By Simon Miller

Fundamental reforms of over-the-counter (OTC) derivatives markets around the world are having a profound impact on how derivatives are used, raising particularly challenging questions for sovereign institutions, according to a BNY Mellon report.

With regulatory reforms aiming to centralise and manage counterparty credit risk and increase transparency, the inconsistencies in the framework are causing confusion as to what sovereigns’ obligations are and the potential cost of compliance.

"Sovereigns are generally regarded as low risk counterparties, and as such have not generally been required to provide collateral," observed Jai Arya, head of BNY Mellon's Sovereign Institutions group. "With global regulatory reforms, however, precisely what is in and out of scope with respect to sovereigns remains murky. The classification of sovereigns and subsequent variation in Basel III capital adequacy rules must be addressed to avoid market distortions and regulatory arbitrage. In addition, the cost of compliance to the new rules could potentially hit sovereigns - and those servicing sovereign counterparties - very hard."

The report, Sovereigns in Search of Solutions: OTC Derivatives Reform: Direct and Indirect Impacts, noted that the continuing debate over 'extraterritoriality', defined as the applicability of a set of rules outside the direct jurisdiction of the overseeing regulator, adds further complexity.

For example, European sovereigns have generally expressed concern over the potential impact on counterparty selection as a result of the proposed Dodd-Frank Act's extraterritorial scope. The de facto exclusion of US financial institutions as potential counterparties could have a very negative impact on derivatives pricing, liquidity and risk management.

"We expect that a common approach will be reached between the major strands of regulatory reform to avoid market distortions and regulatory arbitrage, but inconsistency and conflict between national and supranational rules persists," said Nadine Chakar, head of Derivatives360(SM), BNY Mellon. "Until a consistent framework of exemptions from both capital adequacy and clearing requirements across jurisdictions may be agreed, sovereigns may find that their OTC derivatives activities become subject to mandatory clearing."

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