Foreign regulations landing on Asian soil: Case for a unified response

Following the financial crises of 2008, regulators in both Europe and the United States, empowered by the collapse of major financial institutions such as Lehman Brothers and Bear Sterns, did little to reflect on the initial reason for existence of the OTC markets and the benefits it had once bought to both the banks and the buy side, and instead opted for a broad set of initiatives to restrict and control OTC activities. Gradually as these set of initiatives unfolded into a series of stringent acts enforced by US regulations such as Dodd Frank and the European Market Infrastructure Regulation (EMIR), financial markets began to realize the enormity of the new measures, which would not only have an impact on the execution and clearing of trades but fundamentally alter every post-trade activity ranging from margining, reporting, capital requirements and netting methodologies.

Perhaps the most controversial of all these reforms is the extraterritorial nature of the regulations. Both the Dodd Frank Act as well as its counterpart EMIR are designed to regulate OTC activity well beyond its borders.

This brings us to Asia. Over the past decade, Asia has seen relatively strong economic growth averaging 8% across the region concurrent with a small but steady increase in financial market activities, which unlike other regions, have seen no major crises since 1997. Asian banks have also been commended on their well-capitalized balance sheets and prudent risk management practices with seven of the top 20 safest banks in the world hailing from the Asia Pacific region. It is therefore no surprise that Asian market participants, ranging from banks to asset managers and sovereign wealth funds are all whispering the same question behind closed doors: “Why should Asian markets pay the price for irresponsible mortgage financing backed by unlimited issuances of CDO’s and over leveraged banking activities,” all of which took place thousands of miles beyond its shores.

The more important question that needs to be addressed in Asia however is a fundamental one: Are the Dodd Frank and EMIR regulations necessary for the well-being and growth of Asian markets? The answer lies in analysing some of the key reforms proposed by regulators. For example, both DF and EMIR require the bulk of the OTC trades to be centrally cleared through approved Centralized Clearing Parties (CCPs). For Asia, clearing trades on CCPs is an extremely costly and cumbersome venture. For a start, CCP’s will have to be built in every jurisdiction that trades OTC derivatives. A challenging endeavour in itself. More dubious is the fact that once a CCP is created, it will require the approval of both Europe (as ESMA recognized) and the US (as DCO approved) before its participants can trade on it. Failure to get approval would result in the clearing member being penalized in the form of higher capital charges as they would be deemed trading in a non-qualified CCP as well as prevent US or European counterparties in obtaining recognition for the cleared trade. If one were to adopt a more a cynical perspective, one would also point out that a failure by an Asian CCP to qualify as a DCO or ESMA recognized CCP, would actually allow its offshore competitors like LCH from Europe or CME from the US, to obtain a free passport to enter Asia and have Asian market participants clearing through them instead. This gives rise to the broader question of cross border recognition and whether CCPs should in fact be approved by a more impartial global body and not just regional regulators who may have their own interests at stake.

The other question that needs to be addressed is whether regulations originating offshore are really suitable for Asian markets, which are innately different in size, product range, depth and sophistication. Take for example regulations on mandatory client clearing. A small insurance company in Singapore executes five to 15 trades a week with their executing broker purely to hedge its market risks or even fund some of its currency liabilities. Going forward under the various regulations, they will need to employ an executing broker, a clearing broker, a collateral manager and either a fund administrator or custodian to ensure it is meeting all of the regulatory requirements. This is causing undue cost and logistical pressure on the buy-side companies who are considering exiting the OTC derivatives market even if their initial objective was simply to hedge their risk using OTC products.

"There are too many obstacles to trading OTC products in this new regulatory environment in the way of mandatory confirmation, reconciliation and margining requirements which are increasing the costs of hedging our portfolio risk," says William Mitchell, fund manager at Majoeira Capital in Singapore.

So now to our final question: how should Asia respond? Perhaps the boldest reaction to global OTC reforms have so far come from the Australian regulators, CFR (Council of Foreign Regulators) who on April 4th this year announced that “it would not be appropriate to mandate central clearing for non-dealers at this point.” While the move by the Australians was quietly applauded in the region, it still displays a unilateral stance towards foreign regulations and further reinforces the view that the APAC region functions in a fragmented manner.

For Asia to respond optimally, it will need to first look inward and assess its own strengths. So, let’s take a look at the deck of cards Asia has at its disposal: as mentioned, it is the fastest growing region globally averaging approximately 8% GDP growth. Its population at 4.4 billion is seeing a structural shift in its composition to middle and upper classes, with its high net worth individuals currently worth a staggering $14.2 trillion. Its foreign exchange reserves stands at $4 trillion while it is estimated that approximately $8 trillion worth of high grade assets are held in the region. The point here is not to brag about Asia’s success relative to other regions but to demonstrate that Asia as a whole is self-sufficient and the concurrent strong growth in its population and economy would mean that domestic financial markets should be able to support themselves organically and even if this means without offshore investment.

However before Asia uses its strong hand in this complex and often conflicting web of global regulations, Asia needs to display unity through harmonization of its regulations and market practices and a cross border interoperability which will ensure domestic markets can provide support for each other in the region.

Given the political tensions that exist today between the various jurisdictions in Asia, this may be an overly ambitious feat to achieve. However there have been glimmers of hope recently as Asian jurisdictions have started cooperating with each other towards a broader regulatory framework for the region. The best example of this was evidenced in December last year with the Asia Pacific Regional Committee (APRC) of the International Organization of Securities Commissions (IOSCO) writing to the European Union, “stating that (European) equivalence judgments may not be fully appropriate to Asian CCPs, due to different market conditions, products and the fact that these CCPs mainly serve domestic market participants.” The response to this was encouraging with IOSCO proposing to the EU that a time extension be applied to allow the Asian CCPs to qualify as recognized ones. While the stakes were small and the victory itself, largely symbolic, it still provided encouragement to Asian regulators and reinforces the view that a united Asia is a strong Asia, and only a strong Asia would be able to protect its domestic OTC markets that are so essential in supporting the future growth of the overall Asian economy. Tom McMahon, CEO of UD Trading Asia sums it up accurately stating that “It is a good opportunity for Asian regulators to coalesce to a unified front at the prompting of what some would view as undue European and American regulatory pressure.”

For a region that prides itself for its long history, a rich and diverse culture and the success of its own growth, there appears to be a strong consensus that the future of Asian markets should be decided in Asia and by its own regulators and participants and not dictated by offshore reforms that do not appreciate the complexity and the uniqueness of this continent. Mark Ho, Regulatory Reform Advisor at Standard Chartered Singapore takes a more conciliatory approach, suggesting “there is a need for international comity where the international regional regulators work in cooperation with each other, acting with mutual respect and in deference to the local rules of each local regulator in their jurisdiction.” Ho’s vision is certainly commendable but respect is earned and not given and for Asia to earn it, it must reveal its strength through a display of regional harmonization, a uniform regulatory vision and finally, a unified response.