Over-the-counter derivatives markets in Asia will see a number of significant rule implementations this year as the scope of mandatory clearing and reporting continues to expand. Geopolitical developments in Britain and the United States are expected to have an important bearing on the region.
Proposals for mandatory clearing of OTC derivatives in the European Union and the United States are well underway as both aim to begin clearing obligations in 2017. Hong Kong looks set to be the first jurisdiction in Asia to kick off mandatory clearing in July this year as it expands the scope of coverage from non-deliverable forwards and interest rate swaps to include all OTC derivatives instruments.
Securities and Futures Act Underwent Second Reading
In Singapore, the Securities and Futures (Amendment) Bill 2016 had its second reading on 9 January during which the Monetary Authority of Singapore ("MAS") indicated that it would finalise and implement regulations for mandatory clearing of widely traded OTC derivatives contracts later this year.
As part of the SFA amendments, MAS will be empowered to require OTC derivatives products that meet prescribed criteria to be traded on organised trading facilities such as exchanges, rather than over-the-counter. Operators of organised trading facilities will also have to be approved by MAS and comply with its requirements. MAS will also require intermediaries in the OTC derivatives markets to comply with its regulations. MAS has yet to define who these intermediaries are.
The timing and scope of implementing the trading requirement is unclear, which is largely dependent on international developments and market liquidity conditions, MAS said. It noted that the EU, Hong Kong and Australia have not made trading of OTC derivatives products on organised trading activities mandatory, although the United States and Japan have introduced such requirements.
Following the SFA amendments, commodity derivatives market operators and intermediaries will be regulated under the SFA. Derivatives products seeking to be listed and traded on organised trading facilities will not require case-by-case approval from MAS.
All Eyes on Margin Rules for Non-Centrally Cleared Derivatives
Margin requirements for non-centrally cleared derivatives remain the main focus as market participants await the implementation of variation margin rules on 1 March this year, said Tom Jenkins, partner at KPMG China.
Coordinated efforts by the Australian Prudential Regulation Authority, Hong Kong Monetary Authority ("HKMA"), and MAS to implement the final rules for both initial and variation margin for non-centrally cleared derivatives in their respective jurisdictions on 1 March 2017 was a big relief to market participants. The three regulators have said they will allow the industry a six-month transition period to comply with the full set of margin rules.
HKMA, for instance, has said licensed banks in Hong Kong have to comply with the margin rules by 31 August 2017.
"If you look at what HKMA has done, it is to bring the timeline for the implementation of the margin requirements in line with the original proposal made by the MAS," said Jenkins.
ISDA Master Agreement
Financial institutions in Asia are now putting in place the necessary preparations as they get ready for 1 March implementation. The preparatory work includes sorting out legal documents, ensuring they have the ability to meet the strict requirements on the type of collateral that can be posted, that they have sufficient liquidity for collateral, and the ability to meet the required timing for settlement.
Trade documentation, specifically the credit support annex ("CSA"), one of the four parts of the International Swaps and Derivatives Association ("ISDA") Master Agreement, is one area which has generated considerable industry concerns. The CSA covers the terms of the collateral arrangement between two counterparties to mitigate credit risk arising from derivatives positions.
Geopolitical Issues Will Affect Margin Rules
Many banks are said to be scrambling to get their clients to have the ISDA Master Agreement updated so that they can begin to post margin for non-centrally cleared swaps and be compliant. Andrew Pal, consultant at DerivAsia in Singapore, said the margin rules may potentially be disrupted if banks fail to get the ISDA Master Agreement updated on time.
Canadian, US and Japanese regulators postponed the implementation of the margin rules one month later after the rules were introduced on 1 September 2016, after realising market participants were not ready. Pal said this suggests the 1 March implementation date may be delayed.
"A lot of banks are frantically trying to get their clients to have the ISDA agreement updated to be able to post margin for non-centrally cleared swaps. It may not be a clean start in March; it was a delayed start initially," he said.
Pal also pointed to the UK's plan to begin negotiating its exit from the EU in late March as a possible cause for a delay in preparing for the margin rules on 1 March, as Brexit may divert legal resources required for ISDA remediation.
"Who knows what is going to happen to Brexit? With the upcoming elections in Holland, France, Italy and Germany, people are going to focus on these and geopolitical issues. What [rules] is Donald Trump going to repeal? The Volcker Rule needs to be amended to give banks clarity that market making should be about client facilitation, not prop trading," he said.
Jenkins said the large global banks, which have been focusing on US and European regulations, are more advanced in their preparations for margin rules implementation than the domestic and regional banks in Asia, but much remains to be done as far as complying with local regulatory requirements are concerned. The larger banks face an added layer of complexity as they try to understand which set of local rules they need to comply with as well as work through the application of substituted compliance granted by regulators in different jurisdictions.
According to Jenkins, the rules in a number of jurisdictions have a substituted compliance feature which seeks to reduce regulatory burden on market participants. The key question lies in how regulators will apply substituted compliance. For instance, HKMA and US regulators require market participants to apply for substituted compliance which they will then approve or disapprove. Certain jurisdictions, however, have a deemed substituted compliance feature, which means substituted compliance will be granted automatically.
"The end point is the same between deemed substituted compliance or waiting for regulators to grant it in that ultimately substituted compliance will only be applied if regulators view the other jurisdictions’ regulations as comparable. That's the complexity that financial institutions have the work through," Jenkins said.
Margin Rules Implementation Most Onerous
Market participants see 2017 as an important year for the implementation of a number of OTC derivatives rules with the margin rules for uncleared derivatives being the most onerous.
"The cost of implementation and the cost of providing the margin are what makes margin rules the most challenging part of OTC derivatives reforms. The coverage of instruments for margin rules for non-centrally cleared derivatives is much broader compared to the instruments that are required to be mandatorily cleared and reported," Jenkins said.