Financial Stability Board’s strong outreach in Global Financial resilience is expected

Korea will be the first emerging economy to host the Financial Stability Board meeting on the 20th of October, 2010. In its third plenary meeting in Basel, Switzerland, the board decided to have the fourth event in Seoul before the G20 summit. Since Korea is also the chair country of upcoming G20 forum, a Financial Services Commission official said that Korea will be able to take the lead in reforming the financial framework.

 The Financial Stability Board (FSB) was established in April 2009 as the successor to the Financial Stability Forum (FSF). The FSF was founded in 1999 by the G7 Finance Ministers and Central Bank Governors to promote stability in the international financial system. Yet, among the leaders of G20 countries, there had been a broad consensus on stronger institutional ground with an expanded membership. And this movement resulted in the creation of FSB, an extended form of FSF. In an attempt to strengthen its effectiveness, financial authorities from the G20 nations, international financial institutions and several global standard setting bodies joined the FSB as the new members. The FSB performs the initiative role to develop and implement strong regulatory, supervisory and other policies in pursuit of financial stability. 

 As a member of FSB, Korea, especially the Bank of Korea and Financial Services Commission came to have an even more crucial role. FSC is involved in FSB Steering Committee which provides operational guidance and sets the agenda in general. So FSC has been trying to boost regular meetings among the FSB leaders and to continue active discussions. One of them was the financial reform conference called “Envisioning a New Financial System: An Emerging Market Perspective” which Dong-Soo Chin, the chairman of FSC held on Sep.2 in Seoul. The conference called attention to the increasing impact of emerging markets to the world economy, paving the way for more balanced participation of emerging countries in the global finance sector.

 

 

(Sep.2th Korea-FSB Financial Reform Conference, taken from Herald Media)

In fact, a decade ago, Korea felt the tremendous pain due to 1997 Asian Financial Crisis. In the wake of 1997 crisis, Korea had no choice but to strongly restructure corporate and financial field, dealing with long-neglected structural problems hidden behind rapid growth. Passing a time of economic revitalization and renewal, Korea learned valuable lessons and now, it is positioned as one of the competitive global economies. This unique experience enables Korea to serve as a potential broker that can bridge the gap between the emerging and the advanced markets.

 Sharing Korea’s pre-experience and know-how, particularly on financial regulation reform, perspectives of emerging economies can be brought into the global reform process. Many experts admit that Asia will be the engine of future global economic growth. In order to make the emerging markets less vulnerable to external shocks, global financial safety net is strongly required and in this sense, international standards will help them free from poor financial infrastructure.

 Currently, a lot of critical financial agenda are on the FSB table. For instance, to enhance transparency among market participants, prudent oversight of capital, liquidity, leverage and risk management is necessary. Along with Basel III, which delineates the rate of bank capital buffer, Bank Levy is considered a possible measure to increase banks’ crisis management capability, although the feasibility of the proposal still remains to be seen. Furthermore, efforts to reduce systemic risk generated by interconnectedness among financial institutions worldwide led to global coordination to devise measures that cover broader range of financial markets and instruments. Systemically important financial institutions will be strictly monitored and the size of “shadow banking” such as hedge funds and off-balance sheet entities will be shrunk. New international controlling standards on hedge funds will emerge and Central Counter Parties will be installed for over-the-counter (OTC) derivatives. In addition, more standardized forms of OTC products will be used and regulation on credit rating agencies will be intensified. 

                                                                                               (Picture from the Korea Times)

The FSB will take up a vital role of making these regulatory reform recommendations to the G20 summit. Once a certain regulatory reform is approved and adopted through the Financial Stability Board and G20 forum, those international standards are to be implemented by each country. Throughout this highly critical process, Korea is anticipated to undertake a number of initiatives to assess each regulation across sectors, identify regulatory gaps and examine related issues, and reflect emerging Asian market perspective. Gearing up for the G20 summit, FSB activities are an important step in facilitating G20 reform agenda. Everyone hopes to see successful outcome from the impending FSB meeting in Seoul.

Lee, Ki Yeon (kiyeon.m.lee@gmail.com)

Central Counterparty (CCP): Regulatory Initiatives to Strengthen the OTC Derivatives Market Infrastructure

Since the start of the financial crisis, some commentators have been arguing that excessive use of over-the-counter (OTC) derivatives products among financial entities has caused massive collateral damage and systemic risk that nearly brought down the system. Accordingly, they are calling for more regulations that should be put into place for these instruments. But on closer inspection, it is not hard to discern that OTC derivatives per se were not the main culprit that contributed to the fiascos of AIG, Bear Stearns, and Lehman Brothers. Yes, it did add to the prevailing opacities and complexities endemic in many of their questionable operations, but there were certainly many other things cropping up at that time. Therefore, it would be misleading to conclude that all policy aims should be directed toward limiting these trades altogether. Instead, by inducing market participants to clear their derivatives transactions through CCPs, it could in fact potentially mitigate the severity of any possible systemic risks in the future. And that is actually the main reason why leaders from G-20 countries are going about their plans to institute CCPs across all 20 nations by the end of 2012.

Here we would like to introduce some theoretical backgrounds that back today’s regulatory initiatives. And then we would like to address Korea’s progress and lay out some caveats that need to be considered before it becomes fully effective. It is only after successfully dealing with these factors that we will be able to ensure the effectiveness and successful implementation of the forthcoming regulatory regime.

What is a central counterparty (CCP)?

Central counterparties (CCPs) function as an intermediary between two entities who want to set up financial transactions. Through a legal process called “novation,” parties that are involved in the transaction transfer their rights, duties, and terms to the CCP. Once the trade becomes novated, the CCP assumes every counterparty risks that should have been borne by the two parties. But, for bilateral derivatives transactions, dealers act on behalf of the end-users of the contracts, i.e. corporations, to execute their client’s trades. In this case, opposed to the roles of CCPs, each party assumes all counterparty risks and has the responsibility to assess the creditworthiness of their counterparty, set and collect collaterals, keep track of each other’s changes in credit quality, and handle the real payments. Most importantly, closing out of a transaction could be either or both unwieldy or not feasible. This is where the advantage of CCP over bilateral contracts comes in. CCPs provide multilateral netting benefits, enabling every member to freely adjust their existing positions. But what if a member defaults on its obligations? Does the other counterparty that is in-the-money (ITM) have to worry about potential losses that can possibly occur from a party walking away from its obligations? No. The CCP settles the defaulting member’s trades and fills up the deficiency, the amount that exceeds the posted margin from the defaulted party.

Then, having defined the role of a CCP, what are the major benefits other than multilateral netting?

Revisiting the multilateral netting benefit discussed above, through allowing easier entry for interested parties by enabling them to trade anonymously, a CCP can heighten the chance for them to embark on their planned trades that they otherwise would have forgone; this would eventually enhance the overall liquidity in the market. Another benefit arises from reduced workloads related to legal and operational tasks. Once a party becomes a clearing member, CCP handles settlement, netting, and margining works. Furthermore, workforces that were assigned to ascertain counterparties’ creditworthiness could now devote to other tasks. But from a regulatory perspective, probably loss mutualization and improved transparency would be of most interest to policy makers. Organizational arrangements of CCPs, at least in the U.S., specify certain layers and associated parties involved in each layer, which will assume losses accruing from a member’s default. This structural design effectively disperses big losses to the rest of the members, and thereby aids in preventing institutions from failing. Furthermore, trade repository’s roles of collecting and disseminating trade information will enhance price discovery and ultimately lead to better transparency. And, for the purpose of surveillance, it will provide a more convenient tool for regulators to assess market conditions.

Now, let’s take a look at Korea’s readiness ahead of 2012, the proposed deadline for every country to fully develop its CCP infrastructures.

Progress in Korea

When assessing the situation in Korea, one has to bear in mind that the OTC market in Korea does not share much similarities of those in the U.S. or other countries that have sizeable markets. Korea only makes up a fraction of the total amounts outstanding of OTC derivatives in the world (see Figure1). And while the world market is mostly inundated with interest rate contracts, in Korea, foreign exchange contracts have a big share as well. For all those reasons, some pundits point out that restrictive regulation and applying “one size fits all” approach could impede growth and innovation, which are the cornerstones of an underdeveloped market to grow its pie. Nevertheless, it is important to comply with the new regime that is being shaped by world leaders in an effort to strengthen regulatory harmonization and convergence across countries.

After the Pittsburgh summit, Financial Services Commission (FSC) has set up a task force to put infrastructural mechanisms in place. Currently, working groups are tracking recent regulatory trends and case studies from the developed countries. Outlines for infrastructural introduction and related new legislation will be proposed this year. And it is expected that by the year 2011, several agents will be designated as CCP operators. And then finally, CCPs will start its service by 2012.

But before CCPs come into use, key issues that should be dealt profoundly are as follows:

First, Korea has to introduce CCPs that are well suited with its current market environment. As mentioned above, Korea does not have a mature market. For that reason, excessive restrictions posed to market players could be counterintuitive at this moment. CCPs that will be newly established in 2012 should function in a finest manner that could achieve optimality, whilst conforming fully to the frameworks that are laid out by the G-20 summit. And the decision of designating who will be the CCP operators and determining the ranges of products that will be subject to central clearing should seek both conformity with the ongoing regulatory trends and efficiency.

Second, Korea has to establish a strong legal framework of CCPs. It should stipulate the definition of clearing, basis of the establishment of CCPs, conditions of establishment, etc. And most importantly, it should also include contexts that explicitly state how this new initiative could serve the broader public interest as well. We have witnessed contagious effects and chain reactions that originated from failures of big financial institutions. It is important to realize that CCPs itself could fail in a same way. In fact, competitions among CCPs in an effort to attract larger amounts of deals could promote lax risk management practices such as requiring less initial margins. Jon Gregory, former Global Head of Credit Analytics at Barclays Capital, argues in his paper that “when several CCPs are effectively competing then margin requirements will be a key distinguishing feature.” Once undesirable momentum builds up, meaning CCPs start to under charge, taxpayers could be asked to bail out insolvent CCPs in an extreme case. Randall Kroszner, former Federal Reserve governor, is especially well aware of this possible event. He believes that the strong historical track records of CCPs in the U.S. could be attributed to no implicit backing from the government. In his speech in 2006, Kroszner explains that most of the organizational arrangements were evolved from private-market disciplines, and any suggestion of possible support from the government could destroy these mechanisms developed from the past. He concludes with his speech that the government should avoid regulatory protectionism and let the backbone of the structure operate in a frictionless manner: providing transparency of default rules and ceding influence over risk controls to those with the “skin in the game.” Korean policy makers should also be alert to the possible breakdowns when there are excessive regulations on the system, and ensure that private innovation spurs.

Third, once the products that will be subject to central clearing are determined, standardization of these products should subsequently follow. Until now, interest rate related products have proven to be relatively easier to standardize than others. But as foreign exchange contracts account for a large portion in Korea, there needs to be more discussions and studies regarding this certain category to attain maximum effectiveness.

Lastly, Korea has to establish infrastructural systems that go together with CCPs. We have yet to build electronic trading systems and trade repositories to fully meet the requirements stated in the G-20 communiqué. But for the latter component, we currently do have a system that embodies similar functions that of trade repositories have. In Dec. 2009, Financial Supervisory Service (FSS), who oversees and supervise financial institutions and the financial market in Korea, launched a derivatives transactions monitoring system. The system collects information regarding identity of the counterparty, underlying assets, and trade objectives. Moreover, from the data collected, it can also perform stress tests that can function as an early warning system to detect unusual risks building up in the market. Although FSC has not yet decided whether it will build a new trade repository from scratch or improve the existing system that is currently being used, the latter is also being considered as an option.

Conclusion

Many discussions about the CCP were revolving around the willingness of banks to offload their existing positions to CCPs. As most of the existing positions are allowed to be rehypothecated to others, it would require banks to post more margins than the current level. This could indicate that banks would have to raise more capital to meet the regulatory demands. Another related topic of discussion is how much and to which degree there should be “penalties” assigned to firms who do not post their trades to CCPs. There are already some studies that measure how much capital or taxes should be levied to incentivize firms to offload their positions to CCPs. Another related question is how much capital should be set for non-standardized trades that are not required to clear through CCPs. Darrel Duffie, in his staff report to the Federal Bank of New York, argues that highly aggressive impositions on firms to centrally clear their OTC derivatives trades could stifle development of new products and limit the end users from fully exploiting risk management tools. This view is in stark contrast to that espoused by John Hull, who argues that requiring every derivatives trade, including both standardized and non-standardized, to be cleared centrally is feasible. Those who concur with this view, that, if a critical mass does not move to CCPs, it will be difficult to attain maximum multilateral netting benefits. Lastly, there are some ongoing talks about how CCPs can realize interoperability. Diana Chan, CEO of EuroCCP, says an ATM card could be offered as a simple analogy for understanding the concept of interoperability. “Without interoperability among banks, consumers would only be able to withdraw cash at an ATM installed by their own bank.” To put this into the context of CCPs, it enables cross netting among different CCPs and enables market participants to choose which CCPs they will use regardless of the trading venue. In effect, even though two trading parties are using different CCPs, one will not be affected by another CCP’s default. But these linkages could convey more pronounced risks in market stress situations than in the absence of interoperability.

Luckily enough, we are now having the luxury to learn from the lessons that we were not “directly” exposed to. But as the OTC derivatives market develops and grows, all of the discussions that are taking place right now will become directly relevant. We should seriously take everything into consideration and not repeat the same mistakes.

Donald Lee (DonaldLee.DLee@gmail.com)