Summary of Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives

Following a consultation process to a proposed report, late last month the International Organization of Securities Commissions (IOSCO) published its final report outlining standards to help reduce risk in the non-centrally cleared OTC derivatives markets. The report, titled “Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives,” has been developed in consultation with the Basel Committee on Banking Supervision (BCBS) and the Committee on Payments and Market Infrastructures (CPMI).

Why the standards have been developed?

As part of the regulatory reform programme to strengthen the OTC derivatives market, the G20 leaders encouraged standardisation and central clearing of as many OTC derivatives as possible. However, a substantial proportion of OTC derivatives is not suitable for central clearing and will need to meet enhanced margin requirements for non-centrally cleared OTC derivatives. A final framework for these margin requirements (BCBS261) was published by IOSCO/BCBS in September 2013.

Alongside margin requirements, the standard setters have also looked at various other techniques that may contribute to reduction of risks in the non-cleared OTC market through the report. The nine standards proposed in the report are aimed at mitigating the risks in the non-centrally cleared OTC derivatives markets and level-setting to help prevent regulatory arbitrage opportunities across regulatory jurisdictions 

Benefits

The proposed risk mitigation standards are expected to bring about three main benefits:

• Promoting legal certainty and facilitating timely dispute resolution
• Facilitating the management of counterparty credit and other risks
• Increasing overall financial stability

Summary of proposed 9 standards:

1. Covered entities that should employ risk mitigation techniques include financial entities and systemically important non-financial entities. Which entities are covered will be precisely determined by national regulators. Only non-centrally cleared OTC transactions between covered entities in scope.
2. Implement policies and procedures to execute written trading relationship documentation prior to a trade. Documentation should include all material rights and obligations depending on type of market participant and class of non-cleared OTC transactions.
3. Implement policies and procedures to ensure trade confirmations as soon as practicable after execution. Regulators may specify deadlines but may vary depending on time zones and nature of transactions and counterparties.
4. Covered entities should agree on and clearly document the valuation process with counterparties. All agreements on valuation process should be documented in trading relationship documentation or trade confirmation. The valuation processes should aim to minimise disputes and should use standard 7 for their resolutions. Any periodic updates to the processes must be reflected in relevant documentation.
5. Establish and implement policies and procedures to ensure portfolio reconciliation at regular intervals. All transactions in the portfolio, both collateralised and uncollateralised, should be reconciled for material terms and valuations.
6. Establish and implement policies and procedures to assess and engaging in portfolio compression, on bilateral or multilateral basis.
7. Agree on processes for identification and resolution (including escalation routes) of disputes with counterparties, and prompt notification to regulators about unresolved disputes depending on material value/age based thresholds.
8. The regulators should implement the standards described in the report as soon as practicable, taking into account timelines for BCBS261.
9. The report recommends cooperation between different regulatory regimes to minimise the risks of inconsistencies/conflicts and facilitate cross-border transactions.

Links to relevant final reports:

Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives:

http://www.iosco.org/library/pubdocs/pdf/IOSCOPD450.pdf

Margin requirements for non-centrally cleared derivatives (BCBS261):

http://www.bis.org/publ/bcbs261.htm