IV Regulatory Environment for OTC Derivatives Activities

Burkhard Drees, Garry Schinasi, Charles Kramer, and R. Craig
Published Date:
January 2001
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Although OTC derivatives on the whole tend to be lightly regulated (as noted in Section III), regulatory systems that are relevant for OTC derivatives can be complex and can have identifiable effects on the organization and location of OTC derivatives activities. Because OTC derivatives transactions usually involve sophisticated counterparties and OTC derivatives markets provide only a limited price discovery function, investor protection and related regulations play only a minor role in the official oversight of the OTC derivatives market. The other two traditional rationales for financial regulation—fostering market efficiency and reducing systemic risk—are important for OTC derivatives markets and are usually addressed by prudential regulations that typically apply to institutions as a whole and not to specific OTC derivatives products. This section illustrates these issues by reviewing the regulatory environments in key jurisdictions. It then analyzes the effects of regulation and regulatory uncertainty on OTC derivatives activities. The section concludes with a discussion of the key challenges for supervision and regulation associated with the use of credit derivatives.

Regulatory Environments in the United States, the United Kingdom, and Other Key Jurisdictions

The United States

The various regulatory agencies in the United States are organized around markets, financial instruments, or institutions, and sometimes span two or three of these concepts.56 The regulation of financial services has also been tailored according to whether these services are privately or publicly offered, and by whom; whether they are concluded on a principal or agent basis, and on or off an exchange; and whether they involve the commitment of funds to a custodian for investment or safekeeping.

As a result, no single U.S. regulator governs the many types of derivatives products traded in the OTC market. Derivatives range from products that are subject to comprehensive futures or securities regulations—mostly instruments traded on organized exchanges subject to rules on price transparency, trade practices, and anti-manipulation protections—to historically unregulated transactions such as forward contracts. Further complicating the regulatory environment is the fact that OTC derivatives are used by entities that are subject to one or more regulatory regimes, either as intermediaries (for example, securities broker-dealers, and futures commission merchants) or as end-users (such as pension funds and investment companies).

There are three key financial regulators whose mandates impinge directly on OTC derivatives activities; the Commodity Futures Trading Commission (CFTC); the Securities and Exchange Commission (SEC); and bank regulators. The CFTC oversees organized derivatives exchanges (primarily futures markets) and transactions in futures contracts and commodity options. It also supervises intermediaries that operate in these markets, such as futures commission merchants (FCMs). The CFTC imposes minimum capital requirements on FCMs and requires FCMs to have adequate internal controls, record keeping, and reporting procedures. CFTC rules also preclude certain types of end-users (primarily small private customers) from engaging in various OTC derivatives transactions.

The Commodity Exchange Act (CEA) is the legal basis for the CFTC’s authority. Under the CEA, futures contracts and commodity options have to be traded exclusively on CFTC-approved exchanges, unless there are specific exemptions. Forward contracts have traditionally been expressly excluded from the CEA and are thus unregulated. The CFTC’s rules applicable to OTC derivatives have evolved as a series of exceptions to the CEA, its exchange-trading requirement, and other regulatory requirements. In 1993, the CFTC exempted swap agreements from most provisions of the CEA, subject to restrictions on the design and execution of such transactions. The exemption criteria, which were meant to prevent an unregulated exchange-like market in swaps, have created a significant degree of ambiguity and uncertainty about the regulatory treatment of swaps, as financial and technical innovations (such as electronic trading and settlement) have tested the limits of the swaps exemption (which is explained further, below).

The SEC enforces federal securities laws that cover transactions in “securities” as defined by law, including some OTC derivatives such as securities options.57 The SEC oversees both primary and secondary markets in securities, and also regulates securities broker-dealers.58 A key issue in determining whether the SEC regulates derivatives—and financial institutions trading them—is the extent to which such derivatives are “securities” in the legal definition, or are embedded in instruments that are predominantly securities. For example, options on securities, securities indices, and certificates of deposit that are not traded on exchanges are considered securities and are thus subject to SEC regulation. Securities derivatives are subject to the SEC’s entire regulatory framework, regardless of whether these products are traded on registered exchanges or in the OTC market. To the extent that OTC market participants and market makers for OTC options act as brokers59 or as dealers60 in securities, they are subject to the SEC’s extensive regulatory requirements applicable to broker-dealers, including capital and margin requirements.

Because a growing market share of the activities in OTC derivatives contracts that are not considered securities is conducted by unregistered affiliates of registered broker-dealers, the SEC adopted in 1992 a “Risk Assessment Program” to monitor the risks such activities pose for parent broker-dealers. Members of the Derivatives Policy Group (DPG), which include the largest broker-dealers and FCMs, voluntarily disclose information about their unregistered affiliates whose activities may have a material impact on the parent broker-dealers and FCMs.61 As part of this program, the SEC and the CFTC receive quarterly information on derivatives positions, internal controls, and risk management techniques.

Banks are supervised by the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Federal Reserve, or by state banking regulators, depending on the type of their bank charter, deposit insurance, and Federal Reserve membership. In contrast to futures and securities regulators, banking regulators approach financial activities almost exclusively from the point of view of the integrity of the individual institution and its capacity to perform banking functions. Banking supervision therefore only involves direct oversight of institutions and does not rely on oversight of markets or specific financial products. Bank supervisors can address derivatives activities by limiting the types of permissible transactions, imposing internal control and risk management requirements, and by requiring that appropriate levels of capital are held against derivatives positions.

Wholesale Market Regime in the United Kingdom

The U.K. context has two important features: first, a single financial regulator, the Financial Services Authority (FSA), is being established, and second, U.K. regulators differentiate the regulatory treatment of professional and nonprofessional business according to the market participants’ degree of experience and expertise, and their relative need for protection. As in many other countries, there is no system of product regulations in the United Kingdom, but there are conduct of business requirements that normally apply to all “investment” transactions.62

A special wholesale market regime (the Grey Paper Regime) applies to clearly defined wholesale transactions and provides “light touch” supervision and regulation.63 Within this special market regime, fewer requirements apply to listed “wholesale money market institutions,” which comprise both banks and securities houses. Certain activities of listed institutions are exempt from the Financial Services Act. They include dealing in investments, arranging deals in investments, and advising on investments. The rationale for the FSA’s “Grey Paper Regime” for the wholesale cash and OTC derivatives markets is that “caveat emptor” should be applied to dealings between firms and their professional counterparties to a larger extent than to dealings with retail customers.64, 65

The relevant wholesale markets are defined by the products traded in them, the institutions conducting the trading, and minimum size of transactions.66 Central to the regulatory regime is a list of institutions that act in the relevant markets either as principal or broker.67 An applicant needs to demonstrate to the FSA that it is financially sound and has an appropriate ownership structure, managerial and operational resources, and that its systems and controls are adequate. The FSA does not list institutions as wholesale money market institutions that are generally regarded as customers or end-users.

The core of the wholesale market regime is a prescribed code of business conduct (the “London Code”) that wholesale market institutions must comply with.68 The London Code has been developed in close cooperation with market participants and sets out principles, standards, and controls that participants in the wholesale market should observe. It applies to most wholesale market dealings that are not regulated by the rules of a recognized exchange. The Code comprises general standards (which describe the responsibilities of principals, brokers, and employees), principles of control (including know-your-counterparty and confidentiality rules), and best practices for dealing procedures.

Unlike in the United States, legislation in the United Kingdom permits “recognized clearinghouses” for OTC markets that are supervised by the FSA on criteria set out in the Financial Services Act. Similarly, multilateral trading of OTC derivatives products is, in principle, permitted. Any person offering multilateral execution facilities would, however, be regarded as conducting investment business and would therefore require authorization. Persons offering multilateral trading facilities for OTC derivatives that do not fall within the definition of “investment” would not be subject to the requirements of the Financial Services Act. For example, the Exchange Clearing House (ECHO) provides netting facilities for spot and forward foreign exchange contracts that are not considered investments. ECHO is nevertheless listed as a money market institution and is therefore supervised by the FSA.

Regulatory and Supervisory Frameworks in Other Financial Jurisdictions

Regulations and supervision relevant for OTC derivatives markets typically have five dimensions: permitted transactions: authorization and licensing of counterparties; restrictions on counterparties: rules for market making and trading; and disclosure requirements.69

Most jurisdictions do not impose restrictions on the design of OTC derivatives products and thus do not limit the range of products that can be traded. Particularly, nonstandardized bilateral OTC transactions between licensed counterparties or banks are typically not directly regulated. Although OTC transactions are mostly not regulated through market- or product-based requirements, they are indirectly affected by prudential and conduct regulations that are aimed at financial institutions.

In most countries, authorization rules for participants in the OTC derivatives market generally differ depending on whether the institutions are conducting business exclusively on their own account or engage in transactions on behalf of clients. Most countries do not have licensing requirements specifically for OTC counterparties. An important exception is Japan, where securities firms need special authorization to engage in OTC derivatives. In Europe, by contrast, if a party to an OTC derivatives transaction effects the transaction for proprietary purposes, it does not need a license. However, if a firm undertakes OTC derivative transactions on behalf of customers, it must be licensed as a financial services or credit institution and is then subject to standard supervision since, according to the EU Investment Services Directive, OTC financial derivatives activities are considered investment business. If authorization is required, it is up to the home country supervisor to decide whether or not to license an institution for the full range of financial services or whether to restrict the authorization to conduct OTC business based on an assessment of whether the firm is fit and proper. Some European countries restrict the use of OTC derivatives by collective investment schemes (including France and Spain). Germany, in addition, restricts the use of OTC derivatives by insurance companies and mortgage banks.

Only in very few jurisdictions are OTC derivatives transactions prohibited outright for particular types of counterparties (such as retail end-users), but some countries have “suitability rules that determine what types of transactions are suitable for a given counterparty. A case in point is Australia, where unsophisticated counterparties are not allowed to trade on OTC derivatives markets (under Australia’s exempt futures declaration) and thus must use exchange markets. Most countries do not prohibit individuals from engaging in OTC derivatives transactions, but some jurisdictions impose additional requirements on transactions with retail or unsophisticated customers and lower requirements for wholesale or professional market participants. Many countries require that dealers transacting with non-dealers in derivatives markets obtain information about their customers to help ensure the customer’s suitability.70 In some cases (for example, in Germany) special disclosures are required when dealing with unsophisticated counterparties.

A few jurisdictions have rules that restrict market making, multilateral trading, or centralized clearing of OTC derivatives transactions. Similar to the case in the United States, in Australia, exempt futures markets (that is, OTC derivatives markets) are prohibited from having centralized clearing systems and multilateral trading facilities. But most countries have no explicit rules against multilateral electronic execution facilities, and a number of jurisdictions explicitly permit centralized clearing of OTC derivatives, including the United Kingdom, Sweden, and the Netherlands. Choice of law provisions (which are important since ISDA master agreements are drafted only for New York and English law) are accepted in most jurisdictions, though some uncertainty remains about their enforceability in court.

Effects of Regulatory Rules and Modes of Supervision on the OTC Derivatives Markets

Despite the fact that OTC derivatives are one of the least regulated segments of financial markets, their flexibility and global reach facilitates regulatory arbitrage so that even relatively “light touch” regulation and supervision have identifiable effects on the OTC derivatives markets. This is particularly apparent in the organization of the market, the way in which products are traded and transactions cleared, and the location of specific OTC derivatives transactions. These decisions, and thus indirectly the regulatory framework, have implications for the distribution of risks in the OTC derivatives markets, and for the effectiveness of market surveillance.

A key question for a U.S. non-bank financial institution is whether an OTC derivative transaction must be booked in a registered (and thus regulated) broker-dealer or can be done through an unregulated affiliate.71 If the OTC derivative instrument is a “security” as defined by law, the transaction has to be conducted through a registered broker-dealer, which is subject to the Securities Exchange Act and supervised by the SEC. The term “security” includes stocks and bonds, but also options on securities and indices of securities. Thus, while some OTC derivatives instruments are considered securities (such as OTC options on equities and U.S. government securities), others are not (swaps, for example).

The potential costs associated with broker-dealer regulation in the United States (compliance with capital requirements, disclosure rules, and margin requirements) have affected the way U.S. securities firms conduct their OTC derivative transactions.72 Since those derivative transactions that are considered securities in the United States (such as equity derivatives) would fall under SEC jurisdiction, these transactions are mostly conducted abroad through American broker-dealer affiliates located primarily in London. For those transactions that are not securities, most broker-dealers have established unregulated affiliates within the United States. Unregulated affiliates, which have grown rapidly in recent years, often hold large OTC derivatives positions and can be major providers of credit (and therefore leverage) to market participants, including to hedge funds.73 Such affiliates avoid the explicit and implicit costs of regulation, but add to the operational complexity of the parent firm and contribute to legal, operational, and other risks. According to some market participants, multiple legal entities also limit the use of some risk mitigation techniques, such as netting, and complicate interactions with customers.

Unregulated affiliates can also pose challenges for supervision and market surveillance since these affiliates are not subject to reporting requirements.74 But information on unregulated affiliates is not completely lacking. As mentioned above, since 1994, the six largest U.S. securities broker-dealers and futures commission merchants, which form the DPG, have agreed to provide the SEC and the CFTC with information about risk profiles, credit quality and credit concentrations, and the quality of internal controls of their affiliates that deal in OTC derivatives.

To further improve market surveillance, consideration has been given to integrate unregulated broker-dealer affiliates to varying degrees—into official oversight. A special voluntary regulatory regime for OTC derivatives dealers that offers lighter regulation and supervision than for registered broker-dealers has been introduced by the SEC. More recently, two alternative approaches have been advanced: special reporting requirements, and outright regulation of OTC affiliates.

To integrate activities of unregulated affiliates into official oversight, the SEC has established the category of “OTC Derivatives Dealers” (see Box 4.1: SEC-Registered “OTC Derivatives Dealers”).75 Securities firms can—on a voluntary basis—establish separately capitalized entities that deal in eligible OTC derivatives instruments, including both securities and non-securities OTC derivatives instruments. These entities would face a less burdensome regulatory capital regime than traditional broker-dealers, but would be subject to reporting requirements and oversight of their internal control systems. This special “broker-dealer lite” approach was also designed to allow U.S. broker-dealers to compete more effectively and to conduct more efficient risk management by centralizing both securities and non-securities OTC derivatives transactions in one legal entity. However, it is doubtful whether many broker-dealers will voluntarily register their affiliates as “OTC Derivatives Dealers,” since broker-dealers can continue to achieve even more regulatory relief through unregulated affiliates—admittedly with the drawback that unregulated affiliates cannot offer the complete line of OTC derivatives.

As for reporting requirements, the President’s Working Group on Financial Markets (PWG)76 recommended expanding the authority of regulators to require broker-dealers, futures commission merchants, and their unregulated affiliates to report information on credit risks, exposure concentrations, trading strategies, and risk models.77 A report by the General Accounting Office proposed that Congress consider expanding the SEC’s and CFTC’s regulatory authority to examine unregistered affiliates of broker-dealers and FCMs, set capital standards, and lake enforcement actions, with a view to more effective oversight of potential systemic risks in financial markets.78

Box 4.1.SEC-Registered “OTC Derivatives Dealers”1

A SEC-registered “OTC Derivatives Dealer” must be affiliated with a fully regulated broker-dealer. At the same time, however, the parent broker-dealer is prevented from moving its general securities business into the OTC derivatives dealer or from using the affiliate for extensive proprietary trading. Eligible OTC derivatives instruments include both securities and non-securities OTC derivatives instruments; securities derivatives that are listed or traded on a national securities exchange or on NASDAQ are excluded. “OTC Derivatives Dealers” must comply with reporting requirements and must establish comprehensive systems of internal controls for managing risks.

As key advantages, “OTC Derivatives Dealers” are exempted from certain provisions of the Securities Exchange Act and the Securities Investor Protection Act, and they face reduced capital requirements and margin rules. A special net capital rule allows OTC dealers to use value-at-risk models to calculate capital charges for market risk (subject to SEC approval) and to take lower charges for credit risk than broker-dealers. The credit risk capital charge consists of two parts: (1) similar to the Basel Accord charge for banks, a capital charge that depends on the creditworthiness of the counterparty and is based on the net replacement value of all outstanding transactions with each counterparty, taking netting and collateral arrangements into account; and (2) a special charge if the net replacement value of positions with any single counterparty exceeds 25 percent of the OTC dealer’s net capital. “OTC Derivatives Dealers” that extend credit have to comply with the less onerous Regulation U on margin requirements (which applies to banks) rather than the stricter Regulation T (which applies to broker-dealers).

1 For a complete description of the regulations that apply to SEC-registered OTC Derivatives Dealers, see United States, Securities and Exchange Commission (1999).

Regulatory Uncertainties and Their Implications for OTC Derivatives

Conceptually, the regulatory treatment of many OTC derivatives lies somewhere between full regulation and (almost) no regulation. As financial products evolve and technology introduces new structures for trading and clearing, these regulatory boundaries are being tested. Associated uncertainties about the applicability of regulations influence activities in the OTC derivatives market. Particularly in such a dynamic and relatively unstructured area as OTC derivatives, legal certainty is crucial. Counter-parties must be certain that the contracts they enter into are permissible in the given jurisdiction and that the provisions of the contracts are enforceable. Any hint of legal ambiguities could impede innovation and move trading to jurisdictions that provide firmer grounds. This is, to some extent, the case in the United States, where financial innovation may have been stymied by “[a] cloud of legal uncertainty “that has hung over the OTC derivatives market in the United States.”79

In the United States, legal uncertainties arise primarily from three sources. First, there are concerns about whether some OTC swap contracts (primarily those that are standardized, which compose the bulk of swaps) could be construed to be futures contracts and would thus be subject to the CEA. Second, there are questions about whether certain types of mechanisms for executing and clearing of OTC derivatives could alter the status of otherwise exempted or excluded instruments. Finally, there are also ambiguities about which securities-based derivatives fall under the jurisdiction of the SEC or CFTC. or may in fact be prohibited. These uncertainties force financial institutions to carefully evaluate legal risks when they develop new products and, as a result, may have reduced the flexibility of financial markets.

Uncertainties about the standing of swap agreements have emerged in connection with the CFTC’s Swap Exemption. The Futures Trading Practices Act of 1992 granted the CFTC authority to exempt certain transactions from the CEA (and from exchange trading requirements). The CFTC has used this authority to exempt swap agreements, hybrid instruments, and certain OTC energy contracts. Exemptions of these instruments from the CEA were deemed justified since prices established in these OTC derivatives markets do not serve a significant price discovery function and are less susceptible to manipulation than prices established in regulated futures markets.

In 1993, the CFTC issued the Swap Exemption, which excludes any swap agreement from the CEA that meets certain criteria. These criteria impose restrictions on the design and execution of transactions that distinguish the exempted swap transactions from exchange-traded products, and are meant to prevent the emergence of an unregulated exchange like market for swaps. To qualify for the exemption, a swap must be concluded between eligible swap participants; cannot be standardized as to the material economic terms; cannot be part of a central clearing arrangement; and cannot be traded through a multilateral transaction execution facility (MTEF).80

Uncertainties in the interpretation of these conditions have, however, emerged. The rise of electronic trading has blurred the line between bilateral and multilateral trading, and the advantage of centralized clearing systems has become widely recognized as trading volumes have increased and a wider range of users have entered the market.81 As a result, the limits of the swap exemption have become viewed as impediments to further developing the swaps market and in particular seem to be inhibiting the industry’s consideration of introducing electronic trading platforms and clearing arrangements to mitigate risks.

In response, the PWG called for a clarification of the swap exemption, the admissibility of clearing arrangements, and a review of the regulatory status of electronic trading systems for swaps.82 The PWG did not see compelling evidence that would warrant regulation of swaps;83 most swaps dealers are affiliated with broker-dealers (which are supervised by the SEC), with FCMs (which are supervised by the CFTC), or with banks (which are subject to supervision by bank regulators); and OTC derivatives markets do not serve a significant price discovery function. The Working Group therefore recommended that the exclusion of swaps should be codified as statute by Congress.84 Under this recommendation, bilateral swap agreements entered into by eligible swap participants on a principal-to-principal basis should, in principle, be excluded from the CEA.85 The PWG also recommended that electronic multilateral trading systems where participants act solely for their own account should be excluded from CEA regulation since they have the potential to promote efficiency, transparency, and liquidity, and to reduce risks. According to the PWG, the method by which a transaction is executed has no obvious bearing on the need for regulation in markets that are not used for price discovery. Exchanges that have been designated as contract markets by the CFTC should also be permitted to establish electronic multilateral trading systems for qualified swaps.

Standardization and clearing of exempted swaps should also be permitted, subject to appropriate regulatory oversight, since central clearing can reduce counterparty risks by mutualizing risks, and by facilitating offsets and netting (see Box 4.2: Clearinghouses). While recognizing that clearing tends to concentrate risks and responsibilities for risk management in a central clearinghouse, the PWG recommended that organizations that clear futures, commodity options, and options on futures should be authorized to clear OTC derivatives, subject to CFTC oversight. Similarly, securities clearinghouses, which are subject to SEC oversight, should be authorized to clear OTC derivatives. Clearing through foreign clearing systems should be allowed if these systems are supervised by foreign financial regulators according to standards.

Regulatory uncertainties have restricted the type of underlying securities for OTC derivatives.86 Ambiguities about the extent of CFTC or SEC jurisdiction to regulate certain securities-based derivatives, such as equity swaps, credit swaps, and emerging country debt swaps, are largely the legacy of the 1974 amendment of the CEA that gave the CFTC exclusive jurisdiction over all futures (on physical and financial commodities) without superseding or limiting the jurisdiction of the SEC.87 But the broad definition of “commodity” in the Commodity Exchange Act raised concerns that OTC markets for government securities and foreign currency would have been covered by the Act.88 Therefore—upon the Treasury’s request—an amendment (the Treasury Amendment of 1974) was inserted into the Act that excluded from it, among other things, transactions in foreign currency, government securities, and mortgages, “unless such transactions involve the sale thereof for future delivery conducted on a board of trade.” However, these amendments did not eliminate conflicts regarding each agency’s jurisdiction. Ambiguities and potential overlaps of CFTC and SEC jurisdictions remained, in particular, over novel financial instruments that have elements of securities and futures or commodity option contracts. In an attempt to address these problems, the Shad-Johnson Accord between the SEC and the CFTC was concluded in 1983. which explicitly prohibits futures contracts based on the value of an individual security (other than certain “exempt securities”).89 The Accord also gives the SEC authority over options on securities, certificates of deposit, foreign currencies traded on a national securities exchange, and groups of indices of securities. The CFTC obtained authority over futures contracts and options on futures contracts on exempt securities, certificates of deposit, and indices of securities. The Shad-Johnson Accord, however, itself created some uncertainty, particularly about the status of swap agreements that reference “nonexempt securities,” such as equity swaps, credit swaps, and emerging market debt swaps. From time to time, concerns arose that these swaps might be viewed by regulators as futures contracts on nonexempt securities, which in fact would be prohibited by the Shad-Johnson Accord.

Box 4.2.Clearinghouses

Some have suggested that an exchange-style clearinghouse for OTC derivatives that served as central counterparty could simplify risk management, confirm trades, and net exposures multilaterally, resulting in lower counterparty, operational, legal, and liquidity risks.1 A clearinghouse for OTC derivatives might increase the scope for early unwinding of contracts and improve the liquidity of OTC derivatives markets through offset (extinguishing a position by taking an opposite position).2 At present, relatively few OTC derivatives contracts are terminated or transferred (assigned) before they expire, in part because termination may have undesirable tax consequences, and ordinarily both counterparties must agree to an assignment. More often, exposures are unwound by entering an opposite contract. Without offset—for example, cancellation of the original obligation by entering an opposite obligation—an opposite obligation may reduce market risk, but at the cost of increasing counterparty risk.

A few clearing arrangements are already in place, though they probably handle only a tiny amount of global OTC activity. In Sweden, the OM Exchange clears, sets margins, and performs multilateral netting on OTC contracts. In November 1999, the Eurex exchange announced plans to offer clearing of OTC Euribor deals (initially Eurex members could use the Eurex clearinghouse to clear OTC trades in short-term Euribor futures). Also, in August 1999, the London Clearing House (LCH) set up the SwapClear facility to clear “vanilla” interest-rate swaps and FRAs of ten years’ maturity or less denominated in dollars, euros, pounds sterling, or yen (the system has received an exemption from CFTC regulation; the LCH also has an arrangement for the clearing of repo transactions, called RepoClear). Margin requirements and contingencies in the event of member default are similar to those for exchange-traded contracts. Only a few banks initially participated in SwapClear, though more were expected to join later.

Major dealers are generally wary of centralized clearing arrangements. Some have raised questions about how the multilateral clearing of selected contracts would affect bilateral and multiproduct netting agreements. Others have pointed out that clearinghouses might be tainted by adverse selection, as lower-rated banks would find such an arrangement more attractive than highly rated banks would; others have raised concerns about moral hazard. Still others have concerns that only a limited array of swaps will be eligible for clearing, and that liquidity may become fragmented between SwapClear and the overall OTC market. Key players may also be opposed to a clearinghouse for strategic business reasons, as clearinghouses would lower the “cost of admission” to OTC derivatives markets by mitigating counterparty risk. The assessment and management of counterparty risks is a key source of value added to major market players, who do not want additional competition amid narrowing bid-ask spreads. Finally (as explained above), some aspects of the U.S. regulatory regime have raised concerns that centrally cleared contracts may be regulated as exchange-traded contracts.

1 See Folkerts-Landau and Steinherr (1994). The effect that the introduction of a clearinghouse would have on the nature and distribution of risks in OTC derivatives markets would depend in part upon the structure of the clearinghouse. Principal clearinghouses act as principals to trades, and assume the counterparty risk of clearing members; fiduciary clearinghouses execute members’ instructions and safeguard their assets in an agency capacity, and do not assume counterparty risk on cleared transactions.2 See Hills, Rule, Parkinson, and Young (1999).

To eliminate these ambiguities, the PWG recommended to alter the Treasury Amendment to preserve the CFTC’s authority to regulate transactions in Treasury Amendment instruments only to the extent that these transactions occur on an exchange that is open to retail or agency transactions.90 Other markets for Treasury Amendment securities would be explicitly excluded from the CEA. There would also be scope for electronic trading of such instruments outside of the CEA, and, as in the case of exempted swaps, clearing of Treasury Amendment instruments, subject to official oversight, would be allowed without affecting their exclusion from the CEA. The Working Group also recommended to explicitly exclude hybrid instruments that reference securities from the Shad-Johnson Accord.91

Financial Innovations and Challenges for Supervision and Regulation: The Case of Credit Derivatives

Credit derivatives are one of the fastest growing areas of the OTC derivatives market. Credit derivatives, however, can be a source of regulatory ambiguities. Since they combine features of traditional credit products and features of traded instruments, they are difficult to integrate into existing regulatory and supervisory frameworks, and they challenge the way bank supervisors have traditionally viewed credit risk: as a cradle-to-grave phenomenon where banks hold credit exposures until maturity and only get actively involved in managing credit risk in the workout of problem loans.92 With the use of credit derivatives, by contrast, banks can actively unbundle and manage credit risks in novel ways, and can alter their credit risk profiles rapidly.

What distinguishes credit derivatives from many other OTC derivatives is that credit derivatives give rise to dual credit exposures: a credit exposure to a counterparty (as in other OTC derivatives) and a credit exposure to the reference asset.93 Notwithstanding this duality, there are no uniform global standards that specify whether a credit derivative position should be viewed as being primarily part of the banking book (which would stress the credit risk in the reference asset) or the trading book (which would stress the credit risk of the counterparty).

Within the Basel Accord on capital adequacy for banks, capital treatments of credit derivatives differ depending on whether the credit risk of the reference asset or the counterparty credit risk is viewed as the primary risk in the credit derivatives position. In the latter case (the derivatives approach), credit derivatives are viewed just as other derivatives, such as interest rate swaps, and the capital requirements are mostly based on the market value of the derivatives position. By contrast, the direct credit substitute approach treats credit derivatives as similar to traditional credit instruments, such as letters of credit and guarantees, and capital charges are based on the total nominal value (notional value of the derivatives position). As a result, capital charges based on the direct credit substitute approach (in the banking book) tend to be much larger than the charge according to the derivatives approach (in the trading book). Thus a bank can “leverage” its credit exposures significantly more by investing in credit derivatives that are part of its trading book than by funding loans.

To illustrate, consider the example of a total rate of return swap (TRORS). If the TRORS is treated as a credit substitute, the guarantor would have to hold 8 percent capital toward the nominal amount of the guarantee (the notional value of the derivative) if the reference asset is a corporate liability or loan. If, by contrast, the same credit derivative is treated as a standard derivative instrument, the capital charge to cover credit risk would be much lower and would have two components: (1) a charge based on the type of counterparty assessed on the market value of the derivative (8 percent for corporate counterparties, 1.6 percent for a bank counterparty), and (2) a (small) charge to cover potential future exposure that is calculated as a percentage (an “add-on factor”) of the notional value. Moreover, the matrix of add-on factors in the Basel Accord does not specify the value of add-on factors for credit derivatives (it only contains add-on factors for interest rate, foreign exchange, equity, and commodity derivatives). National regulators therefore have to issue their own guidelines. For example, the Federal Reserve decided to apply equity add-on factors when the reference asset is an investment-grade instrument (or its bank-internal equivalent) or is unrated but well secured by collateral, and to apply the commodity add-on (actors for all other reference assets.94

In the absence of uniform classifications, the divergent capital requirements may open scope for regulatory arbitrage, for example, in case one party to the transaction (say the guarantor) treats the derivatives position as a trading instrument while the other party treats the position as a guarantee. In that case, the reduction in the capital charge that the protection buyer claims may be larger than the capital charge that the protection seller has to hold against the credit derivative in its trading book. As a result, the combined capital held against the position may not be sufficient to cover the underlying loan exposure. Preventing these constellations poses considerable coordination problems for financial supervisors.

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