Classification of sovereigns and subsequent variation in Basel III capital adequacy rules must be addressed to avoid 'market distortions and regulatory arbitrage'

NEW YORK and SINGAPORE, July 11, 2012 — Fundamental reforms of over-the-counter (OTC) derivatives markets around the world are having a profound impact on how derivatives are used, raising particularly challenging questions for sovereign institutions, according to a BNY Mellon report.

In the report titled Sovereigns in Search of Solutions: OTC Derivatives Reform: Direct and Indirect Impacts, BNY Mellon explores inherent inconsistencies in the application of key OTC reform provisions and the potential impact on sovereign institutions, a base of increasingly influential global investors that use capital markets and OTC derivatives for implementing their investment strategies and hedging exposure.

The core objectives of the proposed reforms, which include The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), the European Market Infrastructure Regulation (EMIR), and similar measures throughout Asia-Pacific, are to centralize and manage counterparty credit risk and increase transparency. The evolving and inconsistent regulatory framework raises important issues for sovereigns regarding their obligations and the potential cost of compliance.

"Sovereigns are generally regarded as low risk counterparties, and as such have not generally been required to provide collateral," observes Jai Arya, head of BNY Mellon's Sovereign Institutions group. "With global regulatory reforms, however, precisely what is in and out of scope with respect to sovereigns remains murky. The classification of sovereigns and subsequent variation in Basel III capital adequacy rules must be addressed to avoid market distortions and regulatory arbitrage. In addition, the cost of compliance to the new rules could potentially hit sovereigns - and those servicing sovereign counterparties - very hard." 

The report notes that the continuing debate over 'extraterritoriality', defined as the applicability of a set of rules outside the direct jurisdiction of the overseeing regulator, adds further complexity. European sovereigns have generally expressed concern over the potential impact on counterparty selection as a result of the proposed Dodd-Frank Act's extraterritorial scope, for example. The de facto exclusion of U.S. financial institutions as potential counterparties could have a very negative impact on derivatives pricing, liquidity and risk management.

"We expect that a common approach will be reached between the major strands of regulatory reform to avoid market distortions and regulatory arbitrage, but inconsistency and conflict between national and supranational rules persists," says Nadine Chakar, head of Derivatives360(SM), BNY Mellon. "Until a consistent framework of exemptions from both capital adequacy and clearing requirements across jurisdictions may be agreed, sovereigns may find that their OTC derivatives activities become subject to mandatory clearing."

Additional observations from BNY Mellon include:

• New OTC derivatives rules focus on central clearing as a means of controlling credit risk and increasing transparency. Counterparties to non-cleared trades may be subject to much higher collateral and capital requirements.
• The widespread use of OTC derivatives reflects their usefulness in managing exposures and hedging risks and it is not expected that sovereigns will choose to curtail their derivatives activities.
• The economics of servicing sovereign counterparties are changing, and banks may be forced to pass on higher collateral and capital costs through the pricing of bilateral OTC derivatives trades.
• More sovereigns may choose to embrace central clearing and post collateral to central counterparty clearing houses ("CCPs").
• Sovereigns engaged in cleared derivatives markets will need to consider the costs and benefits of each direct CCP membership and the appointment of futures commission merchants to clear on their behalf.
• As more stringent regulatory capital and collateral requirements are imposed, banks are under pressure to source and deploy eligible collateral assets as cheaply and efficiently as possible to sustain returns.
• Even if mandatory execution, clearing and reporting requirements are not imposed on sovereigns, the indirect impact on bilateral derivatives pricing could be sufficiently material to warrant a detailed analysis of the relative costs and benefits of voluntarily adapting to central clearing or two-way collateral arrangements.
• The likely scope of sovereigns' collateral management operations is unlikely to be as complex as those managed by commercial banks, but should not be underestimated.

"Our goal as a leading provider of end-to-end derivatives services is to afford investors the opportunity to navigate through some of the business issues and legal ramifications related to derivatives reform, recognizing the direct and indirect impacts of the changing landscape of derivatives clearing and collateral management," Chakar added.

A copy of the full report is available here.

BNY Mellon recently formed Global Collateral Services to address the expanding collateral management needs of broker-dealers and institutional investors. Global Collateral Services brings together the company's global capabilities in segregating, allocating, financing and transforming collateral on behalf of clients, and includes BNY Mellon's market leading broker-dealer collateral management, securities lending, collateral financing, liquidity and derivatives services teams.

Derivatives360(SM) includes trading and execution, derivatives middle office outsourcing services and back-office recordkeeping services. Middle Office services available through Derivatives360 include collateral management, affirmation and confirmation, independent (third-party) valuation, portfolio reconciliation and lifecycle event management. The company's back-office recordkeeping services include custody, accounting, cash collateral reinvestment and consolidated reporting.

BNY Mellon is a global financial services company focused on helping clients manage and service their financial assets, operating in 36 countries and serving more than 100 markets. BNY Mellon is a leading provider of financial services for institutions, corporations and high-net-worth individuals, offering superior investment management and investment services through a worldwide client-focused team. It has $26.6 trillion in assets under custody and administration and $1.3 trillion in assets under management, services $11.9 trillion in outstanding debt and processes global payments averaging $1.4 trillion per day. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation (NYSE: BK). Additional information is available on www.bnymellon.com or follow us on Twitter@BNYMellon.