Financial Mail - Investors Monthly
PLAYING CATCHUP
The internationally aligned rules for trading derivatives over the counter are late but looming in SA, writes Ruan Jooste
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.