Regulating Derivatives in the Caribbean Group of Securities

Regulating Derivatives in the Caribbean Group of Securities Regulators (CGSR) Conference Presenter: Johann Heaven PROVEN Management Limited

Regulating Derivatives are often and inappropriately portrayed as unregulated, arcane, and excessively risky instruments.

Caribbean Derivatives Market • In the Caribbean, derivative products, primarily include: • Forward exchange rate contracts (forward exchange rate swaps and options) • Cross-currency swaps • Interest rate swaps • Oil options and swaps • Bond options

Caribbean Derivatives Market • Market participants are relatively few and institutional in nature • Participants utilize derivatives for both speculative purposes and to hedge against exchange-rate risk, commodity price risk and interest rate risk. • There is no established Exchange for the trading of derivatives. • Majority of the contracts are customized OTC transactions

Caribbean Derivatives Market • Risks posed by the Derivatives Market: – Lack of transparency – Counterparty risk – Operational risks – Systemic risks

Caribbean Derivatives Market • The importance of regulating derivatives are to: • Ensure the integrity of markets • Deter manipulation by agents • Protect participants from losses arising from fraud or the insolvency of counter-parties. • Monitor off-balance sheet risk of Financial institutions

Regulatory Approach

Regulatory Approach • Optimal form of government regulation is determined by market characteristics which include: • The size of the market • the types of instruments traded • the types of market participants • the nature of the relationships among market participants.

Market Participants

Speculators vs. Hedgers • The Commodity Futures Trading Commission (CFTC) classifies market participants as: – Commercial traders are those that use derivatives for hedging purposes. – Non-commercial traders are those that do not own the underlying assets or its financial equivalent and only hold positions in futures contracts.

Hedgers • Derivatives are enormously useful instruments in the management of risk. They are used by Hedgers: – to hedge an existing market exposure (forwards and futures), – to obtain downside protection to an exposure even while retaining upside potential (options), – to transform the nature of an exposure (swaps) – to obtain insurance against events such as default (credit derivatives). – to manage exchange-rate risk, input costs, financing costs, or credit exposures

Speculators • Derivatives are also highly levered instruments • The leverage makes derivatives attractive to speculators • Speculators add considerable liquidity to the market • By taking the opposite side, they facilitate the positions hedgers want to take. • Leverage however magnifies the effect of price moves.

Speculators

Size of the Derivatives Market

Size of Derivatives Market

Size of Derivatives Market

Nature of the Derivatives Market

OTC Derivatives • Over-the-counter (OTC) derivatives have terms that are privately negotiated between two parties rather than traded on an exchange with standardized terms. • The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties.

OTC Derivatives • OTC derivatives include: – Forwards – contracts to buy or sell assets at a future date based on a price specified today. – OTC Options – contracts to buy or sell an asset at a given price within a specified date. – Swaps – contracts to exchange cash flows on an agreed schedule. – Credit Default Swaps – contracts where a buyer makes a payment to a seller in return for a promise that the seller will compensate the buyer if a specified credit event occurs.

OTC Derivatives

Regulatory Approach • The International Swaps and Derivatives Association (ISDA) is a trade organization of participants in the market for over-the-counter derivatives. • It is headquartered in New York, and has created a standardized contract (the ISDA Master Agreement) to enter into derivatives transactions. • ISDA has more than 820 members in 57 countries; • Its membership consists of derivatives dealers, service providers and end users

ISDA Master Agreement • The master agreement is the central document around which the rest of the ISDA documentation structure is built. • It sets forth all of the general terms and conditions necessary to properly allocate the risks of the transactions • It does not contain any commercial terms specific to a particular transaction • Once it is executed, the parties can enter into numerous transactions as evidenced by written confirmations.

Exchange-traded Derivatives • Exchange-traded derivatives are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. • A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange. • A derivatives exchange acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee.

Exchange Traded Derivatives

Exchange Traded Derivatives

OTC vs. Listed Derivatives

Caribbean Derivatives Market • In the Caribbean, derivative products, primarily include: • Forward exchange rate contracts (forward exchange rate swaps and options) • Cross-currency swaps • Interest rate swaps • Oil options and swaps • Bond options

Caribbean Derivatives Market • Market participants are relatively few and institutional in nature • Participants utilize derivatives for both speculative purposes and to hedge against exchange-rate risk, commodity price risk and interest rate risk. • There is no established Exchange for the trading of derivatives. • Majority of the contracts are customized OTC transactions

Regulatory Approach • What is the optimal balance between governmental regulation and self-regulation? • There are three types of failures associated with governmental regulation: – the costs to run regulation bureaus, to collect information and to monitor markets – the credibility of the proposed mechanism – The behavior by constituencies directly or indirectly affected by the regulation

Regulatory Approach • What is the optimal balance between governmental regulation and self-regulation? – The self-interest of market participants generates private market regulation. • There exists a moral hazard problem associated with government intervention – if private market participants believe that government is protecting their interests, their own efforts to protect their interests may diminish. – If the incentives of private participants are weak or they lack the capabilities to pursue their interests, then government intervention may improve regulation.

Regulatory Considerations

Regulatory Developments • Mandatory reporting regulations are being finalized in a number of countries, such as Dodd Frank Act in the US, the European Market Infrastructure Regulations (EMIR) in Europe, as well as regulations in Hong Kong, Japan, Singapore, Canada, and other countries and has as its objectives: – – – – the minimization of systemic risk from derivatives use increased the transparency of the OTC derivatives market protecting against market abuse preventing regulatory gaps reducing the potential for arbitrage opportunities fostering a level playing field for market participants reduce regulatory uncertainty and provide market participants with sufficient clarity on laws and regulations

Regulatory Developments • Major implications of the Derivatives Reform: – All standard derivatives contracts were to be traded on exchanges or electronic platforms. – Standard derivatives were to be cleared through central clearing-houses. – Deals were to be reported to trade repositories. – Margins set aside to guard against shifts in the values of derivatives were to be robust.

Caribbean Regulations • Establish the Caribbean Derivative Trading Commission “CDTC” responsible for: – Regulating the regional derivatives market – Protecting market users and the public from fraud and manipulation – Fostering an open, competitive, and financially sound derivatives market – Ensuring the financial integrity of the clearing process – Recording and reporting on trading activity – Sanctioning of companies or individuals for misconduct or fraud

Caribbean Application • The Caribbean Derivative Trading Commission “CDTC” should: – Establish a regional legal framework for the Derivatives Market – Encourage Regional Stock Exchanges to establish and facilitate trading of standardized derivatives contracts. – Encourage the Exchanges or Private Sector to establish a Derivatives clearing house – Provide oversight to the OTC market. – Establish an ISDA type Master Agreement for the trading of OTC contracts.

Questions?