Monday, April 04, 2011

Financial Stability Board Reports on Progress in Achieving Harmonized Cross-Border Derivatives and Hedge Fund Regulation

The body tasked by the G-20 with monitoring the globally harmonized adoption of financial regulations reported that regulatory regimes for hedge fund and OTC derivatives are being imposed on a generally consistent basis cross-border. The Financial Stability Board noted that, while there has been significant progress to date on global implementation of financial regulations, there is much to be done before a more resilient financial system has been secured. While fully recognizing that regulations must be nationally appropriate, the Board emphasized that they also must be internationally consistent. Experience teaches that uneven regulations across borders will inevitably lead to regulatory arbitrage, instructed the Board, and defeat of the G-20 common regulatory objectives.

Improving the OTC derivatives markets is a critical component of the reform agenda and includes mandatory reporting of OTC derivatives transactions to trade repositories, which will enable the authorities to assess the build-up of potential vulnerabilities in the financial system. The Board has taken an especial interest in derivatives regulation, having set up an OTC Derivatives Working Group, led by representatives of IOSCO and the European Commission, to identify factors that make derivatives suitable for clearing and set out policy options to support the consistency of implementation of clearing, trading and reporting requirements across jurisdictions.

The Board reported that efforts to strengthen the infrastructure of the OTC derivatives markets are taking place at national and regional levels. At a high level, the Dodd-Frank Act requires central clearing for all swaps that the CFTC or SEC determine are required to be cleared. It includes a limited exemption from the mandatory clearing requirement for counterparties that are not financial entities and who also are using swaps to hedge or mitigate commercial risks.

Generally, swaps subject to the clearing requirement are required to traded on an exchange or swap execution facility unless no exchange or swap execution facility makes the swap available for trading. Furthermore, the Dodd-Frank Act requires that all swaps, both centrally and non-centrally cleared, be reported to a data repository or, if no data repository will accept the transaction, to the CFTC or the SEC, respectively

In the EU, there is a somewhat bifurcated approach to derivatives regulation. The European Commission has proposed legislation on central counterparties and trade repositories in an effort to increase transparency in the OTC derivatives market and reduce counterparty credit risk. Issues concerning trading of OTC derivatives on exchanges or electronic platforms will be dealt with in the framework of the review of the Markets in Financial Instruments Directive (MiFID) Directive. The reform is likely to encompass amendments to require transaction reporting of clearly specified OTC derivatives for market abuse detection purposes to be developed in conjunction with central counterparties and trade repositories.

To increase transparency, the Commission proposes that detailed information on OTC derivatives contracts must be reported to trade repositories and made accessible to regulators. In addition, it requires that trade repositories publish aggregate positions by class of derivatives. To reduce counterparty credit risk, the proposal introduces stringent rules on prudential, organizational and conduct of business standards for central counterparties.. It also mandates central counterparty clearing for contracts that are eligible and imposes risk management techniques for derivatives that are not cleared by a CCP. The proposal provides limited exemptions from clearing and reporting requirements for non-financial firms whose positions excluding transactions that are directly linked to commercial activity do not exceed a threshold.

In Japan, the Financial Instruments and Exchange Act was amended to require central counterparty clearing for specific OTC derivatives transactions where the reduction of settlement risk through central clearing would be deemed necessary for the stability of the Japanese market. The exact products included in the central clearing requirement will be specified by Cabinet Office Ordinances. In addition, there will be a mandatory reporting requirement for financial institutions. For trades that are subject to mandatory central counterpary clearing, the CCP must store the trade information and report it to the regulator. Separately, financial institutions may either submit information to the designated trade repository (foreign or domestic), or to the regulator directly. Implementation of the amended law will take place by November 2012.

The Korean Financial Services Commission organized a task force in cooperation with academia and related agencies to build the infrastructure for OTC derivatives markets, including establishment of a central counterparty, and make revisions of related laws by 2012.

The Hong Kong Monetary Authority and the Hong Kong Stock Exchange have respectively decided to establish a trade repository and a central counterparty for OTC derivatives transactions. Interest rate derivatives and non-deliverable forwards will be the first two products handled by the new clearing house. In the future, the new regime is expected to also handle other OTC derivatives traded in Hong Kong such as equity derivatives. The Hong Kong regulators envision that the trade repository will be a centralized registry that maintains an electronic database of records of OTC derivatives transactions.

Hedge Funds

Legislation to establish registration, reporting and oversight arrangements for hedge
funds and their advisers has advanced in most G20 jurisdictions, reported the Board, which specifically urged continued dialogue between EU and US regulators both bilaterally and through the Board’ offices and IOSCO, to achieve a level of consistency across national and regional initiatives and avoid regulatory arbitrage or disadvantaging cross-border participants.

The US Dodd-Frank Act eliminates the private fund investment adviser exemption and subjects nearly all advisers to private funds to registration and record-keeping requirements. It also requires hedge fund advisers with assets under management above a certain threshold to register with the SEC. Fund advisers are required to report on funds’ leverage, counterparty exposure and other such information as deemed necessary by the supervisors for the assessment of systemic risk. The Dodd-Frank Act also provides for prudential safeguards for any hedge fund that may be identified as systemically relevant.

The European Commission’s Directive on Alternative Investment Fund Managers requires hedge fund managers to be authorized and supervised, to report regularly to competent authorities on their major exposures and use of leverage, and to comply with a series of ongoing operational and organizational requirements. The Directive requires transposition into the national legal systems of the Member States.

While some jurisdictions are now putting in place a regulatory regime covering hedge fund managers, the Securities and Futures Commission has for some time had regulatory supervision over those hedge fund managers who operate in Hong Kong.

A small number of G-20 countries reported to the Board that they do not have a specific regulatory framework for hedge funds, largely because hedge funds are not of systemic importance in their domestic financial systems. Other factors may be that they do not see a need for a specific regulatory framework for the protection of professional investors.