Authorities in Singapore, Hong Kong and Australia all announced earlier this month that the highly-anticipated regulatory changes for derivatives traded over-the-counter (OTC) will take place in a phased-in fashion starting from March 1, 2017.
The new rules will require dealers post and collect collateral on non-cleared OTC derivatives trading. These 'margin' rules will make it compulsory for financial institutions to exchange variation margin (VM), a form of collateral, on their non-cleared derivatives from March 1 and to phase in the posting of initial margin (IM) based upon a threshold notional outstanding number that reduces annually, according to Keith Noyes (pictured), Asia Pacific regional director at the International Swaps and Derivatives Association (Isda). Assets used to meet IM and VM requirements should be high quality and highly liquid, and should be able to hold their value in times of financial stress after accounting for an appropriate haircut.
"This will affect all derivatives users across the region as this new regulation will make variation margin posting compulsory for all entities under the scope of the rules, unless those entities are able to claim end-user hedging exemptions," Noyes explained, noting that regulators will be phasing in the new requirements with a six-month implementation period. The exchange of VM is an important risk discipline practice, while IM is designed to reduce systemic risk, he said.
Notably, OTC structured products would be covered by the margining requirements, Noyes pointed out, adding that "the analysis is more complicated for those structured products embedded in a note or a fund".
"Apac structured products frequently have OTC derivatives embedded in them. If that OTC derivative were cleared then it would not be subject to the new margin rules, although it is worth noting that structured products, due to their bespoke nature, are not usually cleared," he said. "It is also conceivable to embed a listed derivative in the structure, but the listed derivatives would not be subject to the OTC margin rules."
This is the final element of the G-20 reforms, part of a global initiative to make transactions in the OTC derivatives market safer and it brings an "unprecedented" change to the derivatives trading practices, Noyes argued.
A Hong Kong Monetary Authority (HKMA) spokesperson said that structured products, including the popular accumulators/decumulators, "would likely be subject to the standards if they fall under the definition of an OTC derivative product defined in section 1B, Part 1 of Schedule 1 of the Securities and Futures Ordinance".
"The March 1 'big bang' implementation will affect thousands of financial entities across the region. They would need to rewrite thousands of collateral documents at once - and it's likely to stretch the resources of the industry to absolute limit," Noyes said. "Unless they make these changes, they won't be able to trade/hedge. It's a big challenge, and firms might struggle to make the necessary modifications unless they start work now."
Nicole Tan of UBS' equity derivatives sales team in Singapore agreed that "implementation is likely to be both time consuming and challenging".
"Those who can implement quickly have the potential to capture a disproportionate market share as the rest play catch up," Tan said, adding that the regulation will have an impact on the structured products market, as issuers widely use various vanilla OTC products for hedging / payoff construction purposes.
Tan noted that political uncertainty regarding Brexit, the election of Donald Trump and impending European elections have all affected investor sentiment in the region, and the upcoming OTC rules and IRS 871(m) regulation will prove additionally challenging.
The new rules come in the wake of the financial crisis, as the G20 leaders agreed to adopt a series of reforms designed to reduce risk in derivatives markets, ranging from greater reporting, to the adoption of central clearing as well as promotion of electronic trading.
Singapore's Monetary Authority (Mas) on Friday published a staff paper on the potential benefits of introducing a trading mandate on OTC derivatives. The authority outlined greater pre-trade transparency, liquidity pooling onto centralised trading platforms and fairer trading practices as the primary benefits of platform trading of OTC derivatives. The Mas noted that the upcoming reporting, clearing mandates and margin requirement are a priority for the immediate future, and added that post-trade dissemination of OTC trades might be a feasible interim solution, before any eventual transition to platform trading.
Click here to see the full "Liquidity and policy analyses for platform trading of OTC derivatives: A perspective of smaller markets" paper.
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