FSA in derivatives clean up

FINANCIAL authorities yesterday called for improved transparency on over-the-counter derivatives products as well as higher charges for non-centrally cleared trades.

In a paper called “Reforming OTC Derivatives Markets”, the Treasury and the Financial Services Authority (FSA) said the financial crisis had highlighted “shortcomings in the management of counterparty credit risk and the absence of sufficient transparency”.

The paper said: “We strongly support the use of central clearing for clearing eligible derivatives through robustly managed clearing houses that meet a uniform set of high standards. These should be further supported by effective supervision by home state regulators.”

It added: “ Trades which are not centrally cleared should be subject to robust bilateral collateralisation processes and/or the appropriate risk-proportionate capital charge.”

The report included calls for registration of all derivatives in trade repositories and for international agreement on which derivatives products should be clearing-eligible.

OTC derivatives are contracts that are traded directly between two parties, without going through an exchange or other intermediary. Examples of derivative products include swaps, forward rate agreements, and exotic options.

Dominated by banks and international hedge funds, OTC derivative market is the largest market for derivatives, and is largely unregulated.

The report cited the liquidity squeeze at insurer AIG as evidence of weaknesses in managing counterparty risk and said the failure of Lehman Brothers showed OTC exposures were not sufficiently transparent to market players or regulators.