Regulators identify weaknesses in OTC derivatives markets

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The over-the-counter derivatives market was criticised by two senior regulators at the International Swaps and Derivatives Association's annual general meeting in Beijing last month, with both identifying weaknesses they claim contributed to the financial crisis and which still need to be addressed.

Theo Lubke, senior vice-president at the Federal Reserve Bank of New York, identified six main problem areas in the OTC derivatives market. Meanwhile, Liu Mingkang, chairman of the China Banking Regulatory Commission, zeroed in on inconsistent regulations across jurisdictions and the overreliance on self-regulation by markets.

While praising the derivatives industry for the strides it has made in improving operations infrastructure, Lubke said there is still an overreliance on manual processes. Another area of concern for regulators, he added, was what he referred to as "structural design weaknesses in how counterparty credit risk is managed".

Citing the exits from the market of two major dealers in 2008 - Bear Stearns and Lehman Brothers - Lubke noted there were strong incentives for non-dealer counterparties to move trades away from the banks as their condition deteriorated. "In the week or two run-ups to both those situations, we saw a tremendous outflow of liquidity from each bank. Their buy-side counterparties didn't want to lose their initial margin if there was a bankruptcy proceeding, or at least have their initial margin be caught up in that process. This structural flaw helped contribute to the run on both banks," said Lubke.

Meanwhile, he warned the OTC derivatives market can allow for excessive risk-taking on a bilateral basis, citing troubled US insurance giant American International Group as an example. Lubke also said "there is opacity in the OTC market that doesn't have commensurate public policy benefits". Consequently, he urged the industry to improve transparency, particularly on the pricing of transactions and the volumes traded on any one position.

Although he did not regard the use of credit default swaps as a primary cause in the growth of structured credit instruments such as collateralised debt obligations of asset-backed securities, Lubke did believe it was "a factor in helping facilitate the excessive speculation in the US real estate market".

Last, and perhaps most damningly, Lubke said: "It is simply unacceptable in today's environment that the design and structure of the OTC derivatives market can be controlled by a handful of large dealers. This is not something that can continue. If this market is going to see its maturation into something that works for the benefit of the financial markets and participants as a whole, the arrangements of decision-making over key design elements need to be done in a more transparent manner. That includes a broader range of market participants being involved in the process."

However, while asserting that exchanges provide more transparency and clear operational performance standards, he said it "would not be the most prudent public policy to push everything on to exchanges". Lubke acknowledged there was still value in the OTC market in terms of creating customised products and allowing for innovation, which is much harder to achieve in an exchange-traded environment.

Liu, meanwhile, criticised both the practice of self-regulation and the incentive structure in the financial sector. "There is still an overreliance on self-regulation and not enough prudential regulation," he remarked. "Regulators and financial regulators need to change their mindset - it would be a big mistake to simply allow extreme freedoms for markets as it often leads to careless behaviour.

"Furthermore, many financial institutions only took responsibility up until the sale of a product and shed responsibility after the sale: they did not take their fiduciary duty seriously because of the sector's incentive mechanisms," he added.

Liu also argued capital adequacy rules need to be reworked, joining the chorus of calls for risk-based measures of capital to be supplemented with leverage ratios (see pages 57-59). "Highly leveraged vehicles have been used excessively, with companies using liabilities to speculate on their operations. As a result, capital adequacy ratios became ineffective. There need to be limits on and supervision of leverage," he said.

Throughout the two-day event, market participants urged greater consistency and co-ordination among regulators, claiming regulatory and legal certainty is vital for stable markets. Lubke and Liu shared the same concerns.

Any efforts to address industry problems need to be based on collective responses by regulators and market participants, Lubke remarked. "There is a real collective action problem, not just among market participants, but also among regulators. As a regulator, you don't want to be out in front putting in place additional costs and restrictions within your jurisdiction if market participants can simply move somewhere else to trade."

Liu took the debate a stage further, arguing there are significant impediments to globalisation. "We have seen a lack of co-operation on regulation and a lack of a consistent regulatory framework. Even though we are operating in a globalised market, you have different rules in different countries. If you have large cross-border activities but no common solutions, how can we embrace globalisation?" he questioned.

Rob Davies.

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