SOUTH AFRICAN OTC DERIVATIVE MARKETS
Although the South African financial market is small relative to global standards, OTC derivatives play an important role in the financial markets and economy. In a study commissioned by the National Treasury and conducted by Price Water House Coopers (‘PWC’), the outstanding notional amounts as at June 2012 for OTC derivatives was valued at R27.7 trillion. This amount includes interbank trades between domestic and foreign banks, between domestic banks, and other non-financial participants including corporates.
The most common type of derivative asset class, accounting for over 85% of transactions traded in the domestic market, are interest rate derivatives at an estimated outstanding notional amount of R24.3 trillion. Foreign exchange derivatives are the second largest at 12.1% of the total notional amount.
The results also indicate that derivatives products are particularly popular amongst banking institutions and corporates who use them primarily for risk hedging. The majority of the interest rate derivatives transactions involve significant exposure to global markets as these are dominated by inter-bank trades between local and foreign banks. This is consistent with trends in global OTC derivatives markets which are largely characterised by cross-border transactions.
Even though, the South African financial markets were not severely impacted directly by the financial crisis, the indirect impact of sluggish market performances due to slowing global economic activity, adversely affected job ratios in particular. It is therefore necessary to implement better and stronger measures to prevent domino financial impacts.
APPROACH TO REGULATORY REFORMS
The Financial Markets Act, which came into force on 3 June 2013, has as its objectives the reduction of systemic risk, the protection of regulated persons, clients and investors and the promotion of fair, efficient and transparent financial markets. The Financial Markets Act, as enabling legislation, provides for the regulation and supervision of the OTC derivatives market and related market infrastructures, such as clearing houses and trade repositories that are necessary for the implementation of G20 requirements.
In April 2012, National Treasury released a document entitled Reducing the risks of over-the-counter derivatives in South Africa3. This document expanded on the discussion on the regulatory and legislative reforms for the South African OTC derivatives markets and outlined the three phases of implementation of OTC derivatives reforms:
- Phase 1 – Code of Conduct and Registration of market participants, and Central Clearing
- Phase 2 – Standardisation, Central Clearing and Central Trading (where appropriate)
- Phase 3 – Risk management – margin and capital requirements for non-centrally cleared derivatives (where appropriate).
In terms of s 107 of the Financial Markets Act, it is required that all regulations are consulted on with recognised industry bodies. As such a consultative approach was undertaken to develop and implement requirements in the phases set out above and OTC Derivative Working Groups, chaired by the National Treasury and the Financial Services Board (‘FSB-SA’), were constituted. These included representation from major bank and non-bank institutions, the Johannesburg Stock Exchange, STRATE, the South African Reserve Bank (‘SARB’) and industry associations such as the Banking Association of South Africa
regulatory framework for the OTC derivatives market. Each working group was responsible for a different aspect of the regulatory framework with the following mandates: (‘BASA’), and the Association for Savings and Investment South Africa (‘ASISA’) to advise the Minister on the most appropriate
- Registration and Code of Conduct, to advise the Minister on the regulation of OTC derivatives providers and the code of conduct that governs the behaviour of OTC derivatives providers, their employees and clients.
- Central Reporting, to advise on the appropriate framework for the reporting of OTC transactions to trade repositories.
- Central Clearing, to advise on the appropriate framework towards mandating of central clearing.
OBJECTIVES OF THE REGULATORY FRAMEWORK
The proposed regulatory framework is informed by the following objectives of the Financial Markets Act.
Objective 1: Contributing to the maintenance of a stable financial market environment and reducing systemic risk.
Included in the authorisation requirements for OTC derivatives providers are prudential, governance and sound risk management requirements. The licensing and supervision provisions for central counterparties and trade repositories will ensure risk management, prudential and governance requirements that are appropriate to the risks that each of these bring to financial markets.
Central reporting obligations for OTC derivatives providers will facilitate the monitoring of potential systemic risk by the relevent authorities. The enabling provisions for central clearing recognise the potential reduction in systemic risk from the compulsory clearing of certain asset classes or products. Additional requirements relating to timely confirmations, portfolio reconciliations and portfolio compression also contribute to the stability of the financial market environment.
Given the cross-border nature of the market, the regulatory framework takes into account the transfer of risks across jurisdictions. In this regard, the framework allows for a process of recognition of external market infrastructures and exemption from direct supervision by the FSB-SA where the registrar is satisfied that the legal and supervisory arrangements of the jurisdiction where the market infrastructure is supervised, are equivalent to that of the South African regulatory framework.
Objective 2: Promoting fair, efficient and transparent markets
The regulatory framework includes a code of conduct which will be binding on all OTC derivatives providers, their employees and clients. The recognition and equivalence framework for external market infrastructures will promote efficiency by allowing market participants the choice to access the functions or securities services of a broader range of market infrastructures while still ensuring the appropriate management of risks. The requirement on TRs to publish aggregated OTC derivatives data and provide authorities with transaction level data will improve market transparency.
Objective 3: Boosting investor confidence and investor protection
The code of conduct provides requirements aimed at protecting investors, such as enhanced disclosure requirements and appropriateness tests to ensure that retail investors understand the risks associated with the derivative transactions. OTC derivatives providers are also required to act in the best interests of the client or counterparty through the safeguarding of collateral and margin.
The prudent licensing and regulatory requirements for central counterparties and trade repositories will contribute to the attainment of this objective.
The development of the regulatory framework was guided by the following five principles:
Principle 1: Adoption of Appropriate International Standards
It is important that the South African regulatory framework reflects, where appropriate, international best standards and practice. As an example, the regulatory framework draws judiciously, as a minimum, on the standards set by international standard setting bodies such as IOSCO.
Principle 2: Developing Harmonised and Equivalent Regulatory Frameworks
The global nature of international derivatives market means that any legislative or regulatory requirements imposed in one country are likely to impact OTC derivatives providers or counterparties in other jurisdictions. In order to ensure that South African market players can continue to trade across borders, a necessity for the continued efficiency and risk management associated with the local OTC market, South Africa’s regulatory and supervisory framework must be assessed to be equivalent by the relevant authorities in other jurisdictions.
Regulations of equivalent jurisdictions ensure level playing fields, minimise duplication and uncertainty and reduce the opportunity for regulatory arbitrage.
Principle 3: Alignment with Existing Legislation
Alignment with relevant existing legislation such as the Financial Advisory and Intermediary Services Act (FAIS Act) No. 37 of 2002, and the Banks Act No. 94 of 1990 further assists in levelling playing fields between domestic participants, avoiding duplication and minimising regulatory arbitrage domestically.
Principle 4: Implementing the Twin Peaks Model of Financial Regulation
The regulatory framework recognises the financial stability and prudential oversight roles that the SARB will play within the twin peaks framework, which will be implemented shortly and is described in more detail below.
Principle 5: Minimising Market Disruption
Despite the benefits of enhanced regulation for the OTC derivatives market being well recognised, these benefits cannot be achieved without some degree of market effect. In this regard, the working groups have been fundamental to improving the authorities’ understanding of the possible impact of OTC derivatives market regulations and as a means of communicating anticipated regulatory changes to market participants in advance of implementation.