As US and European policymakers push ahead to complete drafting new rules to govern global securities market, the need for transparency and risk mitigation in global over-the-counter derivatives markets remains a critical focus. Although much of their initial focus was on requiring OTC derivative trades to be cleared through a central counterparty (CCP), policymakers and regulators are now examining other steps that are equally critical to helping mitigate risk, enhance transparency and ensure that regulators have access to crucial market data. One of the most effective proposals under consideration is to require the reporting of all OTC derivatives trades to a central repository where all underlying position data (and possibly transaction data) can be held, with unfettered access provided to all regulators globally. This paper explores the value of such a premise—particularly in terms of the powerful tool that a global repository provides for regulators—as well as the severe data fragmentation problems that are likely to hinder effective regulation if the result of policy decisions on both sides of the Atlantic is a reporting system that is not unified.
In the United States, regulatory agencies are racing to meet a mid-July 2011 deadline for creating new regulations that will carry out the intent of the Dodd-Frank law which the US Congress passed in July 2010. The new law, which Congress wrote in response to the mortgage meltdown in the United States as well as the global financial crisis, is the most ambitious remaking of US financial services rules and regulations in almost three quarters of a century. Meanwhile, policy makers in Europe are likewise trying to address the underlying and contributing factors that led to the collapse of Lehman Brothers as well as and concerns about OTC derivatives. The European Markets Infrastructure (EMIR) legislation, first released in September 2010, is expected to be decided upon in 2011 following further discussion by the European Parliament. There is a consensus that financial markets, which have become increasingly global in recent decades, need new rules to ensure transparency and reduce systemic risk. Included in that consensus is the mandate that all over-the-counter (OTC) derivative trades be registered in a regulated repository and in certain cases guaranteed by or cleared through a regulated central counterparty.
As an organization that provides CCP services in cash markets for equities and fixed income securities, DTCC understands and recognizes the value a CCP can bring to the derivatives markets. A CCP can collect margin and provide a trade guarantee, thereby reducing market exposure. But even if there are as many as five CCPs that will clear CDS transactions, these CCPs are by themselves not a panacea, since trading data will be collected across multiple jurisdictions and geographic regions. Essentially, a CCP does not eliminate the need to retain the full details on all underlying trading positions as a way to ensure transparency and support regulatory oversight. Likewise, as an organization that since 2006 has provided a centralized data repository for credit default swaps executed throughout the world, and currently services some 1,800 global dealers, asset managers and other market participants on an at-cost basis, DTCC has experienced and recognizes the degree of transparency and accountability that such a repository can deliver.
We know from our own experience that, in order to protect the safety and soundness of markets, it is necessary for regulators to have timely information about the market-wide exposure of the major market participants. Without a place where data on global trades can be centrally sourced, in other words, without a unified repository, it will be very difficult for regulators to glean all the information they need to make a knowledgeable assessment of market conditions and risk exposure in a reasonable amount of time.
Why is this so important?
Because if the world has five or six clearinghouses for cleared OTC trades, and multiple trade repositories for non-cleared OTC trades, and each of them reports independently to regulators, the result will be information so fragmented that no single entity will have an overview of the entire market. As a result, regulators, investors and the general public will not be able to see the market picture as a whole, a situation that could prove dangerous at a time of market stress. Instead, there will be increasing uncertainty and instability in the markets—adding to the stress—because of the lack of transparency. Regulators in turn will find it extremely difficult to meet their own mandate to protect investors and the integrity of the markets from systemic risks.
We have had some experience with this kind of situation. At the height of the Lehman Brothers crisis in 2008, our Trade Information Warehouse held nearly 90% of the information on credit default swap (CDS) trading positions. Although market speculation put the CDS risk exposure from underlying bonds written on Lehman Brothers at $400 billion, we were able to alert regulators and tell the market publicly and quickly that the true exposure was closer to a net notional value of about $6 billion. The actual value that eventually changed hands was $5.2 billion. Since November 2008, we’ve been publishing aggregate OTC derivatives data for the public on a weekly basis.
Under a scenario where there’s no requirement for trades to be reported into a central trade repository, there is obvious potential for a market participant to exploit the situation by hiding a large, systemically risky position. All this participant would have to do is split his position across several clearinghouses and trade repositories, making effective use of the fragmentation, inefficiency and delay to hide the size and risk of the aggregate position.
The need for a global solution
Because OTC derivatives are traded globally, it’s critical to have a trade information warehouse that functions globally, especially one unbiased as to how and where a trade has been executed or whether or how it has been cleared. Some market observers argue that having multiple repositories on a regional basis would allow competition and provide legal certainty and protection to relevant parties. But the global nature of the markets, coupled with the technical nature of the products, can lead to significant risks and complexities if data are fragmented. In a multi-repository environment, determining which contracts are registered in which repository or repositories is difficult. For example, a situation in which a French dealer enters into a transaction with a US counterparty on a CDS with a Japanese underlying security leaves questions on which repository, in which country, should hold the contract. This is one reason no reliable method for classifying contracts as relevant to any particular jurisdiction has yet been devised.
At the same time, because OTC transactions are regulated regionally or locally, regulators need to know they will have access to the information they require, no matter where it is physically stored. Meeting that need is a major reason why DTCC launched a European subsidiary called DTCC Derivatives Repository Ltd, which is regulated by the UK Financial Services Authority. Our new European Repository maintains global credit default swap data identical to that maintained in our New-York-based Warehouse Trust Company LLC. It also operates our recently launched Equity Derivatives Reporting Repository. We’ve made clear to regulatory agencies which function outside the United States that the data we collect from across the globe will be available to any of them with a legitimate interest. Having this repository regulated within the European Union should ensure that this will be the case.
Based on our experience to date, our hope at DTCC is that regulators and policy makers across the globe recognize the value that a centralized and global model for trade repositories can have in terms of effective risk mitigation and greater transparency. Over the long-term, DTCC envisages a “global solution” that takes into account the international nature of trading in OTC derivatives but also encompass a “regional approach” which respects the critical importance of oversight by regulators who must safeguard the integrity and soundness of their respective home markets. Such a system should:
- Provide market participants and regulators with a global view of risk.
- Avoid unnecessary complexity, increased risk and the costs of duplicated investment.
- Satisfy regional supervisory policy and legislation.
In our judgment, the necessary level of oversight can be achieved by global co-operation among regulators from all continents and through appropriate reciprocity arrangements to guarantee access to data in designated repositories for each asset class. The effort by the OTC Derivatives Regulators Forum in June 2010 to devise a framework on the global sharing of data is a significant step in that direction. The forum is a group of some 50 international financial regulators who have direct authority or interest in the OTC derivatives market and its infrastructure, and their cooperation on issues worldwide is important.
As policy makers in both Washington, DC, and Brussels work to finish their sweeping regulatory overhaul, we will continue to call on our experience in the CDS market to promote the benefits of maintaining data in a central location and avoiding the risks of fragmentation. We believe this is the best way to gather the material needed to illuminate what many have regarded as a murky and opaque market. A data warehouse can provide the lamp regulators need to shine light on these markets.
About Stewart Macbeth
Stewart Macbeth is a managing director and general manager of DTCC's Trade Information Warehouse (TIW). Based in London, he is responsible for the production operations and business development of the TIW services.
Prior to joining DTCC in 2009, Macbeth was a Managing Director at UBS, most recently serving as the head of Operations Risk and Business Architecture globally. Prior positions include the global head of OTC Derivatives Operations from 2002 to 2005.
He previously ran UBS's fixed income derivatives operations globally from 1996 through 2002. During that time, he established credit derivatives support activities along with the design and implementation of settlement and confirmation applications.
Prior to UBS, Macbeth worked at Swiss Bank Corporation in the Derivatives Product Control area where he was responsible for establishing a joint function with Operations covering exotic rates derivatives operations and P&L. Previously, Macbeth qualified as a Chartered Accountant (ICAEW) at KPMG working in their Financial Services practice.
Macbeth has a Bachelor's degree in Mathematics from Nottingham University and a Master's degree from the University of London.