PLAY­ING CATCHUP

The in­ter­na­tion­ally aligned rules for trad­ing de­riv­a­tives over the counter are late but loom­ing in SA, writes Ruan Jooste

Financial Mail - Investors Monthly - - Contents -

Over-the-counter de­riv­a­tive reg­u­la­tion pro­pos­als still have traders scram­bling to de­ter­mine their ef­fects

Reg­u­la­tion of over the counter (OTC) de­riv­a­tives in SA will soon be a re­al­ity. Lo­cal de­riv­a­tives traders, and to a lesser ex­tent for­eign en­ti­ties that deal with SA coun­ter­par­ties, are scram­bling to de­ter­mine the ef­fect on their busi­ness.

Na­tional trea­sury re­leased the sec­ond draft of the reg­u­la­tions re­lat­ing to stan­dard­ised cen­trally cleared OTC de­riv­a­tives un­der the Fi­nan­cial Mar­kets Act (FMA) at the be­gin­ning of June.

At the same time, the Fi­nan­cial Ser­vices Board (FSB) re­leased a num­ber of draft no­tices per­tain­ing to mar­gins re­quired for bi­lat­eral de­riv­a­tive trades, among other things.

The dead­line for com­ment on the var­i­ous doc­u­ments was July 6.

Some in­dus­try play­ers have raised con­cerns over the prospec­tive rules, as well as the fact that SA is way be­hind other G20 coun­tries in im­ple­ment­ing OTC de­riv­a­tives re­form.

Re­form mea­sures in­clude the as­sur­ance that all stan­dard­ised OTC trades in SA are set­tled via a cen­tral coun­ter­party clear­ing (CCP) house, the es­tab­lish­ment of a trade repos­i­tory (TR) to hold in­for­ma­tion on both OTC and JSE-traded de­riv­a­tives in the coun­try, and the im­ple­men­ta­tion of var­i­ous mar­gin re­quire­ments on bi­lat­eral trades. The lat­ter refers to pri­vate ne­go­ti­ated trades be­tween two coun­ter­par­ties, usu­ally banks.

The 2012 dead­line for bring­ing the as­set class up to code, agreed by G20 lead­ers in 2009, in­clud­ing SA, has come and gone, and though lo­cal leg­is­la­tors have in­tro­duced the FMA, many reg­u­la­tions are still in draft form. Re­quired fi­nan­cial in­fra­struc­ture to im­ple­ment the amend­ments also re­mains a pipe dream.

SA was also tardy in im­ple­ment­ing OTC de­riv­a­tive cap­i­tal re­quire­ments in terms of Basel 3, which calls for higher mar­gins for cen­trally cleared and bi­lat­eral OTC de­riv­a­tive trades.

In the­ory, as of Jan­uary 1 this year, SA banks be­came sub­ject to credit val­u­a­tion ad­just­ment rules, which re­quire banks to hold ad­di­tional col­lat­eral when en­ter­ing an OTC de­riv­a­tive trade with an out­side coun­ter­party, but the SA Re­serve Bank started en­forc­ing it only from April 1.

Ina Meir­ing, a di­rec­tor at Werks­mans Ad­vi­sory Ser­vices, says the de­lay was due to the fact that a lo­cal CCP or TR has not yet been es­tab­lished.

The FMA al­ready con­tains the re­quire­ments of such in­fra­struc­ture but the reg­u­la­tions have not been fi­nalised.

In the mean­time, many lo­cal cor­po­rate bank­ing oper­a­tions, such as Absa and RMB, are util­is­ing well-es­tab­lished in­ter­na­tional CCP coun­ters like LCH Clear­net in the UK, Euro­clear in Europe and the DTCC in the US to set­tle and re­port their de­riv­a­tive trades.

The prob­lem here, says Hedge Fund Academy CE Mar­i­lyn Ram­plin, is the fund­ing cost and risk as­so­ci­ated with plac­ing col­lat­eral in a for­eign cur­rency.

But the rapid trans­for­ma­tion of the de­riv­a­tive space off­shore has forced lo­cal in­sti­tu­tions to utilise for­eign in­fra­struc­ture in the in­terim. Global fi­nan­cial in­sti­tu­tions are able to clear their stan­dard­ised OTC de­riv­a­tive trades via a CCP. Non-stan­dard de­riv­a­tive trades, which can­not be cen­trally cleared, are al­ready sub­ject to bi­lat­eral margin­ing ar­range­ments and the mech­a­nism for re­port­ing all trades to a TR is also in place.

Leg­is­la­tion in place in­cludes the US Dodd-Frank Wall Street Re­form and Con­sumer Pro­tec­tion Acts, the UK’s Mar­kets in Fi­nan­cial In­stru­ments Di­rec­tive and the EU’s Mar­ket In­fra­struc­ture Reg­u­la­tion.

Back home the FMA is still in need of some tweak­ing.

Kelle Gagné, bank­ing and fi­nance di­rec­tor at ENSafrica, says draft reg­u­la­tions and no­tices are un­clear and wide open to in­ter­pre­ta­tion.

She says an in­ter­pre­ta­tion could be that both lo­cal and for­eign fi­nan­cial in­sti­tu­tions need to register with the reg­u­la­tor as au­tho­rised OTC de­riv­a­tives providers in SA, which will add to the red tape bur­den of for­eign op­er­a­tors based in SA.

Though off­shore en­ti­ties regularly trade OTC de­riv­a­tives with SA in­sti­tu­tions, she says, the vol­umes are usu­ally quite small, which doesn’t jus­tify such a reg­is­tra­tion. “For­eign banks are also suf­fi­ciently reg­u­lated over­seas,” she adds.

Fur­ther­more, the draft rules im­ply that sub­sidiaries within the same group that trade OTC

While the bat­tle of the bourses con­tin­ues, banks have al­ready had to ab­sorb costs re­lated to the re­quired re­form

Rules con­tained in draft reg­u­la­tions and no­tices are un­clear and wide open for in­ter­pre­ta­tion

de­riv­a­tives among each other might have to register as OTC providers as well. Gagné says the rea­son is that draft reg­u­la­tions and no­tices don’t ex­clude trans­ac­tions among af­fil­i­ates from the need to register as an OTC provider, or to cen­trally clear or post mar­gin for OTC de­riv­a­tives.

“Com­pa­ra­ble leg­is­la­tion in other ju­ris­dic­tions ei­ther ex­cludes such in­tra-group trans­ac­tions or pro­vides for a process to ap­ply to the rel­e­vant reg­u­la­tor for the ex­emp­tion of such re­quire­ments,” she says. “Trans­ac­tions among af­fil­i­ates are not gen­er­ally for in­vest­ment or spec­u­la­tion, and there­fore pose lit­tle or no sys­temic risk.”

As the rules are cur­rently drafted, lo­cal banks might have to post mar­gin to non­fi­nan­cial in­sti­tu­tions or in­di­vid­u­als with whom they trade de­riv­a­tives over the counter.

That means large fi­nan­cial in­sti­tu­tions would have to put up col­lat­eral to cover the credit risk of the coun­ter­party (in this case non­fi­nan­cial op­er­a­tors or in­di­vid­u­als) in case of a de­fault.

Gagné says this will add to the fi­nan­cial in­sti­tu­tions’ credit risk. “SA reg­u­la­tors should per­haps fol­low other ju­ris­dic­tions’ leg­is­la­tion in this re­gard.”

While the FSB is in the process of con­sid­er­ing public com­ment on the draft doc­u­ments, the de­bate be­tween lo­cal stake­hold­ers on the mer­its of set­ting up a lo­cal CCP or TR con­tin­ues.

Leila Fourie, di­rec­tor: trad­ing and mar­ket ser­vices at the JSE, has con­firmed that the stock ex­change, banks and reg­u­la­tors are in talks to as­sess whether it will be vi­able for the JSE to take on the role of a lo­cal CCP.

“The JSE is work­ing with lo­cal in­dus­try par­tic­i­pants to eval­u­ate the fea­si­bil­ity of a lo­cal OTC CCP. The JSE sees merit in a lo­cal so­lu­tion, but we can only move for­ward if there is broad-based sup­port by lo­cal par­tic­i­pants for such a so­lu­tion,” she says.

Ram­plin adds that a lo­calised of­fer­ing will sub­ject traders to an en­force­able code of con­duct.

In­sid­ers have in­di­cated that the banks aren’t very keen on the idea of the JSE be­com­ing an OTC de­riv­a­tive clear­ing house. “The banks will be ex­pected to foot the bill, be­ing the main spon­sors of the trad­ing plat­form,” a source says. He adds that the size of the lo­cal OTC mar­ket might not even war­rant a lo­cal CCP.

The latest sta­tis­tics avail­able are in the In­ter­na­tional Mon­e­tary Fund’s re­port, “Fi­nan­cial Sec­tor As­sess­ment Pro­gramme on SA”, re­leased in March. It states that ac­cord­ing to a study un­der­taken by PwC and trea­sury, the gross no­tional out­stand­ing value of the lo­cal mar­ket was R27 tril­lion in June 2012.

Trad­ing vol­umes rep­re­sented 7,5% of GDP, which is large com­pared to other emerg­ing economies, but a drop in the ocean when com­pared to the US and the EU.

Of this, in­ter­est rate de­riv­a­tives were es­ti­mated to com­prise 85% and for­eign ex­change con­tracts 12%, the bal­ance be­ing made up of eq­ui­ties, credit and com­modi­ties. The ma­jor­ity (59%) of OTC in­ter­est rate trans­ac­tions were es­ti­mated to be con­ducted in the in­ter­bank mar­ket.

“Vol­umes keep grow­ing, stim­u­lated by volatil­ity, rel­a­tively high in­ter­est rates and high par­tic­i­pa­tion of off­shore deal­ers and in­vestors,” the IMF says.

Where the TR func­tion is con­cerned, Ram­plin says trade re­port­ing is a “grudge pur­chase”. “The view of the mar­ket is that it will add more value to the reg­u­la­tors than the mar­ket and mar­ket par­tic­i­pants are re­luc­tant to pay for this ser­vice.”

Other than the JSE, al­ter­na­tives for a suit­able lo­cal CCP or TR are lim­ited.

The JSE is cur­rently the only li­censed ex­change in the coun­try and is ef­fec­tively a self-reg­u­la­tory mo­nop­oly which has swal­lowed for­mer com­peti­tors like the SA Fu­tures Ex­change (in 2001) and the Bond Ex­change (2009) over the years. Also, the FSB’s re­cent crack­down on OTC eq­uity trad­ing plat­forms, forc­ing some to close down or mi­grate to the JSE, has left po­ten­tial can­di­dates with lit­tle faith in the process.

But some prospec­tive can­di­dates have ac­cepted the chal­lenge. Ear­lier this month, the FSB called for public com­ment on an ap­pli­ca­tion by a com­pany called ZAR X for an ex­change li­cence. This is the first time that such an ap­pli­ca­tion has reached the public com­ment state.

Ear­lier this year, Bravura, a fi­nan­cial ser­vices group which fo­cuses on cor­po­rate fi­nance, aimed to fill the gap left by OTC eq­uity trad­ing.

In 2012, Quote Africa Group, led by for­mer Bond Ex­change ex­ec­u­tives, ap­plied for a li­cence from the FSB for a planned ex­change that would spe­cialise in de­riv­a­tives. De­spite much ef­fort, the ap­pli­ca­tion seems to have stalled. Quote Africa cur­rently has li­cences for Namibia and the Sey­chelles.

Another con­tender, 4 Africa Ex­change, which is be­ing set up by a con­sor­tium in­clud­ing Bravura and agri­cul­tural busi­ness NWK, an­nounced that it had also sub­mit­ted an ap­pli­ca­tion to the FSB ear­lier this month for an op­er­at­ing li­cence.

But while the bat­tle of the bourses con­tin­ues, banks have al­ready had to ab­sorb costs re­lated to the re­quired re­form.

In­dus­try play­ers agree that re­forms will in­crease trans­parency to the reg­u­la­tor and the mar­ket, and re­duce risk for mar­ket par­tic­i­pants, but will put huge pres­sure on lo­cal fi­nan­cial in­sti­tu­tions’ mar­gins.

A Deloitte UK re­port on OTC de­riv­a­tives states that the main costs to be in­curred by traders in fu­ture in­clude new mar­gin re­quire­ments and cap­i­tal charges for ex­po­sures, and gen­eral com­pli­ance costs re­sult­ing from ex­tra re­port­ing re­quire­ments.

Though no num­bers are avail­able for SA, Deloitte es­ti­mates that re­forms in the EU will add an an­nual cost of €15,5bn for the OTC de­riv­a­tives mar­ket, with the clear­ing obli­ga­tion around €2,5bn and cap­i­tal costs linked to bi­lat­eral ar­range­ments at €13bn an­nu­ally.

Deloitte pre­dicts that cost in­creases will lead dealer banks to re­view the prod­ucts they of­fer and pos­si­bly with­draw from cer­tain as­set classes which are deemed to be too costly, or look to in­crease of­fer­ings for as­set classes where client de­mand is ex­pected to be greater.

“This will lead to a shift in the prod­uct mix of­fered by dealer banks and, as a re­sult, us­age across the mar­ket,” the re­port states.

Cost im­pli­ca­tions are not lim­ited to banks. Large buy-side cus­tomers such as unit trusts, pen­sion funds, hedge funds and in­sur­ance com­pa­nies, as well as lo­cal paras­tatals like Eskom and Transnet that use OTC de­riv­a­tives for hedg­ing pur­poses, will also be af­fected.

“The in­creased costs could move some end-users to­wards less pre­cise hedges by us­ing stan­dard­ised cleared OTC de­riv­a­tives in place of a more be­spoke (and ex­pen­sive) de­riv­a­tives, leav­ing them with more risk on their own bal­ance sheet,” Deloitte states.

Pic­ture: THINKSTOCK

Pic­ture: THINKSTOCK

Leila Fourie … We can only move for­ward if there is broad-based sup­port by lo­cal par­tic­i­pants.

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