Regulation and Supervision of the OTC Derivatives Market

Ligia Catherine Arias-Barrera

• Publisher: Routledge
• Year: 2018
• ISBN:
  9781351797719
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

The over-the-counter (OTC) derivatives market has captured the attention of regulators after the Global Financial Crisis due to the risk it poses to financial stability. Under the post-crisis regulatory reform the concentration of business, and risks, among a few major players is changed by the concentration of a large portion of transactions in the new market infrastructures, the Central Counterparties (CCPs).

This book, for the first time, analyses the regulatory response of the United Kingdom and the United States, the two largest centres of OTC derivatives transactions, and highlights their shortcomings. The book uses a normative risk-based approach to regulation as a methodological lens to analyse the UK regime of CCPs in the OTC derivatives market. It specifically focuses on prudential supervision and conduct of business rules governing OTC derivatives transactions and the move towards enhancing the use of central clearing. The resulting analysis, from a normative risk based approach, suggests that the UK regime for CCPs does not fulfil what would be expected if a coherent risk based approach was taken.

Our comments on the Dodd-Frank Act highlight that the incoherent adoption of risk-based approach to regulation affects the effectiveness of the US regime for CCPs. Such a regime does not follow the pace of events of 'innovation risk'; in particular, the foreseeable changes FinTech will bring to the OTCDM and central clearing services. The second inadequacy of the US regime concerns the dual regulatory structure of the CFTC and the SEC, and the inadequate adoption of different and not well-coordinated regulatory strategies. We also analyse the cross-border implications of the US regime for non-US CCPs that provide clearing services to US market participants. Finally, we study the negative effects of the absence of a clearly defined resolution regime for CCPs.

1 Introduction

1.1 The chapters in outline

Following the global financial crisis (GFC), regulators are committed to reduce the likelihood and severity of future crisis. In the area of financial derivatives, regulation is focused on increasing transparency, strengthening market infrastructure, and reducing systemic risk – these post-crisis regulatory reforms frame the research and discussion of this book. Our focus is the major transformation of regulation and supervision of the over-the-counter derivatives market (OTCDM) in the UK and the US, and the consequent move towards the regulation of Central Counterparties (CCPs) as new intermediaries of the market. This is a foundational discussion, revealing that the current UK and US regimes for CCPs are insufficient for a coherent risk-based approach, and highlighting, for the first time, the shortcomings of the UK and the US regimes of CCPs in the OTCDM. Our central hypothesis is that the design and implementation of a coherent risk-based regime would allow regulators to use the approach as the ‘route-map’ of the regulation and supervision of CCPs. To achieve coherence, a risk-based regime must integrate the perceptions and attitudes of regulators and firms related to the risks manufactured in the OTCDM, and also how they should be managed and controlled. We use a normative risk-based approach to regulation as a methodological lens to analyse the regime, and specifically focus on prudential supervision and the conduct of business rules governing CCPs in the OTCDM.

This work is based, principally, on primary sources of information, and it performs an empirical analysis of the UK and the US regimes of CCPs in the OTCDM. In order to better understand the operation of OTCDM CCPs in the UK regime, the research draws from different empirical sources, including interviews with regulators at the Bank of England (the Bank) and the Financial Conduct Authority (FCA), discussions with officials of international standard-setting bodies such as the International Organization of Securities Commission (IOSCO), interviews with members of CCPs recognised and authorised in the UK, as well as a review of the literature on OTCDM reform and functioning of CCPs. This book is a unique contribution to the field, integrating a legal analysis of the regime of CCPs with sociological perspectives of risk and its role in ‘manufactured risk’ markets, such as in the OTCDM. We also include broad-policy considerations, like financial stability, to analyse why prudential and conduct of business supervision is necessary. The main contribution of this study is to highlight, from a theoretical perspective, the risk-based shortcomings affecting the regulation and supervision of CCPs in the OTCDM.

The Bank’s work, ensuring the safety and soundness of CCPs – and, thereby, the stability of the OTCDM – is currently incomplete. During the first four years of the regime, the Bank set out some key supervisory pillars, anticipating that ‘its supervisory effort is based on its assessment of where risks to financial stability are greatest’.¹ This supervision is based on systemic risk management and has been focused on the areas of management of credit, liquidity, and operational risk, continuity of service, and adequate rules in the case of clearing members’ default. In this context, this book identifies areas that have been overlooked by regulators.

Our findings exemplify the shortcomings of the UK and the US regimes of CCPs in the OTCDM. In the UK regime, these shortcomings are undermining the success of the regulatory objectives in enhancing market stability. Current inadequacies include the absence of a coherent conduct of business regime of CCPs, the insufficient legal framework underpinning CCPs’ operations, the lack of a special resolution regime (SRR) for CCPs, and the failure to rule on ‘innovation risk’.

The regulator’s objective is to enhance the stability of the OTCDM by ensuring the safety and soundness of CCPs. We identify that the US regime for CCPs in the OTCDM has some shortcomings that hinder the achievement of those objectives. The regime fails to be responsive to the impact that future innovations might have in the derivatives market and central clearing services. Also, the dual regulatory structure affects the efficient supervision of CCPs, undertaken by the CFTC and the Securities and Exchange Commission (SEC). Finally, the cross-border implementation of the US regime exacerbates issues related to CCPs’ mutual recognition, and the concerns triggered by the rules governing segregation of assets. In assessing these shortcomings, we will use the risk-based approach as the methodological lens to explain how this regulation strategy can contribute to solving them.

In Chapter 2 we explore the risk-based approach to regulation and provide a framework to analyse the UK regime OTCDM for CCPs. Here we highlight the role that risk has in society and in regulation, emphasising the responsibility financial regulators have to recognise that risks and uncertainties, although at different levels, should inform the regulatory process. Cooperation between regulators and regulated firms is important, not just for information sharing, but the integration between different perspectives of risks in the design and implementation of the regime. Following this line of thought, this chapter provides us with grounds to argue that the OTCDM is a centre of manufactured risks. We analyse how the functioning of the market, the role of CCPs, and the regime are all continuously manufacturing risks, and then consider the core elements, limits, and shortcomings of risk-based regimes, exploring the UK model of risk-based approach to OTCDM regulation and supervision.

Chapter 3 explores the approach of the UK regime of CCPs in the OTCDM and the first of its shortcomings, using risk-based regulation as a method for our assessment. The two main pillars of prudential supervision and conduct of business are examined, focusing initially on identifying the motivations to implementing CCPs in the OTCDM, and the Bank’s regulatory priorities in the first years of implementation of the regime, which are guided by the CPMI-IOSCO Principles for Financial Market Infrastructures. The resulting analysis suggests that the UK regime is affected by two drawbacks of risk-based regimes; namely the absence of an organisational culture in implementing risk-based regulation and how the use of risk-based regulation is creating ‘manufactured risks’. Thus, there are some shortcomings that UK regulators should address.

The first weakness is the absence of a conduct of business regime for CCPs; the limited role of the existing rules of conduct of business reveals the need of a coherent regime applicable to CCPs in the OTCDM. This failure goes beyond the lack of design of the regime; it also affects the exercise of enforcement powers. Under the current regime, it is not clear whether the Bank or the FCA could sanction a CCP for the breach of a conduct of business rule.

Adopting a risk-based approach to regulation is useful when regulating systemically important financial institutions (SIFIs), as is the case of CCPs in the OTCDM. However, it is in the nature of a risk-based approach that regulators deliberately overlook certain risks when designing regimes. The attention of the Bank has been focused on managing credit, liquidity, and operational risks faced by CCPs. The result of this prioritisation of risks and their related supervisory actions is that the Bank has abandoned other areas central to the regulation of CCPs. Following this analysis, Chapter 4 explores two more shortcomings; namely the insufficient legal framework underpinning CCPs’ operations and the absence of a special resolution regime (SRR) for CCPs. Regarding the insufficient legal framework underpinning CCPs’ operations, we expose the issues arising from the contractual relationship between CCPs and their CMs. In particular, we examine how regulators in the UK have conferred a high level of discretion on CCPs related to the performance of their obligations, which in turn diminishes clearing members’ and their clients’ rights. In order to rebalance the relationship between CCPs and their members, a duty of care predicable of CCPs should be considered.

It might be anticipated that the Bank’s focus on ensuring the safety and soundness of CCPs has resulted in a complete regime. However, the Bank’s work has been centred exclusively on strengthening loss-allocation and recovery rules for CCPs. Although the remarkable progress concerning the recovery regime is a plausible advance to ensure CCPs’ resilience, there is no special regime for the resolution of CCPs. The resolution regime currently applicable to the UK’s CCPs is contained in the Banking Act 2009, originally designed for banks, and some aspects of such resolution framework are not suitable for CCPs. Following the benchmark set out in the Financial Stability Board’s Key Attributes of Effective Resolution Regimes guide, we explore the reasons for adopting special rules for the resolution of CCPs, as well as emphasise the potential issues that regulators might face when designing and implementing the regime.

In Chapter 5 we highlight how the UK regime of CCPs in the OTCDM is not considering the ‘innovation risk’. In a market that exists and evolves by means of innovation, regulators should be aware of the risk it poses to the achievement of their regulatory objectives. Innovation risk can take different forms and might challenge regulators in several ways. In our discussion concerning the role of risk, uncertainties, and manufactured risks, we illustrate the rationale of innovation and how it affects the effectiveness of the regime. We also emphasise the importance of a coordinated approach between regulators and CCPs; in particular, how the innovative or creative compliance of the regime might frustrate the expected outcomes. We refer to the risk that CCPs, in order to remain competitive, might design and offer alternative products to their clients; products that will escape the mandatory clearing requirement. This situation reveals the potential conflict of interests and the position of influence that CMs may have in front of the governance of the CCPs. As the issues posed by financial innovation are different from each other, so are the potential solutions. We explore the suitability of governance rules to solve, at least partially, the issues related to the conflicting interests that converge within the CCP. This chapter also explains how creative compliance is likely to lead to some of the unintended consequences of the CCP regime as well as refers to the potential dangers coming from the innovative financial techniques OTCDM participants will use to meet the high-quality collateral requirements of CCPs and the novel uses of portfolio compression.

Attending to the importance of the US in the OTCDM and in the developments ...