Making the Trading of Derivatives Safer
Opening Address by Mr Lee Chuan Teck Assistant Managing Director, Monetary Authority of Singapore at the 8th Annual FIA Asia Derivatives Conference at St. Regis Singapore
1 Good morning to all our distinguished guests. And to all our overseas visitors, a very warm welcome to Singapore.
OTC Derivative Reforms: A Half-time Reflection
2 Let me start off by thanking Walter for his kind introduction and for inviting me to address this conference. We are gathered here today at the 8th Annual FIA Asia Conference at an interesting time. After more than three years of industry consultations, quantitative impact studies, legislative changes and regulatory drafting, we are finally at the cusp of seeing the first fruits of global OTC derivatives regulatory reforms. Japan is ahead of everyone else. They have already started this month in mandating the clearing of YEN IRS and CDS trades between domestic dealers. I understand the CFTC will be announcing the first list of products for mandatory clearing very soon, possibly as early as tonight. The rules will start to take effect early next year. The EU, Australia, Hong Kong and Singapore will follow soon after. Other countries are also starting to put in place their regulatory framework for OTC derivatives. In a few years from now, the face of global derivatives trading will have changed irrevocably.
3 In a sense, we are at the half-way point of a long journey; this is a good time to reflect on where we are heading towards and also to remind ourselves what challenges lie ahead. The destination is clear. As stated in the G20 Communiqué of 2009, it is a world where (I quote) “all standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties...All OTC derivative contracts should be reported to trade repositories, and non-centrally cleared contracts subjected to higher capital requirements”. Of course, G20 also said we should do all these by 2012. But even if you allow for some time leakage, this is a commendable goal. These changes will make the system a lot more stable and transparent. If it had been in place before 2008, the sub-prime crisis will likely still have occurred, but it will arguably be a lot more contained.
4 The Lehman episode provides a good illustration of how useful a reporting and clearing regime could be. Lehman Brothers was a counterparty to or a guarantor of over 930,000 OTC derivative contracts. If the transactions had been captured in a trade repository, the extent of exposure to Lehman can be quickly clarified and the inter-bank market might not have seized up in the weeks after Sep 15. In addition, most of Lehman’s contracts that were centrally cleared could be resolved quickly, without large systemic disruptions. LCH Clearnet was able to resolve Lehman’s $9 trillion book of cleared interest rate swaps, using just 35% of its initial margin1.
Challenges for Asia
5 Even though Asia was less affected by the crisis, the lessons were not lost on us. Asian regulators do believe in the merits of a well-regulated OTC derivatives market. Asian markets, as Walter pointed out, are very small in comparison to US and European ones. Take the IRS market for instance. Asia makes up only about 8% of global turnover. Japan accounts for 3.5%, so the rest of Asia – which includes Australia, Hong Kong, Singapore, and of course, the two giants, China and India – account for only 4.5%. In one sense, because our markets are nascent, we have an opportunity to develop and shape them on the right footing. In another sense, however, precisely because our markets are very small and less developed, we also face some peculiar challenges. I’ll highlight three.
6 The first challenge is to ensure that the regulatory changes themselves do not overwhelm the market so that it ceases to function effectively. One can think of several ways how this can happen. For example, if we move all trading onto platforms before there is sufficient depth, liquidity could be seriously impaired. Or if we impose overly onerous requirements on un-cleared trades and transactions before clearing facilities are available, derivatives may become so prohibitively expensive that end-users like fund managers, banks and corporates may choose to leave their risks unmanaged. This is certainly not the intention of the reforms, as regulators do recognise that OTC derivatives will continue to exist and play an important role in risk management.
7 Regulators in less developed markets have to be especially careful in how they implement the reforms. In Singapore, we have been fairly deliberate in the pace of our implementation. We have chosen to start with the deepest products, in our case, interest rate and FX contracts. We can then study the effects on these contracts before extending the requirements to other less liquid products. I should add that even in interest rate and FX contracts, we are proposing to start with reporting and clearing. The viability of a trading mandate remains unclear. We continue to actively engage the industry to better understand the costs and benefits of mandating trading on exchanges or electronic platforms. When we do decide to move, it may be in phases, perhaps starting with RFQ models as well as some post-trade transparency. In other words, we believe that we should move in small steps rather than take a big bang approach.
8 The second challenge is that our market infrastructure – trading repositories, central counterparties, trading platforms etc - remains relatively undeveloped. This means that often times, in addition to drawing up new regulations, regulators in Asia have to work with the industry to develop the right architecture to support the regulations.
9 In Singapore, we realized shortly after the Pittsburgh communiqué that we cannot impose clearing requirements if there are no CCPs dealing with Asian products that most Asian institutions have ready access to. So MAS started working with SGX to expand its AsiaClear functions to financial derivatives. In other words, we started to build, before we started to legislate. In 2010, SGX introduced clearing for interest rate swaps (IRS) denominated in Singapore and U.S. dollars. A year later, non-deliverable FX forwards (NDFs) in seven Asian currency pairs were added to the mix. Almost $300 billion of interest rate swaps (by notional value) have already been cleared at SGX. Similarly, on the trade repository front, we have worked with DTCC and other global trade repositories to set up here.
10 Now I should caution that there is now also the other risk of the opposite happening in Asia. Instead of there not being enough CCPs and TRs, there may be a case where there are too much, and too many. Many markets are developing their own central counterparties and trade repositories. Some of these may be too small to be commercially viable. To support their viability, regulators may be tempted to impose onshore reporting or clearing requirements. This may create substantial inefficiencies as market participants would need to report to multiple TRs and place margins in multiple CCPs.
11 The third challenge is cross-border differences. The nub of the issue is that while the OTC derivatives market is global in nature, regulators are local and set regulations according to local needs. To complicate matters, some regulators have strived for greater local consistency, by making their regulations extra-territorial. This has led to complications and confusions with respect to entities and transactions that span different regimes. A Singapore bank trading a Japanese YEN denominated derivative with a European bank, who also happens to be a US swap dealer, can be subjected to multiple requirements, some of which may be conflicting. If these issues are left unresolved, they could potentially weaken the effectiveness of reforms, fragment markets and lead to regulatory arbitrage. It can also increase the compliance burden on the industry and for regulators.
12 International regulators need to work more closely to ensure a more consistent global regulatory framework. The CFTC’s proposed cross-border guidance released in July this year was a timely first step as the US set out its thinking on this issue. In response, as Walter alluded to, the regulatory authorities in Australia, Hong Kong and Singapore shared our views.
13 In resolving extra-territorial issues, it is helpful if regulators can focus on achieving broadly similar regulatory outcomes, rather than identical regulations. Regulators will have to recognise that exact alignment of detailed rules may not be possible or even desirable, as market characteristics and legal regimes differ. However, what is important is that we all end up with broadly similar outcomes. For example, there has been a fair bit of debate over registration and substituted compliance versus recognition. Rather than focus on their differences, it may be equally meaningful to focus on their similarities. In this regard, for CCPs and clearing, this may not be as difficult as it seems, given that some CCPs are already offering services to and subjected to regulation in multiple jurisdictions.
12 Let me now briefly update the industry on the progress of Singapore’s derivative regulations and the roadmap ahead. This month, the Singapore Parliament passed amendments to the Securities and Futures Act, which laid the cornerstone for our regulatory changes. Broadly speaking, the amendments will (a) introduce a new licensing regime for trade repositories and amend the licensing regime for central counterparties and (b) allow MAS to mandate the reporting and clearing of derivative transactions. Let me elaborate on each of these two parts.
13 First, the regimes for TRs and CCPs. A few key considerations inform our drafting of regulations for TRs and CCPs. Most fundamentally, we believe that our regime must be in accordance with CPSS-IOSCO principles so that entities operating here will be recognized by other regimes and well-accepted by global market participants. Specifically for CCPs, we would need to consider segregation requirements for customers’ monies. The requirements aim to strengthen protection of margins for customers of non-defaulting members, and to facilitate portability of such positions in the event of a default. In line with the implementation of mandatory clearing, it is important to ensure that the level of protection of customer margins for cleared OTC derivatives is comparable to that for un-cleared OTC derivatives. MAS is considering an appropriate model for our local context, taking into consideration the costs and benefits.
14 In addition, we are also in discussions with both Singapore-based and overseas entities, on their plans to seek licensing and offer services to Singapore market participants. The response has been good. Our intention is that there should be enough good quality TRs and CCPs offering their services in Singapore for market participants to choose from. This will minimise market disruption, as participants can continue to clear and report their trades at infrastructures which they are familiar with.
15 Next, the reporting and clearing mandates. In the months ahead, we will be providing details on entities and transactions that will be exempted. At this stage, I can say that there are three things we will likely do (a) broaden our definition of hedging from the one used in the consultation. For some of you that are aware, we proposed an accounting definition in our consultation paper. (b) agree not to require back-loading and (c) exempt FX forwards and swaps. We are still considering other areas.
16 From 3Q2013, we will begin with our regime. We will likely start with implementing the reporting mandate first. With information from the TR in place, this will help us to better formulate the implementation of clearing and other mandates. As I noted before, we will focus on interest rate and FX products since these 2 categories make up 93% of our (Singapore’s OTC derivatives) market.
17 To conclude, allow me to move back to the global journey on OTC derivatives regulations. We are at the half-way point. In this second half, as rules begin to crystallize, and market infrastructure and practices start to set, it is all the more important that global regulators work with each other, and with the industry, to ensure that we all arrive at the destination that we envisaged.
18 There is a lot of work which needs to be done, but I am confident that we are heading in the right direction. I wish all of you a very fruitful conference.