The proposed 2011 amendments to the Capital Markets and Services Act 2007 introduces the most significant changes to the financial regulation regime in Malaysia since the overhaul that was introduced by the 2007 Act itself. This article addresses a single aspect of those changes: the regulation of over-the-counter derivatives ("OTC Derivatives").
Derivatives are financial instruments that derive their value from an underlying instrument or commodity. In Malaysia, we have had derivatives exchanges since 1980, with the establishment of the Kuala Lumpur Commodities Exchange where crude palm oil futures contracts were traded.
Unlike exchange-traded derivatives, OTC derivatives are not traded on an exchange, but are rather negotiated between two parties, one typically an investment bank and the other a corporate, which has an economic utility to be addressed by the instrument. For example, a manufacturing company may have receivables in US Dollars but incurs costs in Ringgit. A declining US Dollar may prompt the company to hedge its risks against further decline.
Derivatives are therefore an important component in a modernised Western economy, because they permit risks to be hedged effectively. Nonetheless, there are ethical concerns regarding the trading of derivatives.
These arise from their very nature. Derivatives can have an element of leverage in them, with the result that the loss incurred by a party may well exceed the initial cost of investment, often by several times. Secondly, the obligations under a derivatives contract remain outstanding for the duration of a contract, which can extend to years. This means that, not only is a party exposed to the market risk of the underlying instrument, but it is also taking on the credit risk of the counterparty for the duration of the contract.
Wall Street has developed such esoteric instruments that few understand, apart from a handful of ex-Mathematics professors prowling the rarefied air of the top Wall Street investment banks. Recent events, such as the sub-prime crisis, have underlined that the lethal cocktail combination of derivatives, dubious sales practices, and investor ignorance can bring the real economy down to heel.
The move by the Securities Commission to regulate the OTC derivatives industry, therefore, is timely, and a natural reaction to implosion of Western markets arising from the sub-prime crisis.
The following paragraphs examine the current scheme of regulation of OTC derivatives, before considering the impact of the proposed 2011 amendments.
The current state of play
The CMSA does not currently regulate OTC derivatives, except to the extent that they may be securities, as defined under the CMSA. In essence, the expression "futures contract" under the CMSA currently only captures exchange-traded derivatives, due to the element of fungibility embedded in the definition of that term.
Whether or not a derivative is securities depends firstly on whether the underlying is itself securities. If it is not — for example if the underlying is a commodity — then the derivative is not securities. If the underlying instrument is securities, then it depends on whether the underlying instrument is physically deliverable under the terms of the derivatives contract. If the derivatives are cash-settled, then the derivatives are not securities, even if it references the price of securities as the underlying.
The practical effect of a derivative in any particular case being construed as "securities" is that any offer or making available of securities and any invitation to purchase or subscribe for securities will require the prior approval of the SC under Section 212 of the CMSA. In addition, any person who carries on a business of dealing in securities will attract the obligation to be licensed under the CMSA. The third pertinent regulatory consideration is the prospectus registration requirements under Section 232, and the obligation to lodge an information memorandum with the SC in the case where the investor or counterparty is a sophisticated or institutional investor.
The scheme of regulation for securities set out in the preceding paragraph relating to approval and disclosure requirements was intended to address more conventional offerings of securities, such as IPOs. OTC derivatives were certainly not within contemplation when these provisions were originally promulgated in the Securities Commission Act 1993. Nonetheless, due to the wide definition of securities, OTC derivatives (to the extent that they may be securities, as described above) are caught by, and sit uncomfortably within, the securities regulatory regime.
OTC derivatives are specifically negotiated contracts entered into by sophisticated participants. As such, many of the investor protection measures contained in the securities regime are inappropriate, and introduce a disproportionate cost of regulation.
The net effect of the existing securities regulation scheme on the OTC derivatives industry was that investment banks structured their derivative transactions so that there was no physical delivery of the underlying instrument, taking the activity outside the scheme of regulation of the CMSA.
It is noted, however, that where a derivatives transaction is structured as an investment product (rather than an OTC derivative), the instrument in question is deemed a "structured product" coming within the ambit of the SC's Guidelines on the Offerings of Structured Products. In such a case, the scheme of regulation is modified. For example, no specific approval of the SC is required where the party offering the structured product is a bank, on the basis that banks are highly regulated institutions and the structured products are specifically negotiated instruments entered into with sophisticated investors.
The Proposed Amendments
Under the amendments proposed under the 2011 Bill, a new definition of derivatives has been introduced, which will capture OTC derivatives as well as exchange-traded derivatives. More than just that, the lacuna that had previously existed in the definition of "securities" has now been closed, with the effect that all forms of derivatives will now be caught, whether cash-settled or physically deliverable, and whatever the underlying instrument. The only exception is the case of exchange rate derivatives (such as cross-currency swaps), presumably on the basis that this is an activity adequately regulated by Bank Negara under the Exchange Control Act 1953.
As a consequence, dealing in OTC derivatives will, with the coming into force of the 2011 amendments, attract the obligation to be licensed under the CMSA. It is unclear whether banks — the typical participants in OTC derivatives — will require a separate licence in the category of dealing in derivatives, or whether they will be exempt from licensing by virtue of being a "registered person" (essentially a category of intermediaries that are exempt from the licensing obligation because they are already adequately regulated under a separate scheme of regulation, such as the banking industry).
The aim of bringing OTC derivatives into the fold of the CMSA is clearly to manage the systemic risks posed by the trading in these instruments, which, when compared to traditional instruments, have an inherently higher risk profile due to the element of leverage and due to the fact that derivative transaction can remain outstanding for long periods, during which a participant may be exposed to not only the market risk of the underlying instrument but also to the credit risk of its counterparty.
In order to minimise the contagion effect of cascading failures of financial institutions in a financial crisis, it is important that the regulators have an understanding of how much risk is actually being borne by market participants. We have seen in the sub-prime crisis that banks under-reported their actual exposure to CDOs, in order to prevent a run on deposits.
To this end, the 2011 Bill proposes the introduction of a trade repository, to whom market participants must report their dealings in OTC derivatives. The function of the repository is to be a data bank containing all available information on OTC derivatives transactions in the Malaysian marketplace, in order to facilitate the timely and orderly transfers of positions in the event of a failure of a market participant or institution. The trade repository does not perform the functions of an exchange; for example, there will not be any price discovery, and all information reported to the repository will remain subject to a statutory duty of confidentiality. Nor will be repository perform the function of a central counterparty, as it is doubtful that the Malaysian OTC derivatives market will achieve sufficient scale for this to be viable proposition.
Powers of the SC
Allied with the establishment of the derivatives trade repository is the substantial expansion of the powers of the SC in regulating securities and derivatives transactions. It is necessary, in my view, to have broad ranging powers in circumstances where the systemic stability of markets is threatened, and this is addressed by the broad powers of the SC in the proposed Section 107H, which empowers the Commission to give directions to the trade repository.
These broad powers are limited to giving directions to the trade repository, and the CMSA will not provide the SC with overarching Danaharta-like powers to modify or cancel trades. This is generally a good thing, as market participants generally get jittery about powers of regulators to amend commercial terms of agreements, due to the reduced legal certainty. Malaysia, for example, is generally not viewed as a netting-friendly jurisdiction due to the powers contained in the Pengurusan Danaharta Nasional Berhad Act 1998. This has the effect of increasing the regulatory capital charge for derivatives transactions entered into with Malaysian counterparties. These costs are passed back to the Malaysian counterparties, with the result that it becomes more expensive for them to hedge their risks.
In addition to the power to give directions, an important addition is the power of the SC to inquire into dubious sales practices, whether or not such practices disclose any breach of securities laws. As our markets mature and the philosophy of regulation moves further along the disclosure-based continuum, more complex instruments will begin to be sold to less discerning investors, and the policing of adherence to suitability standards will become more critical. The SC should be lauded for taking a farsighted approach in anticipation of the proliferation of investment products with embedded derivative features. The crucial issue nonetheless remains ahead: the need to balance appropriate regulation against the freedom of, and innovation by, the markets.