This September, it will be five years since President Barack Obama and other Group of 20 leaders committed to regulating the over-the-counter (OTC) derivatives markets jointly and in each of their jurisdictions. The world’s largest banks would have defaulted in 2008–2009 on their bets in the nearly unregulated $700 trillion global OTC market had it not been for publicly funded bailouts, above all the $29 trillion U.S. Federal Reserve Bank emergency loan program of 2007–2010.
Fulfilling the G-20 commitments has been a political, legislative, budgetary, regulatory and technological struggle, due in part to the opposition of those same publicly rescued banks. For example, the International Swaps and Derivatives Association (ISDA), which represents OTC broker dealers and their largest corporate clients, is one of three parties suing the Commodity Futures Trading Commission (CFTC) to prevent the application of the Dodd-Frank financial reform legislation to the foreign affiliates of U.S. OTC broker dealers. Losing foreign affiliate trades, booked to their U.S. headquartered firms, triggered the 2008-2009 default cascades.
Nevertheless, persistent national and international financial regulators have been hard at work to agree on how to prevent circumvention of national regulations by the cyber-world of global banks. The G-20 leaders assigned much of the work to the Financial Stability Board (FSB), a body of central bankers and top regulators, coordinated by a small secretariat housed in the Bank for International Settlements in Basel Switzerland. In a February 17 letter to G-20 Finance Ministers and Central Bank Governors, FSB Chair Mark Carney outlined OTC derivatives reform as one of four crucial regulatory objectives.
In January, the Senior Supervisors Group of financial regulators reported to the FSB that “Five years after the financial crisis, firms’ progress toward consistent, timely and accurate reporting of top counterparty exposures fails to meet both supervisory expectations and industry self-identified best practices. The area of greatest concern remains firms’ inability to consistently produce high-quality data.” So regulators are still not getting accurate and comprehensive data on the risks (“counterparty exposures”) posed to the financial system from OTC trades. The potential for another financial market failure remains as regulators are still in the dark about much of the OTC universe. As Thomas Hoenig, vice president of the Federal Deposit Insurance Corporation (FDIC), noted on February 24 of the OTC trade-leveraged mega-banks, “If even one of the five largest [U.S.] banks were to fail, it would devastate markets and the economy.”
In February, the FSB released for comment a consultation paper on the feasibility of a global mechanism to aggregate OTC trade data that could be computer monitored by regulators both to prevent excessive risk-taking and violations of national regulations. The Aggregation Feasibility Study Group (AFSG) will make a recommendation to the FSB in May on which, if any, of three proposed OTC data aggregation options should be adopted for implementation.
IATP had submitted comments to the CFTC on data aggregation rules to prevent excessive speculation in agricultural derivatives contracts, which contributes to food insecurity in net import dependent developing countries. IATP’s comment on the FSB consultation paper first explained our interest in data aggregation. As of June 2013, OTC commodity derivatives contracts accounted for just $3 trillion of the reported $693 trillion global OTC gross notional value [an estimate of total risk exposure]. However, commercial hedgers, commodity prices, and hence food and energy security, are affected not only by prices, but by the foreign exchange, interest rate and other derivatives data that will be aggregated for regulator surveillance by the approaches discussed in the Consultation Paper (CP). Therefore, effective agricultural commodity derivatives regulation and financial stability require effective data aggregation practices.
The AFSG presents the FSB with three options for aggregating OTC trade data across borders. First, Option 3 is a status quo data aggregation model for regulators to compile and analyze data outside their jurisdictions. Regulators would access OTC trade data from foreign Trade Data Repositories (TDR), after filing a case-by-case petition for data with the regulator in whose jurisdiction the TDR resides. The AFSG remarked that Option 3 was vulnerable to unjustified refusals of access data that could result in the building up of risk exposures far beyond the capital reserves of banks to pay back in the event of losses.
Option 2 concerns a logical index or catalogue of TDRs in all jurisdictions, defined in terms of FSB agreements on uniform financial product and transaction identity codes, and uniform rules on regulator access to data. Because work on such agreements is already somewhat advanced, the regulator software platform of the logical index for regulator access to foreign TDRs could be built in the near term.
Option 1 would involve the centralized storage of OTC data from TDRs in all FSB jurisdictions. That option would require the agreements to build the standards and computer infrastructure of Option 2, plus hardware and security to protect the centrally stored OTC data from all jurisdictions. While the third option represents the most efficient and comprehensive mechanism for aggregating data and facilitating foreign regulator access to that data for monitoring and enforcement activities, it also presents problems of political feasibility not considered in the AFSG’s analysis of the legal and technical feasibility of the options.
A decision on the location, staffing and financing of a centralized data storage facility will require legislative decisions, as well as diplomatic negotiations. Given the heated nationalistic rhetoric about who’s to blame for the big bank meltdown, the location, staffing and financing decisions could become political flashpoints. We fear that nationalistic rhetoric used by bank lobbyists and some regulators to argue against cross-border application of national market laws will manifest itself in the debate about where to locate the centralized storage of OTC data. The result of a prolonged debate over the location of centralized data storage could be a financially fatal delay in the implementation of political commitments to effective and comprehensive cross-border regulatory cooperation.
IATP urged the AFSG to recommend Option 2 as the best platform for the intensive intergovernmental cooperation necessary to regulate the global banks and OTC corporate clients who otherwise will continue to elude nationally defined regulation. If Option 2 is successfully implemented, it may be possible to agree later on centralized data storage as a further step in regulating the global cyber-markets of finance.
Option 3, i.e., a continuation of the status quo offers an insufficient basis for cross border cooperation to regulate global OTC traders and markets. It is no exaggeration to say that if the Financial Stability Board fails to agree on an effective and comprehensive aggregation mechanism, the Group of 20 Leaders’ commitments to regulate OTC derivatives will remain unfulfilled. Furthermore, continued circumvention of national rules by global banks and OTC corporate clients will leave us vulnerable to another financial services mega-default, even as we still are trying to recover from the economic and fiscal consequences of the 2008-09 default.