Opinion by Vittorio Casamento

OTC derivatives

Derivatives are an important tool used by companies to manage risks associated with their business, such as movements in interest rates, currencies and commodity prices. Over-the-counter (OTC) derivatives are bilateral arrangements that can be tailored to meet the specific hedging requirements of the parties. This makes them particularly suited to more precisely hedging exposure to adverse movements in price.

However, the usefulness of OTC derivatives as a risk management tool is being challenged by the impact of proposed regulatory reforms in the United States and Europe. Financial services industry stakeholders will need to consider the impact of the proposed reforms on their business operations.

It seems that greater regulation of OTC derivatives in Australia is inevitable. Regulatory proposals are broadly supported by participants in the OTC derivatives market, who see regulation as improving the robustness of this market. 

The real issue of concern to end users of OTC derivatives is that regulatory proposals are appropriately designed to improve the robustness and efficiency of the OTC derivatives market without limiting the benefits associated with using OTC derivatives or increasing the costs associated with using them

Global regulatory proposals for OTC derivatives

Following the global financial crisis (GFC) the usefulness of OTC derivatives as a risk management tool will be challenged as regulators around the world consider a range of proposals to regulate derivatives. While greatest attention has been focused on credit derivatives and their contribution to the GFC, the proposed regulations potentially apply to a wide range of OTC derivatives, including less complex derivatives such as interest rate swaps, equity derivatives, commodity derivatives and certain types of foreign exchange transactions. Accordingly, end users of OTC derivatives, such as corporate entities and other non-financial organisations, should be aware of the changes on the horizon and need to consider whether they will be affected by the proposed regulations even if they do not trade in complex derivatives.

Australian regulatory authorities are considering initiatives similar to regulations being developed in Europe, the United States and the United Kingdom to:

• increase the standardisation of OTC derivatives
• increase the use of central counterparties (CCP) to clear standardised OTC derivatives
• improve transparency in the OTC derivatives market through increased reporting and record-keeping for all OTC derivatives, including those not cleared through a CCP, and
• increase the use of collateral and move to daily exposure valuations and portfolio reconciliation for OTC derivatives that are entered into on a bilateral basis.

Australian regulatory proposals for OTC derivatives

ASIC, APRA and the RBA published the Survey of the OTC Derivatives Markets in Australia in May 2009 following their review of the Australian OTC derivatives market. While the survey found that the size of exposures in the Australian market was ‘relatively low by international standards’ and that this market remained ‘robust’ throughout the GFC, it also identified ‘a number of areas in which practices in the Australian OTC derivatives market might be enhanced’. Many of the recommendations made in the survey mirror the initiatives being undertaken at an international level, ie encouraging:

• the standardisation of OTC derivatives
• the use of electronic trading platforms and CCPs, and 
• the greater use of collateral to mitigate counterparty credit risk.

Australian regulatory authorities have yet to promulgate detailed proposals for the regulation of OTC derivatives in Australia. It seems likely, however, that proposals in Australia will closely follow other jurisdictions, given the cost of developing an independent regulatory regime relative to the size of the Australian OTC derivatives market.

The potential impact of proposed regulations on end users

Standardising OTC derivatives

Standardising OTC derivatives involves standardising the contractual terms and/or contractual parameters (eg notional amounts, payment dates, maturities). The issues with this are:

• The terms available under a standardised OTC derivative are unlikely to exactly match the exposure sought to be hedged, leaving the parties exposed to unwanted risk.
• A standardised OTC derivative may not qualify for hedge accounting under applicable accounting standards if it is not effective in offsetting the exposure to which it is intended to relate. This may result in greater earnings volatility, contrary to its intended purpose.
• The use of standardised OTC derivatives is also likely to be incentivised by imposing higher regulatory charges on banks that enter into non-standard OTC derivatives. Such costs will ultimately be passed on to end users via higher prices and premiums.

Clearing standardised OTC derivatives through central counterparties

Entering into bilateral OTC derivatives exposes parties to counterparty credit risk and systemic risk (ie the risk that a counterparty will default because of a default by one of its counterparties). Regulators view central clearing of standardised OTC derivatives as the main tool for reducing such risks and will encourage the use of CCPs by imposing higher regulatory capital charges on bilateral OTC derivatives that would otherwise be eligible for central clearing. However, the use of CCPs presents a number of issues:

• Exposure to creditworthiness of clearing member. Market participants are likely to be required to become members of a clearing system or to become clients of such a member. In the latter case, the participants will be exposed to the creditworthiness of the clearing member – a risk that did not exist before. 
• Liquidity risk. CCPs are likely to require counterparties to provide cash collateral and to meet ongoing margin calls; other forms of collateral such as guarantees or security are not likely to be acceptable. This will expose end users to significant liquidity risk as it effectively imposes an immediate demand on an end user’s cash resources, counter to the commercial objective for the hedge, which is to match the timing of cash flows under the hedge with the businesses commercial cash flows. This requirement is likely to result in cash resources being diverted from otherwise beneficial activities such as investment in their business, or require end users to borrow additional funds, and may act as a significant disincentive to entering into otherwise beneficial hedging arrangements.

Reporting and record-keeping requirements

The establishment of central data repositories to record details of OTC derivatives is intended to improve market transparency by making aggregate market data publicly available and to assist regulators in performing their supervisory functions. In the latter case, greater access to more detailed information about volumes of transactions and open positions for individual market participants will provide regulators with greater insight into the trading activities of market participants.

CCPs would be able to directly feed transaction data into the central data repositories. However, for OTC derivatives not transacted through a CCP, counterparties would be obliged to directly report transaction data to a data repository.

Improving collateral management for bilateral OTC derivatives

As not all OTC derivatives will be capable of standardisation or clearing through CCPs, regulations have been proposed to improve existing bilateral processes between OTC derivatives counterparties. These regulations will require that counterparties mark to market their exposures, exchange collateral and perform portfolio reconciliations on a frequent basis.

Clearly, the administrative procedures required to implement these record-keeping and collateral management requirements would involve substantial costs to end users, which may potentially result in fewer entities entering into hedging arrangements.

Conclusion

In summary, regulatory proposals may result in the imposition of significant costs on end users, with the inevitable outcome being that some will choose not to hedge. Those that do continue to hedge may find that it is not possible to completely hedge their risk using standardised OTC derivatives or that they are exposed to new risks associated with the clearing of OTC derivatives through CCPs.

Ultimately, greater regulation of OTC derivatives in Australia is inevitable and whilst this article focuses on some of the potentially adverse outcomes of regulating OTC derivatives, the regulatory proposals are broadly supported by market participants who see them as broadly improving the robustness of the OTC derivatives market. Indeed, industry participants in Australia and overseas have already begun to implement similar initiatives including:

• adopting uniform auction settlement terms and credit event determination procedures for credit derivatives, with commitment to further standardise contractual terms for credit derivatives and equity derivatives;
• central data repositories already exist for credit derivatives and interest rate swaps and work is progressing to develop data repositories for equity derivatives; and
• market participants have undertaken reviews to improve bilateral collateral management processes with a view to improving market practice and mitigating counterparty credit risk.

The real issue of concern to end users is that regulatory proposals are appropriately designed to improve the robustness and efficiency of the OTC derivatives market without limiting the benefits associated with using OTC derivatives or increasing the costs of associated with using them.

This article has been prepared by Vittorio Casamento, a Senior Associate in the Banking & Finance group, specialising in derivatives and structured finance.

A version of this article first appeared in inFinance magazine.

More information

For information regarding possible implications for your business, contact a member of our Derivatives and Structured Products group.