Further progress is needed on derivatives reform, FSA says

In a speech on progress on market reform David Lawton, acting Markets Director for the Financial Services Authority (FSA), said that although much of the work internationally was well advanced cross-border consistency remained an issue.

"While every national regulator must ensure that its national markets are stringently and appropriately regulated, we must also recognise that derivatives markets cross national borders and that regulatory intervention which fragments the global market could impose huge costs without necessarily reducing risk," he said.

Legal frameworks currently being established by the EU, US and other national regulators provided a "good starting point" by establishing the principle that compliance with foreign regimes which provide equivalent protection was an "appropriate substitute" for traders who would otherwise have to ensure that they complied with many different regimes. However, Lawton added that he did not "underestimate the challenge" of ensuring that international standard-setting work was completed in good time.

Both the EU and US have implemented mechanisms to reduce the reporting burdens on firms involved in cross-border transactions, according to Lawton, while work on access to trade repository data by international regulators is ongoing.

The tight implementation timetable also meant that firms would not be able to "wait for certainty" before ensuring that they were compliant with the new regime, he said. The European Market Infrastructure Regulation (EMIR), which will implement commitments made by the G20 group of major global economies to improve transparency in the derivatives market and protect against market abuse, is due to come into force from 1 January 2013.

"The authorities can only do so much – industry needs to take responsibility for its own readiness," he said.

Once EMIR is in force, all OTC derivative contracts will have to be cleared through central counterparties (CCPs), while all derivate contracts including those involving OTC derivatives will have to be reported to central trade repositories. A derivative is a type of financial contract linked to the underlying value of the asset to which it refers, such as the movement of interest rates or currency value, while 'OTC' derivatives are those not traded on a regulated stock exchange but instead privately negotiated between two parties.

The FSA had, Lawton said, identified "significant implementation challenges" for affected firms which remained outstanding as a result of its discussions with firms. EMIR is "unusual" as it applies to a "huge range" of firms, "from the largest bank to the smallest investment firms", although some exemptions are provided for pension funds and non-financial firms that use OTC derivatives to "hedge", or protect themselves against, risks directly linked to their commercial activities.

Lawton said that many CCPs were not yet fully prepared for firms who were not yet members to access the central clearing process. CCPs sit in the middle of a trade between two parties and assume the counterparty risk, ensuring financial performance of the trade if one party does not meet its commitments.

"Most CCPs' client clearing solutions are still at an early stage of development," Lawton said. "This risks clients being forced onboard in very short order to comply with EMIR's clearing obligation but without sufficient due diligence and awareness of the risks involved ... A lack of standardised client clearing documentation is increasing the scale of these challenges."

The FSA also remained concerned that there had been insufficient development of recovery and resolution processes for failed CCPs, and that how the risks of trades exempt from the clearing requirements would be mitigated through bilateral collateralisation remained uncertain. The European Banking Authority (EBA) published draft technical standards on the additional capital requirements that will enable CCPs to mitigate broader market risks outside of EMIR last week, while the European Securities and Markets Authority (ESMA) is also consulting on technical standards for activities covered by EMIR.

The final version of EMIR is due to be published by the European Commission by the end of August. Lawton said that, following a period where CCPs would have to apply for reauthorisation, the first clearing obligations would likely be imposed "around mid-2013".