Transcript Regulating Derivatives in the Caribbean

Regulating Derivatives in
the Caribbean
Caribbean Group of Securities
Regulators (CGSR) Conference
Presenter: Johann Heaven
PROVEN Management Limited
Regulating Derivatives
Derivatives are often and inappropriately portrayed as
unregulated, arcane, and excessively risky instruments.
Caribbean Derivatives Market
• In the Caribbean, derivative products, primarily
include:
• Forward exchange rate contracts (forward exchange
rate swaps and options)
• Cross-currency swaps
• Interest rate swaps
• Oil options and swaps
• Bond options
Caribbean Derivatives Market
• Market participants are relatively few and institutional
in nature
• Participants utilize derivatives for both speculative
purposes and to hedge against exchange-rate risk,
commodity price risk and interest rate risk.
• There is no established Exchange for the trading of
derivatives.
• Majority of the contracts are customized OTC
transactions
Caribbean Derivatives Market
• Risks posed by the Derivatives Market:
– Lack of transparency
– Counterparty risk
– Operational risks
– Systemic risks
Caribbean Derivatives Market
• The importance of regulating derivatives are to:
• Ensure the integrity of markets
• Deter manipulation by agents
• Protect participants from losses arising from fraud or
the insolvency of counter-parties.
• Monitor off-balance sheet risk of Financial institutions
Regulatory Approach
Regulatory Approach
• Optimal form of government regulation is
determined by market characteristics which
include:
• The size of the market
• the types of instruments traded
• the types of market participants
• the nature of the relationships among market
participants.
Market Participants
Speculators vs. Hedgers
• The Commodity Futures Trading Commission
(CFTC) classifies market participants as:
– Commercial traders are those that use derivatives
for hedging purposes.
– Non-commercial traders are those that do not
own the underlying assets or its financial
equivalent and only hold positions in futures
contracts.
Hedgers
• Derivatives are enormously useful instruments in the
management of risk. They are used by Hedgers:
– to hedge an existing market exposure (forwards and
futures),
– to obtain downside protection to an exposure even while
retaining upside potential (options),
– to transform the nature of an exposure (swaps)
– to obtain insurance against events such as default (credit
derivatives).
– to manage exchange-rate risk, input costs, financing costs,
or credit exposures
Speculators
• Derivatives are also highly levered instruments
• The leverage makes derivatives attractive to
speculators
• Speculators add considerable liquidity to the
market
• By taking the opposite side, they facilitate the
positions hedgers want to take.
• Leverage however magnifies the effect of price
moves.
Speculators
Size of the Derivatives Market
Size of Derivatives Market
Size of Derivatives Market
Nature of the Derivatives Market
OTC Derivatives
• Over-the-counter (OTC) derivatives have terms
that are privately negotiated between two parties
rather than traded on an exchange with
standardized terms.
• The OTC derivative market is the largest market
for derivatives, and is largely unregulated with
respect to disclosure of information between the
parties, since the OTC market is made up of banks
and other highly sophisticated parties.
OTC Derivatives
• OTC derivatives include:
– Forwards – contracts to buy or sell assets at a future
date based on a price specified today.
– OTC Options – contracts to buy or sell an asset at a
given price within a specified date.
– Swaps – contracts to exchange cash flows on an
agreed schedule.
– Credit Default Swaps – contracts where a buyer makes
a payment to a seller in return for a promise that the
seller will compensate the buyer if a specified credit
event occurs.
OTC Derivatives
Regulatory Approach
• The International Swaps and Derivatives Association
(ISDA) is a trade organization of participants in the
market for over-the-counter derivatives.
• It is headquartered in New York, and has created a
standardized contract (the ISDA Master Agreement) to
enter into derivatives transactions.
• ISDA has more than 820 members in 57 countries;
• Its membership consists of derivatives dealers, service
providers and end users
ISDA Master Agreement
• The master agreement is the central document around which
the rest of the ISDA documentation structure is built.
• It sets forth all of the general terms and conditions necessary
to properly allocate the risks of the transactions
• It does not contain any commercial terms specific to a
particular transaction
• Once it is executed, the parties can enter into numerous
transactions as evidenced by written confirmations.
Exchange-traded Derivatives
• Exchange-traded derivatives are those derivatives
instruments that are traded via specialized
derivatives exchanges or other exchanges.
• A derivatives exchange is a market where
individuals trade standardized contracts that have
been defined by the exchange.
• A derivatives exchange acts as an intermediary to
all related transactions, and takes initial margin
from both sides of the trade to act as a
guarantee.
Exchange Traded Derivatives
Exchange Traded Derivatives
OTC vs. Listed Derivatives
Caribbean Derivatives Market
• In the Caribbean, derivative products, primarily
include:
• Forward exchange rate contracts (forward exchange
rate swaps and options)
• Cross-currency swaps
• Interest rate swaps
• Oil options and swaps
• Bond options
Caribbean Derivatives Market
• Market participants are relatively few and institutional
in nature
• Participants utilize derivatives for both speculative
purposes and to hedge against exchange-rate risk,
commodity price risk and interest rate risk.
• There is no established Exchange for the trading of
derivatives.
• Majority of the contracts are customized OTC
transactions
Regulatory Approach
• What is the optimal balance between
governmental regulation and self-regulation?
• There are three types of failures associated with
governmental regulation:
– the costs to run regulation bureaus, to collect
information and to monitor markets
– the credibility of the proposed mechanism
– The behavior by constituencies directly or indirectly
affected by the regulation
Regulatory Approach
• What is the optimal balance between governmental
regulation and self-regulation?
– The self-interest of market participants generates private market
regulation.
• There exists a moral hazard problem associated with
government intervention
– if private market participants believe that government is protecting
their interests, their own efforts to protect their interests may
diminish.
– If the incentives of private participants are weak or they lack the
capabilities to pursue their interests, then government intervention
may improve regulation.
Regulatory Considerations
Regulatory Developments
• Mandatory reporting regulations are being finalized in a number of
countries, such as Dodd Frank Act in the US, the European Market
Infrastructure Regulations (EMIR) in Europe, as well as regulations
in Hong Kong, Japan, Singapore, Canada, and other countries and
has as its objectives:
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the minimization of systemic risk from derivatives use
increased the transparency of the OTC derivatives market
protecting against market abuse
preventing regulatory gaps
reducing the potential for arbitrage opportunities
fostering a level playing field for market participants
reduce regulatory uncertainty and provide market participants with
sufficient clarity on laws and regulations
Regulatory Developments
• Major implications of the Derivatives Reform:
– All standard derivatives contracts were to be traded on
exchanges or electronic platforms.
– Standard derivatives were to be cleared through central
clearing-houses.
– Deals were to be reported to trade repositories.
– Margins set aside to guard against shifts in the values of
derivatives were to be robust.
Caribbean Regulations
• Establish the Caribbean Derivative Trading Commission “CDTC”
responsible for:
– Regulating the regional derivatives market
– Protecting market users and the public from fraud and manipulation
– Fostering an open, competitive, and financially sound derivatives market
– Ensuring the financial integrity of the clearing process
– Recording and reporting on trading activity
– Sanctioning of companies or individuals for misconduct or fraud
Caribbean Application
• The Caribbean Derivative Trading Commission “CDTC” should:
– Establish a regional legal framework for the Derivatives Market
– Encourage Regional Stock Exchanges to establish and facilitate trading
of standardized derivatives contracts.
– Encourage the Exchanges or Private Sector to establish a Derivatives
clearing house
– Provide oversight to the OTC market.
– Establish an ISDA type Master Agreement for the trading of OTC
contracts.
Questions?