Regulatory reforms for OTC derivatives: past, present and future

The economic and financial crisis starting in 2007 revealed significant weaknesses in the resiliency of banks and other market participants to financial and economic shocks. In the context of over-the-counter (OTC) derivatives, which total hundreds of trillions of dollars in notional amounts, the crisis showed that improved regulation of OTC derivatives and markets, together with enhanced market transparency, would be necessary to limit excessive and opaque risk-taking through OTC derivatives and to reduce the systemic risk posed by OTC derivatives transactions, markets and practices. In consequence, the G20 leaders mandated a comprehensive reform of OTC derivatives markets to reduce systemic contagion and spillover risks. Specifically, they agreed that OTC derivative contracts should be reported to trade repositories, and that all standardised OTC derivatives contracts should be cleared through central counterparties (CCPs) and, where appropriate, traded on exchanges or electronic trading platforms. They further stipulated that non-centrally cleared.contracts should be subject to higher capital requirements and that margining standards should be developed for non-centrally cleared trades. The G20 statement gave impetus to a number of related global initiatives, including work on enhanced regulation of financial infrastructures, capitalisation of financial institutions’ exposures to CCPs, and collateralisation of bilateral trades. To achieve the G20’s desired outcome of promoting system-wide stability, it is vital that these reforms incentivise financial institutions to use standardised contracts and to clear through a CCP. This article highlights the pre-crisis conditions in OTC derivatives markets that necessitated reform, details recent and ongoing regulatory efforts to address those shortcomings and to promote system-wide stability, and concludes by discussing plans to assess the impact of the reform programme and potential issues that will need to be monitored as markets respond to the new regulatory framework.