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.