An IOSCO-Basel Committee-Financial Stability Board working group found a net economic benefit from the OTC derivatives regulatory reforms being implemented in the wake of the financial crisis. The working group’s report also found that the derivatives reforms increased transparency and enhanced risk management. However, as the reforms are playing out across different jurisdictions, the report found a risk of regulatory arbitrage.
The Over-the-counter Derivatives Coordination Group, composed of the Basel Committee, IOSCO, the Committee on Payment and Settlement Systems (CPSS), the Financial Stability Board, commissioned a quantitative assessment of the macroeconomic implications of OTC derivatives regulatory reforms to be undertaken by the Macroeconomic Assessment Group on Derivatives (MAGD), chaired by Stephen G
Cecchetti of the Bank for International Settlements. The Group comprised 29 member institutions of the Financial Stability Board, working in close collaboration with the IMF.
In its report, the MAGD focused on the effects of mandatory central clearing of standardized OTC derivatives, margin requirements for non-centrally-cleared OTC derivatives and bank capital requirements for derivatives-related exposures. In its preferred scenario, the group found economic benefits worth 0.16% of GDP per year from avoiding financial crises. It also found economic costs of 0.04% of GDP per year from financial institutions passing on the expense of holding more capital and collateral to the broader economy. This results in net benefits of 0.12% of GDP per year.
In response to the financial crisis, policymakers are implementing reforms aimed at reducing counterparty risk in the OTC derivatives market. These include requirements for standardized OTC derivatives to be cleared through central counterparties, requirements for collateral to be posted against both current and potential future counterparty exposures, whether centrally cleared or non-centrally cleared, and requirements that banks hold additional capital against their uncollateralized derivative exposures.
While these reforms have clear benefits, noted the working group, they do entail costs. For example, requiring OTC derivatives users to hold more high-quality, low-yielding assets as collateral lowers their income. Similarly, holding more capital means switching from lower-cost debt to higher-cost equity financing. Although these balance sheet changes reduce risk to debt and equity investors, risk-adjusted returns may still fall. As a consequence, financial institutions may pass on higher costs to the broader economy in the form of increased prices.
This report assesses and compares the economic benefits and costs of the planned OTC derivatives regulatory reforms. The focus throughout is on the consequences for output in the long run when the reforms have been fully implemented and their full economic effects realized. The main beneficial effect is a reduction in forgone output resulting from a lower frequency of financial crises propagated by OTC derivatives exposures, while the main cost is a reduction in economic activity resulting from higher prices of risk transfer and other financial services.
The main benefit of the reforms arises from reducing counterparty exposures, both through netting as central clearing becomes more widespread and through more comprehensive collateralization. The working group estimates that in the central scenario this lowers the annual probability of a financial crisis propagated by OTC derivatives by 0.26 percentage points. With the present value of a typical crisis estimated to cost 60% of one year’s GDP, this means that the reforms help avoid losses equal to (0.26 x 60% =) 0.16% of GDP per year.
The benefit is balanced against the costs to derivatives users of holding more capital and collateral. Assuming this is passed on to the broader economy, the working group estimates that the cost is equivalent to a 0.08 percentage point increase in the cost of outstanding credit. Using a suite of macroeconomic models, the group estimates that this will lower annual GDP by 0.04%. Taken together, this leads to the group’s primary result: the net benefit of reforms is roughly 0.12% of GDP per year.
Regulatory arbitrage risk. As the regulatory regimes are gradually put in place, the report found indications of potential differences in the scope and application of OTC derivatives regulation across jurisdictions. There is a risk that overlaps, gaps or conflicts in the frameworks, if not properly addressed, could create the potential for regulatory arbitrage as trading migrates to certain jurisdictions.
Among the cross-border issues in this category is the regulatory treatment of central counterparties. For example, the European Market Infrastructure Regulation (EMIR) and the Commodity Exchange Act (CEA), as modified by the Dodd-Frank Act, contain prescriptive rules that may prevent European/US banks from participating in third-country central counterparties that are not currently recognized by the European Securities and Markets Authority (ESMA) or that are not currently registered as a derivatives clearing organization under CFTC regulations.
The potential non-recognition of third-country central counterparties could negatively affect Asian OTC derivatives markets, said the report, as it could affect market liquidity, restrict participation and undermine price discovery. The extraterritorial application of regulatory frameworks could affect European and US banks’ participation as these banks are already clearing members in Asian clearing houses and may be potentially shut out of certain business lines.
Non-recognition could imply that some central counterparties would be treated as non-qualifying, thereby attracting a much higher regulatory capital requirement for trade exposures and default fund contributions, which could act as a disincentive for OTC derivatives trading. Thus, the working group concluded that there is a risk that significant contributors to market liquidity may be forced to withdraw, thereby making those markets shallower. The resulting impact on the price discovery process could also influence hedging decisions, which would adversely affect the ability of financial institutions and companies to manage interest rate and other risks, thereby potentially increasing systemic risk.
Transparency. The report found that enhanced transparency could be a likely benefit of the reforms in that greater standardization of products and lower counterparty risk will facilitate the comparison of pre-trade prices, which should improve competition and lead to more accurate price differentiation. The increased posting of collateral and use of central clearing also means that detailed information about individual counterparties becomes less important. In contrast, as more trades are moved onto central counterparties it will become increasingly important to ensure that market participants have ongoing access to reliable information about the positions, risk management practices and financial health of the central counterparty.
Risk Management. The regulatory reforms will not only reduce the risk of systemic financial crises, said the working group, they are also likely to reduce the risk of less severe episodes of financial turbulence and of the failure of single financial institutions. They do this in two ways. First, minimum margin requirements are likely to make it less likely that risks build up within a financial institution without all main departments, including risk management, realizing it. The reforms may also indirectly lower the risk of financial instability due to poor internal controls at financial institutions.
Second, by reducing counterparty risk embedded in OTC derivatives, the reforms can help reduce price model risk. Currently, pricing models for derivatives take counterparty risk into account, but these risks are difficult to measure or calibrate and often call for subjective judgment. Therefore, reducing counterparty risk lowers this modeling risk, making it less risky to price and value derivatives.