Sudip Bandyopadhyay’s Blog

From the time in the early 1980s when the Derivatives first started trading, in a short span of less than 30 years the derivatives market has become the biggest market in the world. At the end of last year, contracts with a face value of $636,431bn were swirling around the world’s financial system, according to the Bank of International Settlements. Just 3.4 per cent of the total were traded on exchanges. The rest – $614,674bn worth, equivalent to nearly 10 years of global economic output – were agreed and traded in private markets, under terms struck directly between the buyers and sellers.

Over the next year, an entirely new rulebook is to be drawn up for this privately traded part of the financial markets, also called over-the-counter (OTC) derivatives. President Barack Obama’s signature on the Dodd-Frank Wall Street Reform and Consumer Protection Act on July 21 started the countdown.

Under the new regulations, the derivatives world will be divided in two. On one side will be those products that are widely used, simple in structure and actively traded: standardized derivatives. Those will be pushed on to clearing houses to make the financial system less vulnerable to the default of a big derivatives dealer.

Clearing houses can reduce counterparty and systemic risks by standing in the middle of trades – though there of course remains a risk the clearing house itself may fail. The clearing house has a pool of capital and collects collateral and margin – up-front payments against possible losses. If these resources are not enough to cover a default by a member, the others are supposed to cough up.
Cleared derivatives will also have to be traded on electronic systems – although exactly how those systems will be defined, and how quickly and frequently price information has to be made public remains to be resolved. How regulators decide the clearing houses should hold the collateral against trades, and the extent to which derivatives users can offset positions against each other, will also be key.

Once regulators determine what part of the OTC derivatives or swaps markets has to be cleared, the remaining part will also be policed. No one knows what proportion will be uncleared, or what the targets are, although for all derivatives the more heavily regulated exchange-traded futures market provides the likely standard.

What also will be of significant importance is the Convergence or Divergence of the regulations between Europe, US and Rest of the World, including Japan.There is a growing risk of Regulatory arbitrage where market participants shop around for the most favourable set of rules. Markets in Hong Kong and may be Singapore can be big beneficiaries under the circumstances and strengthen their Derivatives and Clearing businesses.