Thursday, August 25, 2011

25/08/2011: BIS publishes a wish-list for global regulation of OTC derivativatives markets

The Committee on Payment and Settlement Systems and the Technical Committee of IOSCO released a report on over-the-counter (OTC) derivatives data that should be collected, stored and disseminated by trade repositories (TRs). The market for these instruments is current estimated at over $600 trillion. Details and report are available here.

Per BIS statement: "The committees support the view that TRs, by collecting such data centrally, would provide the authorities and the public with better and timely information. This would make markets more transparent, help to prevent market abuse, and promote financial stability."

I happen to agree with the above, subject to one core caveat: collecting data is not enough. It is imperative that data collected is organically integrated into analytical frameworks that actually have a meaningful connection to supervision. This, however, is hardly an easy (and low cost) measure to achieve.

The report implies:
  • minimum data reporting requirements and standardised formats
  • the methodology and mechanism for data aggregation on a global basis
  • these requirements and data formats will apply to both market participants reporting to TRs and to TRs reporting to the public and to regulators
  • new information currently not supported by TRs is also identified as being helpful in assessing systemic risk and financial stability, including: current exposure, netting and collateralisation details on bilateral portfolios of OTC transactions; current market values of individual open OTC derivatives transactions; information on collateral assets that are applied to OTC derivatives portfolios, including the valuation and disposition of these assets
Back in 2009, the G20 called for OTC derivatives to be centrally cleared and transactions reported to repositories by the end of 2012. In a number of cases, national markets regulators are already setting up such facilities, for example the Trade Information Warehouse for credit default swaps and the Equity Derivatives Reporting Repository, under the US DTCC.

The CPSS and the IOSCO latest call comes as the global authorities are trying to set international minimum standards to apply to derivatives markets from the end of 2012, when a global system of Legal Entity Identifiers (LEI tags) for individual transactions should come in place.

In addition, the authorities also want to develop a standardized international product classification system to provide better sorting of transactions and underlying data, with potential links to higher level risk analytics.

IOSCO previously published a discussion paper on the role of securities regulators with regard to systemic risk which:
  • Identifies transparency and disclosure as an important tool for dealing with systemic risk, including product transparency and financial sector stress tests. To meet these requirements, the authorities "would need aggregate data on, inter alia, (i) each entity's current gross exposure and exposure net of collateral (in order to assess both the absolute size of its exposures and its relative importance for the markets under consideration); (ii) each entity's current gross exposures and exposure net of collateral to each of its major counterparties (in order to quantify interconnectedness); and (iii) aggregate exposures of all counterparties in terms of specific asset classes, products, currencies, reference entities and underlying sectors." This data can help evaluate potential "knock-on effects of financial distress at any one institution and identify concentrations of risk among groups of closely related institutions".
  • Measuring counterparty exposure will require data regarding bilateral positions, market values of open positions, netting arrangements, collateralisation and disposition and valuation of collateral
  • Determining bilateral positions will require "data on the full set of open trades between a pair of counterparties and their economic characteristics, including all terms that are required to calculate and assign a value to a trade such as effective and termination dates, notional amounts, underlier reference data, counterparty information, coupon amounts and schedules, and other salient economic terms specific to individual types of transactions (e.g., restructuring clauses for credit default swap ("CDS") contracts and reference interest rates for interest rate swaps)"
  • Determining the effect of netting arrangements will require "data on the set or sets of positions whose gains and losses can be netted against one another in determining amounts owed to any counterparty".
It is, perhaps, revealing to read in the paper candid assessment of the two panels that current reporting infrastructure simply cannot cope with the data required for risk analysis (including higher level systemic risk analysis) in relation to the overall derivatives markets.

"Existing TRs, ...do not track and report market values of open positions with regular frequency. ...existing major TRs are organised along asset-class lines while counterparty risk is managed at the bilateral portfolio level. For example, in computing current exposure, gains in a counterparty's position in one derivative product may be netted against losses in another derivative product. ...TRs as currently implemented would be unable to provide a complete set of information for determining current exposures, and ...some data gaps would still remain. For example, gathering information about collateral and reliable market value for non-cleared OTC derivatives is a challenge. Similarly, it is challenging to create an effective system for capturing information on bilateral netting arrangements."

So on the net - the consultative process launched by today's announcement should be a very interesting one and I will be covering it here. In addition, myself and industry research co-author are working on a paper for the QJ of Central Banking which will touch on some of the issues relating to the above.

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