Tim Geithner, US treasury secretary, recently assured key US lawmakers that the definition of a “standardised” over-the-counter derivative contract would be broad and “difficult to evade.” But how the Obama administration exactly will define a standardised trade remains to be seen.
The ability to classify a standard transaction and differentiate it from a non-standard transaction is key to the successful implementation of the administration’s OTC derivatives reform. In fact, the reform cannot begin until a framework for classification is understood.
Consider four approaches to classifying a standard derivative contract: by product (instrument asset class or similar terms); ease of clearance (by volumes and similar terms); by user type (eg: banks, insurance, non-financial); and by intended use (derivatives used for hedging, not trading).
Each can be measured against its cost to standardise, ability to be regulated, and impact to businesses.
● By product or instrument type
On the surface, simply classifying certain OTC derivative products as standardised might be an easy starting point but can pose challenges as there are many subclasses of products and hybrid products that, for example, combine interest rate and foreign exchange risk as a single class. Ultimately, a long list of products and variations could be defined and then classified as either standard or non-standard. However, this approach does not necessarily mean that the instruments would be easy to clear or that there would be demand and liquidity for those instruments to support clearing.
Many simple “plain vanilla” instruments like five year interest rate swaps or FX forwards are customised for a business’s specific risk exposure and this could be re-defined as standard under the reform. They would be required to trade on an exchange, which would result in high costs to clear, profit and loss volatility from contract settlement dates mismatching exposure maturities, and an overall drop in OTC derivative use.
● By ease of clearance type
Geithner told Congress that the administration “will employ a presumption that a derivative contract that is accepted for clearing by any central counterparty is standardised. Further attributes of a standardised contract will include a high volume of transactions in the contract and the absence of economically important differences between the terms of the contract and the terms of other contracts that are centrally cleared.”
Under these broad criteria, many foreign exchange, energy, metals and agricultural OTC derivatives could qualify many non-standard, custom derivatives as standard. The US Commodity Futures Trading Commission (CFTC) would have to then force standardised conventions and dates in order to be able to facilitate clearing, which would result in intense lobbying by constituents who would not be able to use these contracts or would face significant increased costs and P&L volatility. Other mechanisms would have to be put in place to allow for non-standardised transactions that increase in volume to become standardised and vice versa.
Terms that are closely related or fungible - that is, easily interchangeable with another in satisfying an obligation - can sometimes work in the securities and commodities markets, but many of these specific terms impact the net present value or price of these OTC derivatives. This market-driven approach, where the central counterparty clearing house (CCP) will determine standardisation, would not be fair to all parties and would cause many “plain vanilla” hedgers to be dragged into standardisation.
● By user type
Classifying non-standard derivatives used by non-financial corporations (like retailers and airlines) would eliminate most of the business impacts that standardisation would cause, although certainly the capital requirements for non-standard trades proposed by the US administration to deter “spurious” behaviour by those who would tweak terms to create customisation and avoid posting capital would pose a burden. In this case, exemption from posting collateral for non-financial corporations could be considered, but would demonstrate a bias. Regulatory bodies already exist or are being created to monitor most financial groups. In this classification option, regulators would have to monitor behaviour where speculators could buy or form non-financial corporations and use them to engage in un-cleared trading activity.
● By use (hedging vs. trading)
Given that speculation and leverage was at the epicentre of the financial crisis, perhaps the fairest and easiest approach to implementation is to classify by intended use of OTC derivatives. Simply, if an entity can demonstrate that it is using the OTC derivative to put on an effective hedge of a business risk then it can be classified as non-standard with no additional capital requirements. If not, it can be deemed standard if cleared or non-standard with capital if it can’t be cleared.
The question is how would a company be able to demonstrate they have a good hedge and how would a regulator be able to check that is the case? Actually, accounting standards are already in place in the US under Financial Accounting Standards Board (FASB) Statement No. 133 and under the International Accounting Standards Board (IASB) Statement No. 39 outside the US.
Public accounting firms and regulators, such as the Securities Exchange Commission, have been auditing FAS 133 since 2000. Documentation of the rigorous analysis of a hedging relationship is required in order to obtain hedge accounting, but many end-users are willing to perform this in order to avoid the P&L volatility that would result from the mark-to-market change of the derivatives alone. This approach does not deter standardising OTC derivatives for clearing, but allows an alternative, robust definition that also eliminates the risk of “spurious” behaviour.
In the end, perhaps using already existing accounting standards to classify non-standard derivatives from standardised derivatives is the easiest to implement. It is a two-step process of first filtering derivatives for bona fide hedging using hedge accounting standards, then allowing the market to determine the ability to clear the trade for standardisation, which would be mutually beneficial for end-users, market-makers, traders and the regulators, thereby making the successful implementation of this important OTC derivatives reform more likely.
Jiro Okochi is co-founder and chief executive officer of Reval, a global derivatives risk management and hedge accounting solutions provider.
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