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Sovereign Institutions Hit by Derivatives Regulation

<em>Sovereign institutions that use over-the-counter derivatives will be greatly affected by new regulatory reforms, says a new report.</em>
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(July 11, 2012) — New and inconsistent regulations intended to clarify derivatives trading will have a markedly negative effect on sovereign consumers, particularly sovereign wealth funds and state-sponsored pension schemes, according to a new report by BNY Mellon.

Major reforms of over-the-counter (OTC) derivatives markets, such as the Dodd-Frank Act and the European Market Infrastructure Regulation (EMIR), will treat non-US and non-European sovereign institutions as financial end-users, and therefore subject them to new regulatory oversight. Coupled with Asian regulatory changes and Basel III capital adequacy rules, the upshot for sovereign institutions will be a very different—and conflicting—regulatory landscape for OTC derivatives.

“Until a consistent framework of exemptions from both capital adequacy and clearing requirements across jurisdictions may be agreed, the possibility remains that sovereigns may find that some of their OTC derivatives activities become subject to mandatory clearing or collateralization,” warns the report.

BNY Mellon notes that sovereign investors like sovereign wealth funds and state-sponsored pension funds employ OTC derivatives to hedge exposures and implement investment strategies. The sovereign counterparties involved with derivatives trading, however, could face large liquidity and capital challenges as a result of the new regulation, potentially upending the derivatives market for sovereign institutions.

“Sovereigns are generally regarded as low risk counterparties, and as such have not generally been required to provide collateral,” writes 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.”

To read the report in full, click here.