Larry Thompson, DTCC Vice Chairman, General Counsel and Chairman of the Board of DTCC Deriv/SERV LLC
Progress on global derivatives reform is at a critical juncture. The goal of enhanced transparency, identified by the Group of 20 (G20) following the 2008 crisis as crucial to the supervision of the financial system, remains only partly addressed due to a number of practical and legal barriers that limit data sharing across jurisdictions. As a result, the cross-border identification of systemic risk remains challenging for macroprudential authorities.
More specifically, trade repositories, heralded as essential to achieving greater transparency in the global derivatives markets, have not been able to reach their full potential as tools for systemic risk oversight. This is because the 2009 policy response that followed the G20 commitments was developed along national or regional lines, which resulted in a fragmented regulatory landscape.
Fragmented reporting environment hinders transparency
The fact that this policy response has not been tested to date does not mean that the risks that the financial system faced in 2008 are any less real. Derivatives markets remain as global and as interconnected as ever, and we should not confuse transparency at a local level with the ability to monitor and identify systemic risk to protect and preserve financial stability globally.
Major derivatives jurisdictions around the world have developed legislative frameworks to mandate reporting of derivative trades to trade repositories, have devised detailed local rules, and have designated authorised trade repositories to operate within their domains. But far from achieving global consistency, this localised approach has resulted in divergences between reporting regimes, including the scope of reporting obligations and the type of data that is reported to trade repositories. As a result, we have a fragmented derivatives reporting environment across jurisdictions and multiple repositories.
Data collection without aggregation is insufficient to satisfy the global transparency goal
Notwithstanding divergent reporting requirements which exist across major derivatives jurisdictions, data is being collected and compliance has been good. However, data collection itself is not sufficient. Without the ability to aggregate data and convert it into information that can be used to monitor the build-up of risk in the system, full market transparency will not be achieved.
To ensure that the needs of both microprudential and macroprudential regulators can be fulfilled, any efforts to address derivatives data aggregation should be preceded by a clear distinction between the two data sets –a national or regional data set for the purposes of market surveillance and a smaller global data subset for systemic risk oversight.
The data set required for microprudential supervision is already well served by the current national reporting regimes. However, the global data set required for systemic risk surveillance across jurisdictions has proven to be much more challenging.
Removing legal barriers remains a pre-requisite to aggregation
Before data can be aggregated at a cross-border level and used by the relevant supervisory authorities, significant legal barriers need to be removed – some which predate derivatives reform, such as data protection laws, blocking statutes, state secrecy laws and bank secrecy laws. Addressing these challenges will require international regulatory cooperation.
For example, the U.S. Dodd-Frank Act incorporates an ‘indemnification provision’ requiring non-U.S. regulators to indemnify US regulators and trade repositories from possible data misuse before access is granted. This creates a financial cost as well as a legal impediment for non-U.S. regulators and effectively prevents them from viewing data relevant to their jurisdictions collected and held by trade repositories located in the US and operating under the Dodd-Frank Act.
This legislation must be amended to ensure privacy laws and other legislative hurdles do not compromise data aggregation to ensure the regulators globally have a complete and timely picture of risk in the system.
In principle, the agreement on the global data set required for systemic risk oversight should make regulatory cooperation and the removal of legislative hurdles easier since it will focus attention on a specific data set, rather than on the numerous fields which are required for market surveillance.
Data quality efforts critical to converting data into information
Following the removal of legal barriers, market infrastructures can play an important role in supporting data quality efforts, including helping to identify a global data set and addressing data standard issues.
To start, global regulators must agree on the set of data fields which, at a global level, can be used to identify the impact of market activity outside their jurisdiction on their jurisdiction and vice-versa.
To understand why this data set would differ from the current national reporting requirements, consider this scenario. During the collapse of Lehman Brothers, if two parties outside the US were trading on an underlying Lehman Brothers asset, data collected under US rules, which allow for the supervision of US persons only, would have misrepresented the scale of the problem.
Advancing systemic risk oversight, therefore, requires an agreement on the global data set to be aggregated which takes into account the interconnectedness of the financial system.
Once an agreement on this data set has been reached, the focus on improving data quality by advancing consistent standards can begin.
Data standardisation remains a highly desirable outcome and must continue to be improved through a concerted effort by both the industry and the repositories in collaboration with local market regulators. However, this will take time. To accelerate the process, work to standardise fields within the global data set should begin immediately.
The principles for Financial Market Infrastructures (FMIs), which have been published by the International Organisation of Securities Commissions (IOSCO) and are being monitored by the Committee on Payments and Market Infrastructures (CPMI), provide a useful foundation to forge a consensus on common international standards for reporting of derivatives trades.
The principles for FMIs could be extended to include data requirements and standards that have some commonality with existing reporting requirements, but resulting in an outcome which provides harmonisation and standardisation of data at a global level.
Ideally, a single authority should be responsible for monitoring the adoption of standards in national rulemaking, monitoring compliance with those rules and assessing outcomes. This is a proven three-level process that has been successfully adopted by the Basel Committee and the CPMI on monitoring the principles for FMIs and could be extended to create the necessary conditions for aggregating derivatives data for the purposes of monitoring systemic risk.
Data sharing requires a workable governance model
Once the global data set has been identified, it is natural to turn attention to the governance framework required for data sharing.
A governance model would set the conditions upon which regulators could access each other’s data, for example, on the basis of entitlements based upon a jurisdiction’s market share in the global derivatives markets.
Important precedents exist at a multi-lateral level that demonstrates that regulatory cooperation can make cross-border data sharing possible.
The governance model can be founded upon an entitlement scheme, such as the one adopted by the OTC Derivatives Regulators' Forum (ODRF) for credit derivatives, based on regulator type. In practice, this means each entity should be provided with a set of guidelines on how information needs to be presented in terms of aggregation and the underlying detail, as well as allow access based on the individual regulator’s authority. Establishing this criteria will require agreement on to the nature of the trade, and whether that trade should be available to another regulator. This could be determined by either using the domicile of the counterparty or the domicile of the underlying reference entity that was being traded.
What the ODRF example shows us, in particular, is that existing infrastructures can be leveraged to perform the aggregation of OTC derivatives data, provided the relevant supervisory authorities agree on a governance layer. For aggregation to work, as demonstrated in the credit derivatives markets, you need to have consistent data with very clear access rules.
A timetable for action
Trade repositories have the potential to become powerful tools in identifying systemic risk, but they are currently unable to perform this role because there are practical and legal impediments that make transparency unattainable. Urgent action is required to remove these barriers, and any efforts should focus on five key areas.
First, there needs to be an agreement on the global data set required to identify systemic risk. Second, existing laws that prevent cross-border data sharing must be reviewed. Third, consistent standards that apply to this data set must be adopted across jurisdictions, leveraging existing standards where possible. This will require appointing a standards authority, which would monitor and enforce their adoption. Fourth, a governance model that enables data sharing among regulators must be agreed. This should leverage, where possible, proven governance models, such as the one adopted by the ODRF. And finally, fifth, a timetable for action should be agreed and supported by the G20, providing a framework for the completion of the work which began in 2009.
Only when these steps have been taken can we feel confident that the lack of transparency which nearly brought the financial system to collapse has truly been addressed.
This article first appeared in Global Capital on March 31