The evolving and inconsistent regulatory framework around OTC derivatives is resulting in a murkiness regarding the obligations of sovereigns and the potential cost of compliance for these entities, according to a BNY Mellon report.
The report, called Sovereigns in Search of Solutions: OTC Derivatives Reform: Direct and Indirect Impacts, highlights the Dodd-Frank Act and the European Market Infrastructure Regulation (EMIR), and similar measures throughout Asia-Pacific, which will centralize and manage counterparty credit risk and increase transparency. It notes inherent inconsistencies in the application of key OTC reform provisions and the potential impact on sovereign institutions, a base of increasingly influential global investors that use capital markets and OTC derivatives for implementing their investment strategies and hedging exposure.
The report says the classification of sovereigns and subsequent variation in Basel III capital adequacy rules must be addressed to avoid market distortions and regulatory arbitrage.
The report notes that the continuing debate over extraterritoriality, defined as the applicability of a set of rules outside the direct jurisdiction of the overseeing regulator, adds further complexity. European sovereigns have generally expressed concern over the potential impact on counterparty selection as a result of the proposed Dodd-Frank Acts extraterritorial scope, for example. The de facto exclusion of U.S. financial institutions as potential counterparties could have a very negative impact on derivatives pricing, liquidity and risk management.
Sovereigns are generally regarded as low risk counterparties, and as such have not generally been required to provide collateral, observes Jai Arya, head of BNY Mellons Sovereign Institutions group. With global regulatory reforms, however, precisely what is in and out of scope with respect to sovereigns remains murky. The classification of sovereigns and subsequent variation in Basel III capital adequacy rules must be addressed to avoid market distortions and regulatory arbitrage. In addition, the cost of compliance to the new rules could potentially hit sovereigns – and those servicing sovereign counterparties – very hard.
We expect that a common approach will be reached between the major strands of regulatory reform to avoid market distortions and regulatory arbitrage, but inconsistency and conflict between national and supranational rules persists, says Nadine Chakar, head of Derivatives360, BNY Mellons front-middle-back office service provider for OTC derivatives. Until a consistent framework of exemptions from both capital adequacy and clearing requirements across jurisdictions may be agreed, sovereigns may find that their OTC derivatives activities become subject to mandatory clearing.
Additional observations from BNY Mellon include:
New OTC derivatives rules focus on central clearing as a means of controlling credit risk and increasing transparency. Counterparties to non-cleared trades may be subject to much higher collateral and capital requirements.
The widespread use of OTC derivatives reflects their usefulness in managing exposures and hedging risks and it is not expected that sovereigns will choose to curtail their derivatives activities.
The economics of servicing sovereign counterparties are changing, and banks may be forced to pass on higher collateral and capital costs through the pricing of bilateral OTC derivatives trades.
More sovereigns may choose to embrace central clearing and post collateral to central counterparty clearing houses (CCPs).
Sovereigns engaged in cleared derivatives markets will need to consider the costs and benefits of each direct CCP membership and the appointment of futures commission merchants to clear on their behalf.
As more stringent regulatory capital and collateral requirements are imposed, banks are under pressure to source and deploy eligible collateral assets as cheaply and efficiently as possible to sustain returns.
Even if mandatory execution, clearing and reporting requirements are not imposed on sovereigns, the indirect impact on bilateral derivatives pricing could be sufficiently material to warrant a detailed analysis of the relative costs and benefits of voluntarily adapting to central clearing or two-way collateral arrangements.
The likely scope of sovereigns collateral management operations is unlikely to be as complex as those managed by commercial banks, but should not be underestimated.
(JDC)