The collapse of Lehman Brothers, the near collapse of Bear Stearns and AIG, and the numerous defaults of major players in the freight derivatives markets unearthed the dangers posed by unmitigated risks and an opaque market structure in OTC derivatives trading markets.
Against this background the European Commission (EC) has undergone a period of consultation with the aim of enhancing the resilience of derivatives markets. The conclusions of the consultation, and the EC's future policy actions, have been detailed in an EC Communication in October 2009. It is these policy actions which will lay the foundations for new legislation which the EC will publish in 2010.
Noting that the derivatives market is global, the EC has stated its intention to further develop its proposals in line with the G20, the Financial Stability Board and the US, which is also preparing draft legislation.
This client alert explores those proposed industry reforms within the European Union. The second alert in this series will explore the current form the US proposals are taking.
The Basics
Derivatives are contracts whereby cash flows are exchanged between two parties. The direction and amount of the cash flow depends on the future value of an underlying asset. Derivatives are classified by reference to the underlying asset and by the way the contract is structured. The most common types of underlying are currencies, interest rates, equity, commodities and, in the case of credit derivatives, defaults under loans. Derivatives contracts can be divided into futures, options and swaps. Futures are traded on an exchange, whilst swaps are traded bilaterally and are usually referred to as being over-the-counter (OTC). Options can be traded on-exchange or OTC.
Exchange-traded products are, by definition, standardised. Namely, they refer to set quantities of underlying products (known as lots) and the timing of their settlement is also set. The exchange operates as the market place for those instruments, being the place where bids meet offers. The exchange then publishes the price so that it is available to the market as a whole.
OTC contracts are, by definition, not standardised. The underlying value is often, but not always, determined by reference to the price published by an exchange. Notional quantities and settlement terms are at the parties' choice.
The Use of Derivatives
There are two major uses of derivatives transactions. One is to acquire price risk with an aim of making a profit, namely to speculate. The other use of derivatives is very much the opposite of taking risk. Namely, companies may enter into derivatives transactions to protect themselves from price fluctuations. For example, a manufacturing company that exports its product to a foreign country needs to ensure that the gain it makes from selling the product is not eroded by a worsening exchange rate. It will therefore enter into a currency swap with a bank under which the manufacturing company will gain if the producer's local currency weakens against the currency in which the payment is denominated. In effect, this allows the manufacturing company to fix the exchange rate price as at the time the sale price is agreed. Airlines tend to enter into forwards or futures to hedge against higher fuel prices. Customers also benefit from stable prices as a result. This virtuous use of derivatives is referred to as hedging.
One of the key attractions of OTC instruments is their flexibility. They come, quite literally, in all shapes and sizes and can be tailored to the specific needs of a company seeking to hedge its price exposure.
A good example of tailored derivatives is the refining margin swap or crack spread hedge (cracking is the chemical process by which molecules of crude oil are broken down into useful oil product molecules, like gasoline). What concerns a refiner is the reduction of the price differential between crude oil and its refined product. He will therefore wish to receive a sum equivalent to any increase in the price of crude and a sum equivalent to any reduction in the price of the refined product.
The refiner will be able to achieve the above by means of a single swap transaction entered into with a sophisticated trader, most commonly an investment bank. The alternative would entail the implementation of a trading strategy involving the taking of simultaneous positions on crude futures markets and on the derivatives markets for refined products.
Further, the swap transaction also allows for the fine-tuning of the crack spread hedge. Oil is priced worldwide by reference to benchmarks, the most important ones being Western Texas Intermediate, Brent and Dubai. The price the refiner pays for the crude oil and the price received for its refined products are referenced to ratios of the relevant reference benchmark. Such ratios vary depending on the geographic location of the producer, of the refiner and of the export market. Swaps reflect the exact ratio with much more accuracy than exchange-traded products (e.g. the gasoline and heating oil crack spreads traded on the New York Mercantile Exchange).
The benefit of trading on an exchange is that, in exchange for margins from the market participants, the exchange acts (either directly or through an associated clearing house) as a central counterparty to the transaction by taking care of its settlement. The margining requirement ensures that whoever takes a position on the exchange must cover their bet on a daily basis by depositing cash with the exchange. The more the position loses money over the term of trade, the more cash will need to be posted. Clearing ensures that when it comes to settling a transaction the individual player deals with the exchange rather than with whoever was on the other side of the market. As a result, a party that is set to gain from a trade does not run the risk that the counterparty will default on its obligation and is therefore certain of being paid. That is, until the clearing house itself defaults.
Exchange-trading clearly offers both systemic advantages and advantages to the individual player. However, exchanges and clearing houses charge a fee for their services. Also, they apply standardised margining terms that may not be affordable by a number of market players. Furthermore, the standardised nature of the margining terms means that there is no scope for fine-tuning such terms to the individual market participant.
OTC trading offers solutions to all these issues in that parties avoid having to pay a clearing fee and are offered the possibility of negotiating margining terms on a bilateral basis, for example, by allowing for the use on non-cash collateral (e.g. standby letters of credit) and taking into account other forms of security (e.g. parental guarantees).
A Recipe for Disaster. But Was it Really the Derivatives' Fault?
The OTC credit derivatives market exemplified the devastating effects of a lack of public information on both the evaluation of the underlying asset and the price formation of the derivative instrument referencing them. This, combined with mutual dependence and excessive leverage, created the potent mixture referred to by Warren Buffet as the "madmen's poison".
The practice of bundling up sub-prime US residential mortgages with high-rated loans, which is in many respects the core of the problem, may have been exacerbated by the way derivatives markets function. The problem's genesis, however, ought to be identified in other financial practices, most notably securitisations.
Though derivatives may undeservedly be at the centre of attention, the characteristics of OTC trading did make the perpetuation of the unsound practices referred to above possible. The fact that there was a restricted circle of players in the market for credit default swaps (or CDS, the most common type of credit derivatives) meant that the real value of the underlying assets could be kept hidden behind closed doors. The fact that competing players were effectively holding the likelihood of each other's demise as book assets and could trade such risk amongst themselves led to all kinds of distortions. This could not have been conducive of an efficient price discovery mechanism.
Further, the absence of central counterparties meant there was no barrier to prevent contagion from one player to the other. This was very much the cause of the recent turmoil in the freight derivatives market.
Since the beginning of the decade, a huge market in OTC derivatives had developed with freight as the underlying. In the late summer of 2008 (and prior to Lehman's big bang) freight rates collapsed, with some particular rates losing more than 95% of their value over a period of weeks.
Such sudden price movements caused unexpectedly large settlements being due under the derivatives contracts. A number of players were unable to meet their commitments and defaulted. This caused other players that would also trade with them to default, creating a chain effect. Panic ensued and OTC freight trading evaporated overnight as a result.
This crisis exposed a fundamental flaw that was specific to the OTC freight derivatives market. Namely that players would trade with one another on a bilateral basis but without taking the precautions that are typical of OTC trading. Freight derivatives (Forward Freight Agreements or FFAs) were entered into through brokers who then confirmed the transactions by sending standard forms of contracts to each of the parties to the trade. Although such standard contracts referred to the ISDA Master Agreement (the industry wide agreement for derivatives transaction), they would not include counterpart specific provisions that would be customarily built into an ISDA and which would provide bells and whistle-type protection from unworthy counterparties. This attracted a number of unsuitable players to the market who could not absorb the price shock referred to above.
The Proposed Reforms
The EC's October Communication highlights the EC's main objectives as being the strengthening of counterparty credit risk mitigation and the increase of market transparency. These objectives are to be achieved by pushing market players away from OTC transactions and onto central counterparties (CCPs), and by improving the collateral management for non-CCP eligible contracts.
The Communication identifies at least two other tools that may be used to achieve the set objectives, those being the promotion of further standardisation of derivatives contracts and the enhanced use of central data repositories.
It is unclear whether the legislation covering CCPs and trade repositories will come under a single Directive. The October EC Communication imposes deadlines for future policy actions and states that the deadlines for proposed legislation on CCP requirements and on trade repositories will be mid 2010.
On the basis that the Communication talks about the two different sets of legislation separately, it would appear that the plan is for two independent Directives, one governing CCPs, the other governing Trade Repositories.
As to the actual meaning of contract standardisation, the previous EC Communication of July 2009 referred to both the legal and economic terms of the contract. The October Communication, however, made it clear that the EC is not seeking to standardise the economic parameters of contracts.
This change of direction is the consequence of the strong resistance that product uniformity (i.e. relating to the economic parameters of the contract) met during the consultation period following the first Communication. Industry bodies rightly argued that product uniformity may limit hedging possibilities. It is likely that any standardisation will therefore concern the uniformity of the legal terms of contracts and the standardisation of processing and settlement procedures.
What that means in practice remains to be seen. It is also unclear what type of contracts will be amongst those deemed to be standardised. One can certainly be sceptical as to whether more standardisation can be achieved, especially for some classes of OTC derivatives like those that have commodities as underlying. Standardisation has already been achieved with ISDA Master Agreements and with the agreement to use only a handful of standardised coupon values for European-referenced CDSs. That said, the OTC freight derivatives market provided a good example of a market where improvements can be made although, paradoxically, this was through the customisation of contracts rather that through standardisation.
It is also unclear how the concept of a CCP fits into the present framework of organised trading venues as defined in the Markets in Financial Instruments Directive (MiFID). Specifically, it is unclear how it will sit alongside such MiFID concepts as regulated markets (i.e. exchanges), multilateral trading facilities (i.e. electronic trading platforms) and systematic internalisers (i.e. investment firms that trade on their own account outside of regulated markets and multilateral trading facilities and hold counterparty risk).
Unsurprisingly the EC Communications caused a number of large investment firms to hastily apply to their national regulator to qualify as a systematic internaliser. It is debatable whether the status of systematic internaliser offers an actual advantage especially if one considers the obligations that MiFID imposes on such regulated entities.
Moreover, the concept of systematic internalisers seems to be ill-fitted for some OTC derivatives markets. For instance, article 27(3) of MiFID, which requires systematic internalisers to publicise their prices and abide by certain other rules concerning the prices they can close transactions at, appears specific to the way stock broker-dealers operate.
Moreover, the concept of systematic internalisers seems to be ill-fitted for other OTC derivatives markets, like the one for commodities derivatives. One also ought to question how the numerous electronic trading platforms implemented by brokers in recent years will fit in with the new CCP-driven regulatory regime.
CCPs are considered zero-risk counterparties for capital requirement purposes because of their creditworthiness. This is achieved through their multilateral netting processes, which consolidate transactions and reduce costs, along with their requirements to post collateral. Further, the CCP default fund, which all CCP members contribute to, shares any loss should the collateral provided by a defaulting party not be sufficient to cover the loss. This is referred to as loss mutualisation.
Most of the existing trading platforms (which qualify as multilateral trading facilities and as such are regulated at national level) appear to fulfil the requirements of implementing robust margining and central settlement systems but may not be entirely up to scratch insofar as loss mutualisation is concerned.
Then there is the more general issue that clearing houses do still remain vulnerable to a default by a major participant. It has been suggested that they should be given access to central bank liquidity to avoid becoming dependent on liquidity provided by other financial institutions. Does that mean that we will get to see the bail out of a clearing house too?
That should not be the case if, as suggested by the Communication, CCP legislation will include conduct of business and governance requirements, legal protection to collateral provided by clearing members' customers and minimum risk-management standards, which may comprise low regulatory capital charges for centrally-cleared contracts. Those CCPs granted authorisation by the European Securities and Markets Authority (ESMA) will also be able to passport their services across the EU.
The EC intends to reduce operational risk by pushing for the standardisation of the legal terms of contracts and electronic processing. Transparency will be enhanced through requiring the reporting of all transactions to trade repositories, which in turn will be regulated under a common legal framework. This will provide regulators with information on all trades made on-exchange or cleared through a CCP. Because trade repositories hold the register of all positions they can provide regulators with access to the data required to conduct effective macro and micro surveillance (i.e. who is trading what and at what value).
It is difficult at this stage to assess the full impact of the planned CCP legislation especially as one ought to consider its interaction with MiFID, the Market Abuse Directive and Capital Requirements Directive. The first two aforementioned directives will be reviewed in 2010.
In particular, the MiFID Ancillary Commodities Dealing Exemption (Article 2(1)(i)) and the MiFID Own Account Commodities Dealing Exemption (Article 2(1)(k)) are currently the subject of a review on the basis that the exemptions do not create a level playing field with investment firm and banking groups that trade commodity derivatives and who cannot use the exemptions.
There is a concern that the MiFID Own Account Commodities Dealing Exemption is going to be deleted, leaving only the restrictive MiFID Ancillary Commodities Dealing Exemption, which would mean that under the FSA's current narrow interpretation of ancillary, speculative trades and trades with persons other than clients of the main physical energy business would be caught by MiFID.
This in turn would mean that a number of physical trading energy companies would no longer be able to operate in their current set up. This, combined with the CCP regime and with the higher capital charges that will be imposed by the amended Capital Requirements Directive on non-CCP cleared derivatives, may well signify the end of OTC commodities trading as we know it. Indeed, a major European utility has estimated €7.5bn (£6.9bn) in new credit lines or extra cash reserves if EC proposals are passed.
The EC has held its ground, however, and stated that some of the cost of strengthening the market infrastructure for OTC derivatives must be borne by non-financial institutions as they also benefit from safe and sound derivatives markets, though financial firms will be expected to abide by stricter capital requirements and thereby give away some of their competitive advantage.
Proposed US legislation, which is currently under consideration by the Obama administration and the House Committees on Financial Services and Agriculture, provides for a similar regulatory regime as is intended in the EU and exempts those institutions which are not 'swap dealers' or 'major swap participants' from some of the restrictive regulations. These issues will be discussed at length in the second client alert of the series.
The G20 agreed to ensure that all eligible trades for exchange-trading take place on organised trading venues and are seeking to achieve this by the end of 2012 at the very latest. Trading on exchanges will ensure customers are aware of the value of the transactions they enter into. Banks' profits will suffer as a result as the more transparent the pricing the more spreads narrow.
The EC and the US seem to have carefully coordinated their regulatory efforts in order to avoid regulatory arbitrage between the two global financial capitals but they will now have to balance their policy changes as exchange-traded contracts may not meet the needs of the marketplace. Overzealous regulatory intervention may therefore drive business away from London and New York to other financial centres like Singapore, Dubai or Switzerland.