Corporates have been exempted in the US and Europe from posting margin on non-centrally cleared swap transactions they use for hedging purposes, but there are plenty of other measures they can take to mitigate risk.
In fact, corporates lobbied long and hard to be exempted from the swap margin requirements that apply to financial firms. They argued that their swaps played little role in the financial crisis beginning in 2007, and the requirements would eat up capital that could be put to more productive use elsewhere. Nevertheless, the over-the-counter (OTC) derivatives market has continued to grow at a rapid pace, jumping more than 12 percent between 2012 and 2013, to $710 trillion.
Recognizing the risk posed by such a large, unregulated market, the International Organization of Securities Commissions (IOSCO) consulted with the Basel Committee on Banking Supervision (BCBS) and other regulatory groups, and it solicited views from the public on how best to mitigate that risk. The result is a list of standards that in some cases regulators have or plan to put into use, and which provide a framework for OTC derivative market participants to gauge the effectiveness of their own risk-management systems.
The recently issued report describing the standards notes that they provide three main benefits: Promoting legal certainty and facilitating timely dispute resolution; facilitating the management of counterparty credit and other risks; and increasing overall financial stability.
“Risk mitigation techniques promote legal certainty, reduce risk and improve efficiency,” said Manabu Kishimoto, an IOSCO policy advisor who worked on the report. “To maximize the reduction of systemic risk, the risk mitigation standards for non-centrally cleared OTC derivatives set out in this report should be applied as broadly as practicable amongst market participants.”
The nine standards that the IOSCO report describes in detail include:
- Establishing policies and procedures to execute written trading relationship documentation with counterparties prior to or contemporaneously with executing a non-centrally cleared OTC derivatives transaction.
- Establishing policies and procedures to ensure the material terms of all non-centrally cleared OTC derivatives transactions are confirmed as soon as practicable after execution of the transaction.
- Establishing policies and procedures to ensure that the material terms and valuations of all transactions in a non-centrally cleared OTC derivatives portfolio are reconciled with counterparties at regular intervals.
- Establishing policies and procedures to regularly assess and, to the extent appropriate, engage in portfolio compression to reduce portfolio risk concentration.
- Agreeing on the mechanism or process for determining when discrepancies in material terms or valuations should be considered disputes, as well as how such disputes should be resolved as soon as practicable.