but is waiting to see final rules in the US and Europe before proposing legislation for approval. A central clearing house will be established in mid‐2012. Clearing OTC derivatives through a Central Counterparty Clearing House (CCP) as well as reporting of OTC transactions to trade repositories is expected to start next year in Hong Kong. The Singapore exchange meanwhile already launched a clearing of interest rate swaps last year. India has already established the Clearing Corporation of India to act as a CCP as well as trade repository. Although there is no firm timetable for implementation, consideration of OTC derivatives regulations in China, Australia and Indonesia is already underway.
Slow progress on agreed reforms to meet the end of 2012 deadline, as well as the apparent lack of international consensus between regulators on how to achieve the key elements of the reform agenda, could undermine the impact of new regulations even in countries where more stringent rules are to be implemented due to regulatory arbitrage opportunities. It is even suggested that different regulatory regimes will lead to fragmented markets, which will eventually lead to weaker institutions and greater risk to the global economy. On the other hand, some market participants dismiss the idea of regulatory arbitrage based on observed close cooperation among regulators for more harmonisation in the last three years.
*IEA Oil Market Report-August 2011