Derivatives play a vital role in enabling all types of entities to manage their business and financial risks, but it is critical these markets are both safe and efficient. For authorities in emerging and developing markets, the challenge is putting a framework in place that ensures firms in their jurisdictions can access risk management tools via their local markets while using them in a way that is effective and prudent.
ISDA last week published a paper that aims to help with this process. Specifically, it outlines the key issues that policymakers in emerging and developing markets should consider when drawing up an appropriate legal and regulatory framework for derivatives. It also looks at the extent to which global standards created primarily with advanced economies in mind – for instance, those developed by the Group-of-20 (G-20) nations in 2009 – might be applied in emerging and developing markets.
There are some legal and regulatory developments that we think are absolutely foundational, irrespective of jurisdiction – and the enforceability of close-out netting is right at the top of that list. We strongly believe that close-out netting is one of the most important steps a country can take to ensure the underpinnings of its local derivatives market remain strong and able to support future development. By allowing parties to reduce their obligations to a single net payment due from one party to another following a close out, netting drastically decreases credit risk. This reduces the potential for market disruption in the event of a default, while also increasing liquidity and credit capacity.
The number of jurisdictions that recognize the enforceability of close out netting continues to grow. China is one of the latest jurisdictions to take this critical step, passing the Futures and Derivatives Law in April. In response, ISDA has commissioned a netting opinion for China, which we’re aiming to publish when the law comes into effect in August.
There are, however, many other steps regulators in emerging and developing markets need to consider – from determining which agency has authority for the derivatives market and whether specific business conduct standards are necessary, to defining the scope of permitted activity and deciding whether to establish registration requirements. In most cases, regulators should base their decisions on the level of derivatives activity in their markets and consider aligning their approach with other countries of a similar size. Whichever direction local regulators opt to take, it is critical that a framework is in place to encourage continued improvements in risk management – an important factor in driving capital markets development.
Policymakers in emerging and developing markets also have an established set of global standards, including the G-20 reforms, which they can draw on when developing regulations for derivatives in their local markets.
Local regulators should weigh up the size of their derivatives markets when deciding whether and to what extent to apply these standards. Some, like reporting requirements, will likely apply in some form as they enhance transparency and allow supervisors to monitor risk. Others, like mandatory clearing, may be inappropriate in jurisdictions with relatively small derivatives markets or exchange controls – the lack of market depth would likely make it impossible to establish a well-managed, cost-efficient central counterparty.
We believe derivatives are a critical ingredient to the development of vibrant local capital markets, as they enhance risk management and help facilitate access to capital. But being able to hedge risk on a cost-effective basis shouldn’t just be the preserve of advanced economies. We hope this paper will go some way to helping regulators in emerging and developing markets establish their own frameworks, enabling everyone to access safe and efficient markets.
Read ISDA’s paper – Policy Framework for Safe and Efficient Derivatives Activity in Emerging and Developing Markets – here.
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