The Regulation of OTC Derivatives:
Minimising Systemic Risk
Presenter: Roy Havemann| National Treasury |10 September 2014
Outline
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1. Role of the financial sector in the SA economy
2. Post global financial crisis reform
– Twin peaks
– G20 commitments
3. Legislative reform for OTC derivatives
4. Challenges
a) Domestic Harmonisation
b) International harmonisation and equivalence
c) Lack of local FMI and extra-territoriality
A safer financial sector to serve South Africa
betterUpdate
Roy Havemann | National Treasury | 15 August 2013
A stable financial
system is a necessary
condition for growth…
…but not sufficient…
Costs, transparency,
efficiency, effectiveness,
savings
Financial Markets Act of 2013 (FMA)
• Chapter on Independent Clearing Houses *new
– But central clearing counterparties (CCPs) not defined (s107(1))
– “to clear” includes underwriting, i.e. the balance sheet underwrites
transactions cleared
– s48 Ministerial regulations: assets and resources
– FSB licensing and supervisory authority
• Chapter on Trade Repositories *new
– s54 - s56, s58 Ministerial regulations: licensing, assets and resources,
central reporting obligations
– FSB licensing and supervisory authority
• Recognition of external FMI
– s5 Ministerial regulations: security services to be provided
4
OTC Derivative Providers not defined in FMA
• Regulations issued by Minister of Finance
• S5(1)(a): requirements for the regulation of unlisted securities
• s5(1)(b): a category of regulated person other than specifically
regulated under the Act
• s5(1)(c): functions and duties of external CCPs and TRs
• Registrar of Security Services (FSB-SA)
– Board Notices to be issued by the Registrar in terms of s6(7) & (8), s58, s74
• Definition and categorisation of OTC derivatives
• Definition and categorisation of OTC derivative providers (ODPs),
counterparties and clients
• Requirements to be authorised as an ODP
• Code of conduct for ODPs
• Reporting and clearing obligations on ODPs5
Ministerial regulations - definitions
• “OTC derivative”
– Means an unlisted derivative instrument categorised and prescribed as such by the
Registrar excluding
a) insurance contracts
b) forex spot contracts; and
c) physically settled commodity contracts
– Registrar to prescribe in line with ISDA taxonomy
• “OTC Derivative Provider” (ODP)
– Issuer or market maker
• “counterparty”
– another authorised ODP; an authorised user of the exchange; a bank; a long-term or
short-term insurer; a person outside the Republic rendering a service similar to an
ODP; a central bank; a private equity fund/hedge fund.
• “client”
– means any person, other than a counterparty
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ODPs – Requirement to be authorised
• The following requirements must be met:
I. Prudential requirements for all ODPs – bank vs. non-bank
II. Fit and proper requirements
III. Compliance function
IV. Internal control and risk management
V. Business continuity plan
VI. Record keeping and data retention requirements
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ODPs – code of conduct
• The code of conduct covers the following:
I. General principles
II. Categorisation of clients and counterparties
III. Disclosure to clients
IV. Appropriateness for clients (knowledge and experience)
V. Client and counterparty agreements
VI. Timely confirmations (best efforts, T+1 or T+5)
VII. Portfolio reconciliation (frequency depends on size of portfolio)
VIII.Dispute resolution
IX. Portfolio compression (not mandatory but explanation to Registrar required)
X. Safeguarding of collateral and margin
XI. Confidentiality and privacy
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Reporting framework aligned with larger jurisdictions
• Mandatory reporting of all derivatives to a Trade Repository
– T+0, Executed, whether confirmed or not
– Daily reporting
– UTIs, UPIs and LEIs mandatory
– Reporting obligation falls on ODP
– Fields to be reported align with EU and US requirements and take into
account current reporting requirements
• Obligations on the TR aligned with international requirements
• Outstanding issues
– Aggregating data across TRs
– POPI Act, blocking statues in other jurisdictions- confidentiality provisions
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Clearing - "carrot-and-stick" approach
• Incentives to Clear
– Netting benefits
– Requirements to clear if counterparty in US or EU
– CVA but banks temporarily exempt from holding capital for CVA risk on
derivatives denominated and transacted solely in ZAR, as well as for all OTC
derivatives entered into bilaterally between local counterparties – this
expires 31 Dec 2014
• Clearing not yet mandatory
– Too early to tell how local incentives/international requirements will work
– Need to understand market better (PWC DATA EXERCISE)
• Asset classes (mostly IR swaps and FRAs)
• Counterparties (type, local, offshore)
– Need to review exclusive reliance on incentives
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Challenge 1: Domestic harmonisation
• Bank/ Non-Bank/ FMI overlap
• Twin peaks
– ODPs under FMA and Conduct authority as “lead” regulator
– Most trades are inter-bank, which fall under the Banks Act and SARB
regulation
– Prudential regulation of non-bank ODPs – regulatory arbitrage
– FAIS Act: covers ALL product providers
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FINANCIALMARKETS
ACTFAIS BANKS ACT
FSB supervision Reserve Bank supervision
Challenge 2: International Harmonisation
• Balance harmonisation with disruption to market
• Understanding how equivalence will be assessed
– “Line by line” vs. “outcomes based”
– Having our “hands forced”
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Challenge 3: Concentration abroad
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Assumptions:
• FX spots/forwards exempt
from clearing
• Trades with int’l banks
assumed to clear off-shore
• Within IR, only swaps and
FRAs deep enough markets
to support clearing
• Within swaps and FRAs, only
include those with sufficient
liquidity (tenor, currency,
size)
• Includes large corporates
PwC Study 2012
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Cleared trades
Notional outstanding
(R’ Billion)
% of OTC
market
Local interbank only 3,810 14%
Local large corporates* only 5,614 20%
Local interbank and large corporates 9,424 34%
Range 3,800 – 9,400 14% - 34%
• Large corporates defined as top 10 other financial institutions and corporates
• Assumed to have the required trading and operational sophistication to clear
• Comprise hedge funds, asset managers and insurance companies
• Account for 91% of the local non-bank Swap and FRA notional outstanding
balance
Exemptions and the clearable market
PwC Study, 2012
OTC Derivatives Markets Composition
As at June 2012:
• R27 trn (US$2.5trn) notional outstanding (around 6 x GDP)
• >85% of market attributable to vanilla IR derivatives
• 59% inter-bank trades
• Around 60% of inter-bank IR trades are with international banks
-
2,000
4,000
6,000
8,000
10,000
12,000
14,000
16,000
18,000
Commodities Credit Equities Forex Interest rates
Notional outstanding - Interbank
Notional outstanding - Other FI
Notional outstanding - Corporates
15
Study by PwC confirms the cross-border and inter-bank-dominated nature of the
South African derivatives market
PwC
Interbank trades mostly with foreign counterparties
16
• 61% interbank interest rate
trades (notional outstanding) are
executed with international
banks
• 42% of interbank interest rate
trades (volume) are executed
with international banks
Notional balance outstanding (R’ billion)
-
2,000
4,000
6,000
8,000
10,000
12,000
Commodities Credit Equities Forex Interest rates
Local interbank Foreign interbank
-
20
40
60
80
100
120
Commodities Credit Equities Forex Interest rates
Local interbank Foreign interbank
Notional average monthly volume (R’ billion)
PwC Study, 2012
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Local notional
outstanding
Foreign notional
outstanding
Local notional
average monthly
volume
Foreign notional
average monthly
volume
Commodities < R12.5 m < R12 bn R0 < R200 m
Credit < R2.5 bn < R20 bn R0 < R150 m
Equities < R4.5 bn < R8.5 bn > R300 m < R300 m
Foreign exchange > R300 bn > R750 bn < R9 bn > R15.5 bn
Interest rates > R6 trn > R9.9 trn > R100 bn > R75 bn
Notional outstanding are executed with international banks
PwC Study, 2012
Type Potential Options
1. LOCAL CCP • Must be licensed as a clearing house by the Financial
Services Board
• Must demonstrate sufficient assets and resources,
however not required to be “in the Republic”
• Perform the functions of a licensed clearing house in
terms of the FMA
• Meet the requirements of and perform the functions
outlined in the draft Ministerial regulations
2. GLOBAL CCP
Clearing services to local dealers
and operating in South Africa as a
branch or subsidiary of the global
CCP
• Must be licensed as a clearing house by the Financial
Services Board
• Must demonstrate sufficient assets and resources
however, not required to be “in the Republic”
• Must perform the functions of a licensed clearing
house in terms of FMA
• Meet the requirements of and perform the functions
outlined in the draft Ministerial regulations
3. GLOBAL CCP
No local operations, or limited local
presence e.g. a Rep office
• Must be supervised by a foreign supervisory authority,
subject to a regulatory framework equivalent to that
established in the FMA
Off-shore vs domestic clearing and transaction typesC
urr
en
cyCOUNTERPARTIES
Domestic to Domestic Domestic to Foreign
ZAR Pros
• Netting benefits are realised leading to
optimal savings by banks
• Better protection due to greater oversight
and supervision by local regulators
• ZAR will be clearable
• Advantages in default situations & Less
exposure to global contagion
Cons
• Split book between local vs global CCP-
reduces netting efficiencies
• Less diversification and difficult to attract
international clearing members
• Limited number of participants
Pros
• Liquidity provisions
• Greater netting benefits are realised due to
larger number of clearing members
• Larger default funds mean lower DF
contribution and therefore cost
Cons
• Foreign CCPs not clearing ZAR transactions -
requires back to back hedging transactions
that add to risk and cost
• Global contagion effects due to increased
exposure
• Difficult for domestic regulators to have
greater oversight over foreign CCPs
• Default situations – ZAR based transactions
not prioritised
USD N/A • Multilateral netting benefits
Impact of global clearing on SA banks
• Foreign counterparties demand off-shoring clearing of ZAR derivatives, even without
mandatory requirement from SA regulators
• Derivative pricing differences between internationals and SA banks due to:
– Introduction of OIS discounting requirement to incorporate collateral in pricing
calculations
– CVA
– FVA - the cost of converting ZAR to dollars is expensive
• No ability currently to pay IM in preferred transaction currency i.e. ZAR which makes
funding IM sub-economic (even non-sensical)
• Reduced liquidity as Swap Dealers lose appetite for OTC transactions
• Dislocation between short and long dated swaps (currently clearing only available out
to 10year for ZAR IRS). Reduced liquidity over 10 year / pricing dislocation all feasible.
• Change in country risk pricing. CCP equivalent is covered via initial margin – only 1
CCP currently and a handful of clearing members, therefore no ability to control Initial
margin costs
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Domestic to Domestic Clearing (ZAR)
Domestic
CCP
ClientClientDomest
ic Bank
ClientClient
ZAR
ZAR
ZAR
As at June 2012:
• >85% of market attributable to vanilla IR derivatives
• 59% interbank trades
• Around 60% of inter-bank IR trades are with international banks
Domestic to Foreign Clearing (USD)
Counter
party
Counter
party
Domestic
Bank
US
D
USD
ZA
R• As indirect clearers, domestic
banks ODPs (clients) will be charged a clearing fee by foreign clearing members , e.g. Barclays Capital Inc
• Foreign clearing member novatetrades to global CCP
• For every trade cleared with the CCP, banks will be required to post initial margin (collateral) with the CCP
• Foreign CCPs do not accept ZAR IM, would require back-to-back trade to hedge out position
• The cost of converting ZAR to dollars is expensive
• Costs are passed onto clients
Counter
party
Counter
party
Counter
party
Foreign
clearing
member
Global CCPU
SD
International vs Domestic Clearing
Domestic
Bank
US
DZ
AR
If the derivative banks
clear through multiple
CCPs
• will have to contribute
to multiple default
funds if clearing
members
• will incur multiple sets
of clearing fees
• portfolios would be
split across the CCPs
• netting efficiencies
limited and increasing
collateral requirements
Domestic
Counter-
party
Domestic
Counter-
party
Foreign
counter-
party
ZAR
USD
Foreign
clearing
memberGlobal CCP
USD
Local CCP
ZAR
ZAR
Counter-
party
Trade 1 Domestic to
Domestic (ZAR)
Trade 2 Domestic to
Foreign (USD)
Trade 3 Back to back
ZAR hedging
trade
Summary and Challenges
• Twin Peaks implementation
• Harmonisation with other domestic regulation like FAIS
• International harmonisation (our progress depends on rest of world)
• Extra-territoriality
• Access to services concentrated in larger markets where we do not have the
infrastructure
• Pricing disparities and changes
• Regulating the unknown takes time
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QUESTIONS
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