The repercussion of the financial crisis brought together leaders from a wider range of countries to discuss financial regulation. In one of the most significant changes, the G20 substituted the G8 to include relevant developing economies such as China, India and Brazil. Together, these nineteen countries and the European Union designed a new global agenda for an OTC Derivative Markets Reform in 2009. Among other goals, they explicitly agreed to push over-the-counter derivatives trades through electronic trading platforms or exchanges (trading venues).
Still Not Enough Progress
However, seven years have passed since the agreement, and four years since the committed deadline and only those more advanced economies such as the US, the EU and Japan employed provisions for electronic trading platforms of derivatives so far. Some progress is also expected soon in Australia, Mexico and Singapore. Yet, most of the other jurisdictions which were added up to the new forum are notably reluctant to the new regulatory framework, what is intriguing. What could be the possible reasons for these discrepancies and their consequences for the governments and the markets?
To answer this question, one first needs to explain what the regulatory agenda consisted in. Along with proposals from the Basel Committee, supported by the G20, the framework included (i) trading venues, (ii) trade repositories, (iii) capital requirements, (iv) margin requirements and (v) clearing in central counterparties. The other elements were more extensively debated and implemented across the jurisdictions. However, trading venues are an essential piece of framework.
First, trading venues do not only require standardisation as an input, but also promote standardisation as an output. This is important because they facilitate the access and interoperability with trade repositories and central counterparties. Second, trading venues allow the better concentration of regulatory oversight efforts to these limited venues, instead of to the whole market. Third, with the increased monitoring, it can be expected that trading venues stimulate the compliance to all other elements. Notably, trading platforms are not only one more element to the framework, but they are indeed the bridge organising the market macroprudential the other elements.
So why would so many G20 countries not apply these provisions? The reasons vary. Aside the US, which had similar market structures since at least 2002, all other jurisdictions were initially renitent. A 2010 consultation by the European regulators is explanatory to the reasons for caution. On one side, exchanges and electronic trading platforms providers were natural supporters of the reform. On the other, banks were radically against it. Why? Because, originally, promoting the trade in trading venues implies a shift from the dealers’ model, which is dominated by banks, to the brokers’ model.
The Big Money
Now, think of it as a multi-trillion-dollar business ($492trn in notional value and $14trn in gross market value) where the largest values and volumes currently still include these traditional dealers and a realistic explanation for the governments’ reluctance begins to develop. It also explains why, even in those more advanced countries, the concept of electronic trading platforms was increasingly broadened to include traditional voice trading methodologies, bilateral platforms and request-for-quote models.
The relevance of dealers’ influence to the national regulations explains the delay in some jurisdictions and the softening of the provision in others. But there is one additional reason that helps explain why some jurisdictions were even more reluctant to the point of refusing even to consider it.
When asked about trading venues, the economic interests of exchanges and electronic trading platforms providers align. However, when asked about electronic trading platforms, it is natural to expect opposition from those much more established exchanges.
It raises a relevant matter of competition because exchanges normally offer a “vertical silo” of trading venues integrated into a clearing house and a similar trade repository. To defend electronic trading platforms would mean to break this vertical integration into very specific entities, with limited cross-ownership and duties of open access. So, in countries with less traditional capital markets, where electronic trading platforms are not yet established, the markets interest around these structures tilted against it.
One assumes the influence of established industries is a relevant element to explaining the reluctance of some countries to adopt rules for electronic trading platforms of derivatives. So what are the consequences of these delayed or reluctant governments and markets?
Without controlled trading venues, the main goal of the reform for governments is in jeopardy: an indeterminate portion of the market continues to be opaque in bilateral trades outside the governments’ and the markets’ oversight. The real exposure of companies remains unknown since even to the most experienced investors acknowledge that balance sheet explanation notes do not offer any valuable information in this matter. Credit risk, liquidity risk and, ultimately, systemic risk are still “unforeseeable” fatalities, just like before the crisis.
Not Enough Knowledge
Governments in these jurisdictions also lack the information for policies in four important areas: micro-prudential, macro-prudential, macro policies and micro policies. On micro-prudential, think about the many individual companies that, outside regulatory scrutiny, collapsed due to their excessive exposures to derivatives. On macro-prudential, think about how the collapse of the most intricate individual companies can spread the crisis, as it happened in the global turmoil of 2008 after the fall of Lehman Brothers. On macro policies, think about how these markets influence the National Accounts and Balance of Payments – and, in some countries, even monetary and exchange rate policies. Finally, in the micro policies, think of the development of the national financial centres. Without derivatives knowledge, countries are missing the data from billionaire national markets.
This lack of timeliness knowledge is actually measurable. If one compares national exchange trades of derivatives, they are only a fraction of the over-the-counter derivatives triannual surveys performed by the Bank of International Settlement together with national governments. And if one includes the offshore contracts settled in national currencies, almost none is traded in trading venues. There is a considerable regulatory blindness to non-exchange traded derivatives, as well as to offshore transactions.
There are also other implications for the private initiative. Shareholders, bondholders and creditors, in general, are hindered from a deeper level of creditworthiness assessment of their counterparties’ exposures. The financial markets miss the opportunity of development and growth through a higher global interconnectivity.
Finally, the lack of regulation can lead to problems – technological gap and technological chang. Technological gap because other countries in the world are outpacing the development of technologies to the purposes of the regulation, while the national industry is prevented from doing so because of the lack of expectations about future regulation. And technological change because these national companies may invest in expensive systems considering the current situation and later be forced to incur in new costs due to a sudden change of the regulatory framework.
It may take a global view so that these jurisdictions can overcome the pressure of their national interest groups. But to remain blind in the information age is a choice and an expensive one.