Derivatives play a critical role in supporting vibrant capital markets, enabling market participants to alleviate uncertainty, transfer risk and enhance returns. By allowing companies to lock in the cost of issuing debt or create certainty in the exchange rate at which they can convert future overseas revenues, derivatives enable firms to lend, borrow and invest with confidence.
This ability to hedge risk and manage exposures shouldn’t only be an option for firms in the main financial centers – entities in emerging and developing markets should also be able to use these instruments domestically to mitigate risk and facilitate access to capital. But safe, efficient derivatives markets don’t emerge by accident: they require deliberate choices on the legal and regulatory framework. ISDA has long worked with policymakers in emerging and developing markets to help navigate these issues, and we published a whitepaper earlier this year that explores some of the choices and implications, based on best practices and work in advanced economies.
One of the most fundamental steps is ensuring the enforceability of close-out netting. By allowing counterparties to offset their various obligations into a single net amount owed by one party to the other, netting significantly reduces credit risk and increases the capacity for firms to lend. It also encourages greater participation by foreign and domestic institutions, boosting liquidity and competition.
ISDA has worked with authorities across the globe to help draft legislation on the enforceability of close-out netting and has so far published netting opinions for over 80 jurisdictions, providing certainty for firms trading in those markets. The latest of those opinions was published for China in August, following implementation of the Futures and Derivatives Law (FDL) – an important milestone in the development of a well-functioning derivatives market in China.
Netting legislation isn’t enough on its own, though. Local policymakers need to determine the scope of permitted activity, whether registration requirements are necessary and what disclosure standards should apply. Broader regulatory issues – for example, whether to introduce clearing, margin or reporting mandates – also need to be considered, as well as expectations on risk governance and management.
This issue of IQ looks in more detail at what is needed to support the development of effective and robust derivatives markets, as well as analyzing the specifics of China’s FDL and possible next steps. ISDA will continue to assist however we can in the advancement of local derivatives markets – we strongly believe vibrant capital markets and the ability to manage exposures efficiently and cost effectively should be achievable for everyone.
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