Derivatives Users Demand Level Regulatory Playing Field

Terry Flanagan

Market participants are getting increasingly worried that new derivatives rules will be applied inconsistently across borders, leading to greater risks and higher costs for some.

Regulators in the U.S. and Europe are currently trying to resolve issues surrounding extraterritoriality and produce a level playing field that will be suitable for all derivatives users. The G20 group of nations has demanded that national regulators draw up global standards in the derivatives space.

But given the global nature of OTC derivatives markets, close cross-border co-ordination of regulatory and supervisory frameworks is likely to be required to avoid regulatory arbitrage and mitigate systemic risk and adverse spillovers across countries.

“While every national regulator must ensure its national markets are stringently and appropriately regulated, we must also recognize that derivatives markets cross national borders, and that regulatory intervention that fragments the global market could impose large costs without necessarily reducing risks,” David Lawton, acting director of markets at U.K. regulator the Financial Services Authority (FSA), told the annual FIA/FOA International Derivatives Expo conference in London this week.

Lawton said international consistency to regulations was key and that a system of “substituted compliance” should be put in place, which relies on local jurisdictions applying equivalent regulations, instead of extraterritoriality taking hold.

“In our view this is the best way to reduce a potential conflict of laws,” said Lawton. “It avoids creating a situation where our or other regulators’ rules cannot be enforced effectively owing to a lack of jurisdiction.”

Upcoming derivatives regulations in the shape of the Dodd-Frank Act in the U.S. as well as the European Market Infrastructure Regulation in Europe are in broad agreement but some of the text has yet to be finalized and market participants are fearful of the consequences when the new rules are likely to become law from the start of next year.

“I think it is tricky as regulations can easily slip over geographical borders,” Steve Grob, director of group strategy at Fidessa, a trading and technology company, told Markets Media. “How do you apply the rules, for example? Is it by who has invested in the fund that is investing in something that is being traded? Or is it where the trade is done? Or is it where the risk is managed? Or even where it is cleared?”

The previously unregulated $700 trillion OTC derivatives sector, which accounts for roughly 95% of all derivatives trades by volume, has been blamed, in some quarters, for the global financial crisis and the collapse of Lehman Brothers in 2008.

Another challenge facing market participants in the derivatives space is mandatory centralized clearing. The G20 wants to see all OTC trades pushed through clearing from the start of next year, in a bid to reduce risk.

“Most clearing solutions are still at an early stage of development, and this risks clients being forced to on-board in very short order to comply,” said Lawton at the FSA.

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