In the aftermath of the global financial crisis, great concern was expressed over the lack of transparency and risk management of the over-the-counter (OTC) derivatives market, which many believed to be one of the fundamental causes for the events which placed the world on the brink of financial turmoil.
As a result, much regulation has been promulgated to include the recording of OTC derivatives contracts in a Trade Repository (TR) to enable the evaluation of build-up of concentration risk associated with these agreements.
The importance of a Trade Repository for OTC derivatives
A TR for OTC derivatives is a centralised database that maintains a secure and reliable electronic database of the records of open OTC derivatives transactions. The primary public policy benefit of a TR stems from the improved market transparency facilitated by its record keeping function, the integrity of information it maintains and effective access to this information by relevant authorities and the public in line with their respective information needs. It provides reporting to market authorities and to its customers, as well as aggregated information to the public.
The benefits of a Trade Repository include:
- Quick and timely access to data in a time of crisis, which would safeguard SA’s financial markets,
- to reduce systemic risk,
- to improve transparency, and
- to protect investors.
A TR is in line with recommendations set forth by the G-20 where all standardised OTC derivative contracts should be traded on an exchange or electronic platform, where appropriate, and cleared through central counterparties by end-2012 at the latest. “This aims to enhance the stability of global financial markets and protect investors and financial institutions in the event of a crisis,” says Anthony van Eden, Strate’s Chief Operating officer.
As a member of the G-20, South Africa is committed to and acknowledges the need to conform to reporting of OTC transactions to enhance regulatory oversight and improve transparency.
Prior to 2008, extensive financial risk existed in OTC derivatives market as considerable volumes of these instruments were traded off exchanges. “Financial institutions internationally had their blinkers on as they failed to manage the accumulation of risk as the market’s appetite for OTC instruments grew. Using OTC derivatives correctly, such as the use of credit derivatives for example, helps mitigate credit risk and improve liquidity, which is why these instruments are popular,” adds van Eden.
However, some large international financial companies reportedly misunderstood the risks associated with these contracts and failed to adequately collateralise these exposures and had no understanding of whether their collateral was being reused or where it finally ended up. Furthermore, regulators had no oversight of the build-up of concentration risk amongst neither institutions nor their systemic impact on their economies.
Consequently, when investment banks like Lehman Brothers cracked and filed for bankruptcy, regulators immediately became concerned over the credit exposures between counterparties. The lack of central oversight of a largely unregulated market created a wave of panic, as unreliable information led to a wider collapse in the financial markets – and the global financial crisis emerged.
In South Africa, the Financial Markets Bill, which is expected to be promulgated in the next few months, is providing a new framework to regulate the financial markets sector of the financial markets with enabling legislation for a TR. “An approved Trade Repository will bring transparency to the market and greatly enhance regulator’s oversight and ability to respond to market risks or manipulations,” concludes van Eden.