Wednesday, June 8, 2011

Is England's Financial Services Authority Adopting the FDR Framework?

The Telegraph carried an article in which it reported that all derivative trading positions, whether done through a central clearing market or over-the-counter, will have to be reported in the next 18 months.

This blog has long pushed for disclosure of the individual trades regardless of whether they take place through a market with central clearing or over-the-counter.  This is in contrast to the US regulators who have been pushing for trading on a market with central clearing.
Banks, funds and other institutions will for the first time be required to give details of their trading activity in the $600 trillion (£366 trillion) global derivative market under the new rules. 
Speaking yesterday, Alexander Justham, director of markets at the Financial Services Authority, said he thought the rules would be in place by the end of 2012 or early 2013 at the latest. 
Mr Justham said compulsory reporting of derivatives trades would help the regulators of the world's major financial markets more easily spot growing risks and help allow early intervention to stop bubbles growing too large. 
Much of the world's derivatives trading is currently conducted "over-the-counter" or OTC for short, which sees large institutions place bilateral trades with each other, without the use of any form of official exchange or central clearing facility. 
The dangers of this system were highlighted with the collapse of Lehman Brothers, which was counter-party to trillions of dollars of derivatives trades. 
Lehman Brothers' bankruptcy left many investors as counter-parties to trades that were effectively worthless, leading to calls for the establishment of a new central clearing house to act as an intermediary between market participants. 
On top of this, there are moves for increasing standardisation of derivatives contracts to ensure that the risks involved are better understood by investors. 
However, there have been warnings that the new rules could stifle competition.
Naturally, there are two market participants who would be very interested in having the trade data:  regulators and investors with exposure to one of the counter-parties to the trade.

As this blog has frequently discussed, under the FDR Framework this trade data would be made available to all market participants.

It would be used by investors with exposure to a counter-party to adjust the price and amount of this exposure.  As a counter-party's risk increases, those investors with an exposure to it can be expected to increase the price of this exposure and reduce the availability of funding.  This market discipline will help the regulator in managing the risks involved in the derivatives market.

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