Policing derivatives

Since recognising the need for greater transparency and oversight of derivatives markets, acute differences have emerged between the US and Europe over derivatives reform, prompting a top US official to warn of the risk of “enormous regulatory arbitrage.”


While the intent exists on both sides of the Atlantic to police the complex financial instruments that have come under fire for causing or exacerbating the latest global financial crisis, it is perhaps unsurprising that there are disagreements over how derivatives should be regulated.

The differences between the EU and the US centre on how regulators are defining new trading platforms for over-the-counter (OTC) derivatives (contracts that are traded – and privately negotiated – directly between two parties, without going through an exchange or other intermediary, such as swaps), the ownership of clearing houses that will beused to process such contracts and whether brokers can get access to membership of a clearing house to handle OTC derivatives for customers.

In the US, the Commodity Futures Trading Commission (CFTC), the futures watchdog, is in favour of creating new trading platforms called “swap execution facilities” (SEFs) which would require participants to request price quotes from multiple contributors. This would limit the ability of dealers that have effectively long controlled the OTC derivatives markets. But the European Commission has proposed a looser definition of these platforms, which it calls “organised trading facilities.” Industry experts say this could allow the dealers’ current model to continue to exist, prompting banks to shift activity from the US to Europe to take advantage of a laxer regime, in so-called regulatory arbitrage.

Maria Velentza, head of the securities market unit at the European Commission, said in March that “our idea in Europe is not to disturb existing business models for trading of OTC derivatives.” Jill Sommers, a commissioner at the CFTC, has said that her agency was already “out of step” with proposals on SEFs from the Securities and Exchange Commission (SEC), the US’ financial regulator which is also implementing derivatives reforms under the Dodd-Frank act. “We need to be consistent, not just with the SEC but globally, otherwise we could have enormous regulatory arbitrage,” she has said.

There are other important differences too. For instance, Europe is not proposing – as the CFTC is – to place limits on the ownership of clearing houses. Furthermore, brokers are angry that, while it is relatively easy for them to become members of clearing houses as the Dodd-Frank act stipulates, the costs of doing so in Europe look prohibitive.

It appears that – yet again – there is unlikely to be a unified approach on both sides of the Atlantic as to how derivative markets should be regulated. Anthony Belchambers, chief executive of the Futures and Options Association, the European affiliate of the FIA, recognises the problems. “Clearly, there are going to be differences between the US and Europe, and some will be quite fundamental,” he says.

But this is not the only source of disagreement. Tensions are also mounting over attempts by Brussels policymakers to widen the scope of the European Market Infrastructure Regulation (EMIR), which would result in increased competition for derivatives trading among exchanges.

The European regulation was originally intended to increase the robustness of the OTC derivatives market by forcing all OTC trades through a clearing house. But some policymakers now want the new rules to cover derivatives listed on an exchange, turning the EMIR text into a battleground over competition in the European derivatives market.

The inclusion of listed derivatives would break open the lucrative vertical silo model operated by Deutsche Börse where trades executed on the exchange are automatically cleared through its own clearing house Eurex Clearing. Analysts say this could affect the value of the $10bn deal. Deutsche Börse and NYSE Euronext have opposed expanding the scope of EMIR to listed derivatives while derivatives dealers and the London Stock Exchange, which is hoping to break into the listed derivatives market, have argued in favour.

Yet despite the uncertainty about how the regulatory landscape is likely to pan out in Europe and the US, derivative trading has started to pick up again – and not just in the world’s biggest and most developed financial markets. Derivatives exchanges have reported a spike in trade volume on the back of growth in Asia-Pacific and Latin America, and strength in the commodities sector. According to new figures released by the US-based trade body Futures Industry Association (FIA), derivatives exchanges witnessed a 25.6 percent increase in trading volume in 2010 compared with the previous year, with 22.3bn contracts changing hands.

In its Annual Volume Survey, the FIA said the spike was led by large growth rates in volumes in the Asia-Pacific and Latin America; the strong performance of the commodities sector; and a partial revival in the market for interest rate futures in the US and Europe. As of the end of 2010, the Asia-Pacific region accounted for 39.8 percent of trade volume in exchange-listed derivatives worldwide, compared with 32.2 percent in North America and 19.8 percent in Europe. Much of the volume increase in Asia was down to the performance exchanges in China, India and Korea, with Chinese commodity futures performing particularly strongly.

The report came a day after the Bank for International Settlements’ (BIS) Quarterly Review, which reported a 30 percent increase overall in trading on derivatives exchanges in contract terms in the same period. The BIS report found that trading volumes on international derivatives exchanges, measured by the notional amount of traded contracts, rose nine percent in dollar terms in the fourth quarter of 2010 compared with the previous quarter. It added that there was a 38 percent rise in trading of Korean equity index options, which represented 59 percent of total equity index options turnover in the fourth quarter. But trading of short-term euro interest rate options fell 16 percent from the third to the fourth quarters.

The rise in derivatives trading in Asia is fuelling opportunities for growth. The Bombay Stock Exchange (BSE) has signed a licensing agreement to launch derivative contracts with the International Securities Exchange (ISE), the US options exchange owned by Deutsche Börse, which also owns a five percent stake in the BSE. Analysts say that the move demonstrates how exchanges are using their ownership of index businesses to expand into Asia and Asian exchanges. The BSE will be seeking approval from Indian regulators to launch derivative products for Indian investors, based on ISE indices, as part of the BSE’s futures and options product portfolio.

“ISE’s indexes provide investors with equity-based exposure to highly topical investment themes, including emerging markets, widely-traded commodities and water. We look forward to working with BSE as they broaden their derivatives business with new products based on ISE’s indexes,” said Kris Monaco, head of new product development at ISE.

The BSE is not the only exchange to sign such an agreement. Early last year the BSE’s main rival, the National Stock Exchange of India (NSE), signed an arrangement with CME Group of the US. The agreement makes the Indian exchange’s S&P CNX Nifty index, the leading Indian benchmark index for large companies, available to the Chicago operator for the creation and listing of US dollar-denominated futures contracts for trading on CME. At the same time, CME will make the rights to the S&P 500 and Dow Jones Industrial Average indices available to the Indian exchange for the creation and listing of rupee-denominated futures contracts for trading in India on the NSE.

Meanwhile, the Singapore Exchange (SGX) plans to become the “multi-asset-class clearing hub” for OTC derivatives in Asia, according to co-president Muthukrishnan Ramaswami. Use of exchange-traded derivatives in Asia is growing. According to data compiled by the World Federation of Exchanges, Asian markets traded 40 percent of global derivatives last year, outpacing North America for the first time, which accounted for just 32 percent.