Exchange-traded derivative markets emerged almost unblemished in the wake of the recent financial crisis thanks to the concept of counterparties. Even then these markets came under policy scanner as they moved in tandem with over-the-counter credit-default-swap and collateralised-debt-obligation markets in the US during the crisis (Tavares 2011). It made regulators wake up and try vaccinating exchange-traded derivative markets from the contagion of connected markets with overlapping participation.
This initiative on the part of regulators led to a round of rule making in both the US and Europe. It is little wonder that this met with stiff resistance from both sides of the Atlantic. On both shores there was fear that exchange-traded platforms could lose business if participants moved elsewhere to take advantage of the differences in regulatory regimes and practices that exist across exchange-traded marketplaces in various asset classes.
An analysis of the existence and use of various regulatory tools across various exchange-traded marketplaces worldwide reveals that vast diversity exists between developed and developing economies on this front (see Table 1, see also Shunmugam et al. 2011).
Use of several regulatory tools either stopped or became increasingly inadequate or inappropriate in the advanced economies of the west. A possible reason for this is the unflinching belief that had become ingrained in the minds of all stakeholders of different asset classes, including regulators, in these nations. That is, “markets have an inbuilt self-corrective mechanism”.
Table 1. Diversity of regulatory practices in derivatives markets worldwide
Regulatory tools and risk management on the exchange platform: Margins
Risks to the “price-discovery” process in a derivatives market arise from leverage that this market provides to its participants. Leverage arises out of “margins” that the participants are required to keep with the clearinghouse. It enables the participants to converge all possible information at the lowest possible cost to help markets discover their most-efficient prices.
While providing leverage, “margins” also incentivise the participants to keep the market noisy. Noise levels not justified by the fundamentals not only distort price discovery process of the markets but also make price-risk management costlier. Noise levels in a market can be controlled effectively by keeping the leverage at an appropriate level, by using “margins” optimally. Margins are levied either as an ad-valorem rate or a fixed amount per contract. Margins levied as ad-valorem rates help in keeping leverage at a particular level as the prices fluctuate. But margins levied as a fixed value (as practised in many developed economies) do not adjust the leverage level and, hence, could potentially increase noise levels unless they are actively managed by exchange-traded platforms. Notably, margins and their use as a regulatory tool in derivative markets vary widely between developed and developing economies. Strangely, the markets for forex derivatives have lower leverage than the spot forex markets in the US and the UK – a phenomenon that defies the logical role of leverage in information convergence for efficient price discovery and effective risk management.
What has also been in practice in the markets of developing economies is adjustment of the ad-valorem rates in the interim. This is done whenever exchanges and/or regulators feel that exchange-discovered prices are being swayed away from reflecting the fundamentals. Such adjustments in leverage have not been in much practice in the markets in developed economies. The process of price discovery in these markets could get pushed to one side, exposing the underlying assets to risks.
Regulatory tools and risk management on the exchange platform: Position limits
As the number of open positions in a derivatives market determines its participants’ ability to move the prices to their advantage and to benefit from resultant price changes, most exchange-traded marketplaces in developing economies impose limits to which a participant can hold open positions in a given underlying asset class. Although in the past position limits have existed in developed economies such as the US, they have conveniently been set aside as markets in those nations developed as these were considered redundant with the maturity of the markets. Post-financial crisis, the Dodd-Frank Bill woke up the regulators to make effective use of this tool to control risks to and from exchange-traded derivatives. Alas, position limit announcements in compliance with the bill could only raise the fear that business and “benchmark” status of US exchange-traded commodity derivatives would be at stake. What may finally help US regulators implement position limits: The UK joins the proposed European Common Regulator – ESMA – and a consensus is formed among regulators of other concerned geographies.
Regulatory tools and risk management on the exchange platform: Price limits
Limits on prices (also referred to as price circuit filters) are another regulatory tool that helps both exchanges, as “SROs”, and regulators in controlling the risks to the price discovery process and the attendant systemic financial risks to exchange platforms. It is particularly important in the current context wherein “emotion-less” algorithms trade alongside “emotion-filled” human beings. While, such price-swing limiting tools are very much in practice in derivative markets in emerging economies, and used effectively to control price fluctuations in sensitive “local asset classes”, they were conveniently set aside as the markets matured in advanced economies.
Such a mismatch in regulatory practices between developed and developing economies, in the case of “global asset classes”, creates a compromising situation for those economies which are late-adopters of transparent exchange platforms for price discovery. The regulators of exchange-traded derivative markets in the “price-taking” economies are forced to either adjust their regulatory tools to reflect the market conditions of the “price-setting” economies or shut their local markets off from the global market trends and risks. The latter, if implemented in an exchange-traded asset class, would be tantamount to providing the stakeholders with an inefficient risk management platform. Fragile global market conditions fuelled by divergent regulatory practices, as prevalent now, for example in the case of sensitive agricultural commodities, may incentivise global economic stakeholders to keep the process of “globalisation” incomplete.
Globalisation, market risks and the way forward…
The increasing inter-connectedness among exchange-traded derivative markets for various asset classes across geographies – a product of the rapid globalisation of the recent past– has made the situation even more complex. Participants are becoming increasingly used to arbitraging between various regulatory regimes, especially if there is disconnect between the business interests and the regulatory role of these markets.
In this scenario, the strategy that the regulators of exchange-traded derivative markets could possibly adopt is to work in tandem with their peers within the same geography and across the border with a deeper understanding of the underlying market ecosystem. Also, in this era of increasing interconnectedness of markets, regulatory tools, which were earlier designed based on local micro-market structures, need to be more broad-based in line with evolving global macro-market structure and best practices.
- First, formation of a national-level forum will serve to ensure inter-market coordination among the regulators of various asset classes within the sovereign economic boundaries. This should be equally true even for those nations with a single-regulator model for their financial sector, because such a national-level forum with the respective central banks as the pivot will ensure increased coordination among different arms of the same regulator monitoring trading in various asset classes, and those which are supposed to monitor the underlying cash markets, for better regulation.
- Second, it is critical to the regulatory success and market discipline among world economies (as inter-connected units) that there exists a similar forum at the international level which facilitates deliberations, debates and the ironing out of issues related to global financial stability, the functioning of the financial sector, its implications for the real economy, and other key issues. This is essential because, despite the inter-connectedness of today’s globalised world, exchange-traded derivative markets in different economies/geographies are still governed by varied regulatory tools and practices. Establishment of the Financial Stability Board under the auspices of G20 is a welcome, though inadequate, step in this regard. It is widely believed that only through a much larger representation, say, by including the members of IOSCO, this forum could be truly effective in bringing coordination among the regulators to enable exchange-traded markets, worldwide, to function efficiently serving the cause of policymaking for global financial stability.
Such a forum is expected to strive towards encouraging “synergistic coordination” first at the national level and then to be scaled up to the global level for effectively insulating derivative markets from the risks to their effective functioning and, thus, the risks to the real economy in terms of effective allocation of resources for which these markets have been developed.
The author is the Chief Economist with the Multi Commodity Exchange of India Ltd., Mumbai. Views expressed here are personal.
Shunmugam, V, Niteen Jain, and Nazir Ahmed Moulvi (2011), “Regulatory Tools – A Key to Efficient Markets”, to be published in a forthcoming book, Research in Financial Derivatives, University of Pondicherry, India.
Tavares, Carlos (2011), “Short selling and OTC derivatives policy options”, VoxEU.org, 9 January.