On 16 December 2009, the Treasury and the FSA published a joint paper which was entitled Reforming OTC Derivative Markets - A UK perspective.
In this paper the Treasury and the FSA (the Authorities) set out a number of proposals to address systemic shortcomings in OTC derivative markets:
- Greater standardisation of OTC derivative contracts. The FSA believes that increased standardisation is central to the delivery of many of the regulatory proposals. It argues that greater standardisation of economic and contract terms will reduce operational risk and facilitate the adoption of uniform post trade processes, including clearing. The FSA also believes that increased standardisation may contribute to the increased trading of derivatives on organised trading platforms and more meaningful use of trade information by providing greater comparability between products. The FSA will work with international regulators to take steps to identify and agree which products can be further standardised, both in terms of underlying contract terms and operational processes, and ensure that this is implemented on a timely basis. The FSA also states that where suitable levels of standardisation already exist, it will require industry to commit to challenging targets for post-trade processes in order to achieve the objective of trade data straight-through processing for the majority of such trades.
- More robust counterparty risk management. All OTC derivative trades, whether or not centrally cleared, should be subject to robust arrangements to mitigate counterparty risk. For all financial firms this should be through the use of central counterparty (CCP) clearing for clearing eligible products. For trades that are not centrally cleared these should be subject to robust bilateral collateralisation arrangements and appropriate risk capital requirements. In September 2009 the G20 called for all standardised OTC derivative contracts to be cleared through central counterparties by the end of 2012 at the latest. The Authorities strongly support the greater use of CCP clearing arrangements in OTC derivative markets for products which are 'clearing-eligible'. The Authorities also support the setting of challenging interim targets for industry to meet ahead of the 2012 deadline. To achieve an internationally agreed definition of the products that are eligible for clearing by a CCP, the FSA will push for the establishment of an international working group comprising of regulators and industry.
- Consistent and high global standards for CCPs. In Europe, the UK has been leading calls for a Clearing Directive and will press to ensure that this is an effective tool in mitigating any risk that CCPs will pose to the financial system. The Authorities argue that the regulation of CCPs should be reinforced by a robust regulatory framework with home state regulators retaining authority for the authorisation and on-going supervision of CCPs. They also argue for strengthened global prudential and operational standards for CCPs and these should be reflected in any European legislation.
- Capital charges to reflect appropriately the risks posed to the financial system. The Authorities support higher capital charges for non-cleared counterparty risk. The Authorities would like to see risk-proportionate capital charges being applied to bilateral counterparty exposures in order to motivate firms to adopt identified best practices associated with bilateral collaterisation arrangements.
- Registration of all relevant OTC derivative trades in a trade repository. The Authorities are working through the OTC Derivative Regulators Forum to deliver this across a number of asset classes. The Authorities support the view that trade repositories should be subject to regulatory requirements. However, given their global context the Authorities do not consider it appropriate for the European Securities and Markets Authority to have authorisation and supervisory powers over them. The Authorities believe that whilst trade repositories will require some regulatory framework this should be at a reasonably high level which would not require a European regulator. The CPSS-IOSCO Working Group and the Committee of European Securities Regulators have established work streams aimed at defining a broad set of requirements for trade data repositories. The Authorities anticipate that the work in these forums will be finalised in the first half of 2010.
- Greater transparency of OTC trades to the market. Consideration should be given to using existing reporting channels to minimise costs. In the UK, OTC securities derivatives, where the underlying instruments are admitted to trading on a regulated or prescribed market, are subject to the FSA transaction reporting regime. The Authorities support the extension of transaction reports of OTC securities derivatives by Member States that do not currently collect this information. The Authorities also call for further work to assess whether there is a significant risk of abuse occurring in OTC non-securities derivative markets either from transaction reports or from a trade repository. The Authorities also call for further work on pre-trade transparency and on the Commission to conduct a thorough analysis before designing a legislative framework.
- On-exchange trading. Once the above steps have been taken the Authorities do not see at this stage the need for mandating the trading of standardised derivatives on organised trading platforms. The Authorities urge legislators to approach this regulatory tool with caution and due regard to the market impact it may have.