Swap execution facilities divide OTC derivatives market, Asia still bystander

US and European regulations that aim to make over-the-counter (OTC) derivatives market safer have fragmented  market liquidity and driven up cost for end users, industry associations report. Meanwhile, Asia is concerned about the regulation’s timing.

 

According to a report by the International Swaps and Derivatives Association (ISDA) published January 21, trading between US persons and non-US persons have declined significantly since swap execution facilities (SEFs) began operating in October of last year and confusion over which entities should register as such emerged in December.

 

Looking only at the world’s two largest markets for derivatives, the research indicates volumes of cleared Euro-denominated interest rate swaps (IRS) between European and US dealers has dropped 77% since October 2013. This suggests “a breakdown of cross-border trading relationships”, the report’s authors note, and threatens to eliminate advantages of global OTC markets – liquidity, orderly trading and a diversified range of counterparties. Separate liquidity pools have caused prices to differ for similar products.

 

No empirical research has been done to examine how Asian-domiciled derivatives dealers have reacted to Dodd-Frank implementation. Anecdotal evidence suggests fragmentation is occurring in Asian markets as well, since Asian firms do not want to get caught up in US rules, a speaker for the ISDA writes in an e-mail.

 

Mark Austen, CEO of Hong Kong-based Asia Securities Industry & Financial Markets Association (Asifma), says Asian market makers are still trying to get to grips with Dodd-Frank and Emir (European Market Infrastructure Regulation) and for that reason are reducing their interaction with US and European dealers.

 

“The derivatives markets – across instruments – are tiny in the region in comparison to the West, particularly outside Japan,” he adds via phone. “Anything that fragments those markets has a big impact on the overall liquidity. Our big concern is that these sets of regulation are solutions put in place for problems that are faced in the West but have unintended consequences on Asia.”

 

“Markets here suffer and their development is hindered because the US and Europe are solving problems that are really their own doing,” he offers.

 

One contentious issue for dealers in and outside of the US is footnote 88 in the U.S. Commodity Futures Trading Commission’s guidebook to trade execution under Dodd-Frank. It suggests that any dealers trading derivatives under the oversight of the CFTC with a U.S. person will need to register as a swap execution facility with the Commission.

 

One director of a Southeast Asian bank in charge of US-dollar derivatives clearing tells The Asset: “So far, we have not stopped dealing with US counterparties for clearing of USD derivatives and we have not felt an impact on market liquidity. However, we are aware that additional documentation is coming our way.”

 

An Australia-based end user adds he has “not noticed any drop in liquidity for small ticket transactions of up to US$50 million.”

 

Bad timing

 

For Asian market participants, harmonization between US, European and intra-regional regulations as they relate to G20 commitments is a key concern. In an e-mail, a spokesperson of the Hong Kong Monetary Authority notes that regionally, this concern is discussed frequently in form of the Executives’ Meeting of East Asia-Pacific Central Banks (EMEAP), which meets once a year at the executives’ level and twice yearly at the deputies’ level.

 

More so, the spokesperson adds, “given that dealer banks from US and Europe play a critical role in Asian markets, discussion on OTC derivatives regulation has been focusing on the cross-border implication of regulations from the US and EU.”

 

Austen urges Asian regulators to speak with one voice in discussions with their US and European counterparts in order to unlock greater leverage in the political process. As evidence that such a common voice is indeed forming, he cites an open letter by the Asia Pacific Regional Committee of IOSCO, sent to the European Commission in December. It urges European authorities to take local market conditions into account when considering whether Asian CCPs qualify as equivalents of those in Europe.  It is signed by the Committee’s Chairman Ashley Alder, who also heads Hong Kong’s Securities and Futures Commission (SFC).

 

On a regional level, Asian regulators begun reviewing whether “it really makes sense to create a CCP in every marketplace, operate a separate trading platform and put in place that kind of expensive infrastructure [in view of] the size of the derivatives markets here,” Austen points out.

 

“When markets haven’t matured fully, this is to certain extent going to kill them off before they even develop. Hence, I would expect a more regionally coordinated response to G20 implementation going forward.”

 

Another development makes market fragmentation even more alarming, adds Austen. “Fragmented liquidity translates into higher prices, ultimately borne by the end customers of these products,” he expounds in view of local corporates and financial institutions seeking to mitigate foreign exchange and interest rate risk. “When there’s greater volatility due to the tapering and other concerns in emerging markets, this is adding fuel to the fire.”

 

Patchy regulatory framework

 

The regulatory environment in Asia surrounding mandatory clearing of OTC derivative instruments is a patchwork so far. The International Swaps and Derivatives Association (ISDA) provided an update in its October 2013 Asia-Pacific Regulatory Profiles.

 

In India, the Foreign Exchange Dealers' Association (FEDAI) has issued circulars requiring its members to clear their eligible USD-INR FX forward contracts through local Clearing Corporation of India (CCIL), but has postponed deadlines indefinitely.

 

Korean authorities so far have only outlined mandatory clearing for Korean won interest rate swaps, scheduled to start June 30, 2014. Clearing there is believed to be limited to the local KRX central counterparty.

 

In Japan, the clearing mandate covers certain credit default swaps and yen-denominated interest rate swaps only. Countries such as Malaysia and Taiwan have yet to issue any proposals relating to mandatory clearing of OTC derivative instruments.

 

China, Hong Kong and Singapore have begun to centrally clear various instruments, each on different CCPs.