An account with a brokerage firm is required to buy and sell futures contracts. Having agreed a futures contract, the buyer and seller must deliver an initial margin (typically 1% to 5%) of the total purchase price of the futures contract. The profit or loss of the contract for each party is calculated on a daily basis, this being added to or subtracted from the relevant margin account. This reduces counterparty default risk.
The key regulations
The Dodd-Frank Act was signed into US law in 2010. This established a new framework for regulatory and supervisory framework for the OTC derivatives market. Derivatives subject to regulation under Title VII of the Dodd-Frank Act include interest rate, credit default and equity swaps.
In meeting G20 objectives of increasing transparency and reducing systemic risk in the derivative markets, Dodd-Frank has moved all OTC derivatives onto exchanges and swap execution facilities (SEFs). This ensures most derivatives are processed through clearing houses and central counterparties.
The main requirements include reporting swap transactions to a swap data repository, clearing sufficiently liquid and standardised swaps on central counterparties, trading standardised swaps on trading platforms, and establishing higher capital and minimum margin requirements for uncleared swaps.
The EU’s European Markets and Infrastructure Regulation (EMIR) came into force in August 2012. The European Securities and Markets Authority (ESMA) drafted its Regulatory Technical Standards (RTS). These provide the detailed specifications of the regulation. EMIR applies to all OTC derivatives even when an EEA-based company is trading with a non-EEA counterparty.
The main objective of EMIR is to reduce the risks and large credit exposures seen in OTC derivative transactions. Other than some additional reporting requirements, exchange traded derivatives are less of a focus as these are already subject to rules around central clearing.
EMIR’s headline requirements are for central clearing and margining of standardised OTC derivatives, the reporting of all derivative transactions to a trade repository, and risk mitigation measures for all uncleared derivatives (including collateral exchange and confirmation and reconciliation procedures).
Given their heightened importance under EMIR, firms providing central clearing services (known as central counterparties or CCPs) were subject to additional requirements around their structures and procedures.
Most non-financial companies using derivatives for hedging purposes are not expected to put their OTC derivative transactions through central clearing. This means they will not have to put up margin to cover the daily mark-to-market valuation (the most recent market price) of their derivatives.
For many years, derivatives non-balance sheet items. Organisations entering into OTC products recorded the impact of these instruments in their books only when settlements occurred or when they reached maturity. FRS 102, applicable to accounting periods commencing on or after 1st January 2015, changes all that.
Derivatives now have to be presented on the balance sheet at their fair value, and the credit risk to both counterparties in the transaction needs to be reflected in the calculation. This usually requires a valuation, provided by the counterparty bank, or external advisors, deploying relatively complex derivative valuation models. Additionally, changes in the derivatives’ fair value now have to be recorded in the income statement.
Under FRS 102 the derivative is accounted for independently from the hedged transaction, which can be an unrecognised cash flow – for instance, a highly probable forecast transaction, sale, or purchase in foreign currency, or future variable interest rate payments.
This means the impact of the derivative on the income statement may not occur at the same time as the underlying hedged transaction, nor in fact be represented in the same line item (that is, it not being part of EBITDA or interest expense).
Organisations can reduce or eliminate income statement volatility arising from derivatives by applying hedge accounting. But they can only do so providing they can meet certain requirements, and then actively elect to do so. These requirements are:
To document the existence of a hedging relationship between derivative and hedged transactions.
To demonstrate an economic relationship (that derivative and hedged transactions are expected to move in opposite ways), usually by the coincidence of the critical terms of both transactions or by undertaking a quantitative analysis of their correlation.
To specify and quantify causes of ineffectiveness – possible mismatches between the derivative and the hedged transaction – by modelling the hedged transaction, usually using a ‘hypothetical derivative’ (the best possible hedge, being a proxy for the hedged risk and transaction).
On 1st September 2016, new initial margin (IM) and variation margin (VM) rules for non-centrally cleared OTC derivatives were introduced globally. The rules ensure appropriate collateral (such as cash, various debt securities and corporate bonds) is available to offset losses caused by the default of a counterparty.
Although only financial firms and systemically important non-financial entities are covered, each jurisdiction is able to set out its own definition of in-scope, out-of-scope and exempt entities. Most jurisdictions’ rules do not yet require the exchange of margin with certain types of non-financial entity, such as those trading below the EMIR clearing threshold (ranging between €1bn and €3bn, depending on class of OTC derivative). For now, at least, threshold value alone will exclude corporate contracts.
Asia expanding derivatives
Exchange-traded equity and commodity derivatives trading is a developing market in Asia. Hong Kong and Singapore are of course the leading trading hubs, being fourth and fifth largest globally in turnover of OTC interest rate derivatives (behind the US, the UK and France).
China is now opening up overseas investors access to its foreign-exchange derivatives market. Access is limited to the hedging needs of private-sector investors’ onshore bond positions. According to the State Administration of Foreign Exchange, the move in early 2017 enables hedging of bond positions and is seen as a means of driving greater investment inflow. China’s interbank bond market was opened up in 2016 and can trade products including forwards, swaps, cross-currency swaps and options using domestic settlement agents. Whilst there are no specific restrictions on the notional amount of FX exposure, steps such as market access, liquidity, reporting rules, settlement dates are anticipated a future point to bring the market in line with international access.
The key to securing the investment of international institutions in any new jurisdiction is the establishment of rules around close-out netting (the payment of a final sum in the event of insolvency). In this respect, Malaysia is a prime example how a framework can be used to good effect. In March 2015, the Netting of Financial Agreements Act 2015 came into force, providing legal enforceability of close-out netting provisions under Malaysian law.
In seeking to encourage derivatives market trading, Indonesia has sought to improve local banking knowledge and is now allowing international institutions to establish operations in the country in exchange for market training and guidance.
The Securities and Exchange Board of India (SEBI) also allows foreign portfolio investors to trade commodity options and equity derivatives through International Financial Services Centres. SEBI has also set up a risk-based supervision framework for brokers.
At the start of the year, Pakistan’s Securities and Exchange Commission talked about developing new regulations to allow the country’s stock exchange (and supported by Chinese investor cash) to issue a wider range of derivatives. This could open up the market to hedge fund trading. Cash-settled futures and single stock options were on the starting list. And in April this year, Vietnam’s Hanoi Stock Exchange published listing, trading, settlement and membership rules for derivatives trade.
Asia Pacific jurisdictions seem not to be diverging too far from existing international standards and have notably been establishing processes, including confirmations timings and reporting fields, that are mostly aligned with more established trading hubs in other regions. This should serve to make market development a more cost-effective process.
But it also demonstrates that whilst emerging markets see the value of derivatives, they also heed the lessons from previous errors of judgement. The market, despite what the likes of Buffett say, is here to stay.