The impact of cross-border OTC regulations in Asia
Hong Kong Monetary Authority (HKMA) Howard Lee’s remarks about how cross-jurisdictional over-the-counter (OTC) derivatives rules could potentially hurt liquidity in Asia has sparked much discussion across the industry. Treasury Today spoke to FINCAD’s Product Manager, Matthew Streeter, to get his take on possible consequences.
On 21st October, speaking at an Asia-Pacific International Swap and Derivatives Association (ISDA) conference, Howard Lee, Executive Director of Monetary Management at the Hong Kong Monetary Authority (HKMA), used his keynote address to warn of the damaging effects cross-territorial over-the-counter (OTC) derivative regulations could potentially have on liquidity in the Asian markets.
The two regulations at the forefront are the European Market Infrastructure Regulation (EMIR) in Europe and Title VII of the Dodd-Frank Act (DFA) in the US. Both sets of rules have started to be phased in over a several-month period and should be fully in force by September 2014.
Lee’s comments came over a month after the HKMA and Securities and Futures Commission (SFC) jointly published their conclusions on a joint supplemental consultation regarding the proposed scope of activities to be regulated under the new OTC derivatives regime, and regulatory oversight of systemically important participants. They said they were working together on the detailed requirements under the new regime, which will be set out in subsidiary legislation, and plan to conduct a public consultation on these later this year.
There is now much debate around the likelihood of Hong Kong being granted ‘substituted compliance’ by the US Commodity Futures Trading Commission (CFTC). Treasury Today spoke with Matthew Streeter, Product Manager at FINCAD, to gain a better understanding of the situation. The derivatives risk management company opened a local Asia office in Beijing last month in order to have a local footprint to better serve customers in the region.
“It is the interconnectedness of the derivatives market that has driven the regulators to have more control over the OTC segment,” says Streeter. “For example, there are now many entities domiciled in Hong Kong that could be US-headquartered, so these institutions are looking to see what level of regulation will be put in place in this market.”
Talking specifically about Hong Kong, Streeter believes that there will be a consistent regulatory regime, as many of the rules emanate from the G20 post-crisis. “Most of the OTC derivatives traded globally originate with North American banks and institutions whose counterparties are in Asia. Therefore there is a need to have a strong regulatory framework in place in order not to overexposure any one region in favour of another.” Effectively, if one bank, which is subject to stringent regulatory requirements, is trading with another financial institution that has more lenient standards, then the former bank would be exposed to risk from the latter.
Such a division between regimes also opens up regulatory arbitrage opportunities, warns Streeter, but in the long run he believes that those opportunities will not persist.
A fundamental shift
Will the new OTC derivative regulations create a fundamental shift in the market? Streeter believes that they will. “Due to these regulations, new types of financial instruments – whether centrally cleared or exchange traded alternatives – will be traded wherever possible.”
Although many institutions will continue to use OTC derivatives, Streeter sees a trend towards making trade centrally cleared or exchange traded derivative instruments more cost effective compared to OTC traded instruments. “With this change the industry will move towards centrally cleared instruments, which will be a fundamental shift,” says Streeter.
He touches on the fact that the way institutions manage their own capital will also change. “If financial institutions continue to use OTC derivatives, they will require more capital than previously. This will dictate decisions around how to optimally deploy capital, as it will have a big impact on the profitability of financial institutions.”
The Asian OTC derivatives market is small compared to the global market, according to a Celent report entitled ‘OTC derivatives in the advanced Asian economies’, published in September. The market is dominated by five advanced economies: Australia, Hong Kong, Japan, New Zealand, and Singapore, which account for over 90% of OTC derivatives trading volume in Asia and reached $290 trillion in 2012.