Global regulators’ failure to align efforts to reform the $693 trillion derivatives market threatens to undermine economic growth, according to the International Swaps & Derivatives Association.
Investors are struggling to adapt to regional differences to changes agreed by the Group of 20 nations as the industry meets for its annual conference in Munich today. In the U.S. traders have been reporting derivatives transactions to data repositories and have been required to have central clearinghouses back their contracts since last year, while European regulators are still defining the requirements.
Rules introduced after the collapse of Lehman Brothers Holdings Inc. to reduce systemic risk have increased transparency, though they’ve also made hedging more expensive, according to an ISDA survey published yesterday. Legislators say the changes will enhance their ability to monitor risk taking, curb market abuse and make it easier to identify holdings when a financial institution fails.
“People who need to conform to the rules are without a doubt incurring increasing costs and complexity,” Alan Haywood, president of downstream gas at BP Plc and an ISDA board member, said in an telephone interview before the conference. “As an international company working with international counterparties, we want regulation to be pretty consistent worldwide.”
In the wake of the financial crisis, G-20 leaders agreed to seek to push trading as much as possible through central clearinghouses and onto regulated platforms.
The U.S. Dodd-Frank Act mandated that most swaps be backed with a clearinghouse and traded on swap execution facilities, or SEFs, and that all trades be reported to central repositories. The clearing and reporting mandates went into effect last year. Measures are already in place in several other nations including Brazil and Japan.
Though firms in Europe have begun systemic reporting and will start trading contracts through central counterparties by the end of the year the European Securities and Markets Authority, the region’s main regulator, is still struggling to define a derivative and harmonize rules across the 28-nation bloc.
“It’s a real challenge to implement regulation consistently on an international basis,” Elke Koenig, president of German financial regulator BaFin, said at the ISDA conference today. “Fragmentation leads to misallocation and possibly market distortions and inefficiencies.”
Clearinghouses rely on bank members to provide billions of dollars’ in cash and assets to hold on reserve in case of a default. They’re meant to lessen systemic risk by requiring up-front margins to back every trade and monitor prices throughout the day. When losing positions arise, they demand cash so that risk doesn’t build.
The U.S. rules effectively place the responsibility on banks for reporting trades, while the EU’s approach requires both buyers and sellers to post positions, bringing more non- financial companies within the scope of the measure.
“Differences between jurisdictions are very harmful and the more dialogue and more concerted efforts towards global harmonization of rules the better,” Stephen O’Connor, ISDA’s chairman, said in an interview before today’s meeting. “We’d encourage a great deal more international cooperation.”
Attempts by U.S. regulators to extend their oversight have also caused market fractures, he said. ISDA said in December and January that foreign investors have avoided trading with U.S. firms since an Oct. 2 deadline for platforms to register with the Commodity Futures Trading Commission.
The derivatives industry is also facing pressure from the Financial Stability Board, a global grouping of central bankers and regulators, to come up with proposals to write temporary pauses into derivatives contracts struck with banks that hit financial trouble.
Mark Carney, chairman of the FSB and governor of the Bank of England, told journalists last week there was “no lessening” on the focus on so-called contractual stays in derivatives. The measures could prevent the type of turmoil in markets seen with the collapse of Lehman Brothers in the event of another investment banking failure, regulators have said.
Regulators must update G-20 finance ministers on their progress in September.
“Financial markets are global and our preferred outcome would be for all regulators across the world to move at the same time to the same set of rules,” O’Connor said. “The problem is that just doesn’t happen in the real world.”