Introduction

  1. Being a member of the many international clubs South Africa has joined as a country since 1994 comes at a price. The most recent club is BRICS (which started out as BRIC until SA joined and the “S” was added). SA’s membership has, among some sceptics at least, sparked the debate whether, having regard to the size of the country’s population and economy[1], it was worthy of admission – especially when other potential candidate countries have a much larger GDP and population than South Africa’s. Having regard to the statistics in the footnote below, SA strikes one as a junior member of the BRICS club. And, in these very tough economic times when the country can least afford, it is required to make a club membership contribution of billions of rands. But stay in this club SA believes it must because, apparently, there are benefits to be derived from this membership.

 

  1. The club that is of greater relevance here is another one, the Group of Twenty (G20), made up of a group of the finance ministers and central bank governors of twenty countries[2]which include the USA, the UK, France, Germany, South Africa, and others. Starting in 2009, the G20 resolved that derivatives contracts traded over-the-counter (OTC) should be regulated in the same manner as derivatives traded on formal exchanges. This resolution was sparked by the global financial crisis of 2007 which emerged from the US housing market. At the time, banks recklessly lent large amounts of money to low-income borrowers to buy homes. The regular mortgage payment streams were then securitised and sold as securities to mostly institutional investors. Credit derivatives were used to manage credit risk. For the securitisation scheme to work, borrowers had to keep making payments on their mortgages. However, a situation was relatively quickly reached where the household debt levels of borrowers exceeded their income. This caused borrowers to default on their mortgage payments and they eventually gave up their homes. This was referred to as the subprime lending crisis. The knock-on effect was such that it led to the bankruptcy of large American institutions such as the investment bank Lehman Brothers, the insurer AIG, public entities Fannie Mae and Freddie Mac, as well as other financial institutions such as ABN-Amro, Royal Bank of Scotland (RBS), several Icelandic banks, Fortis, Wachovia and a few more.

 

  1. The reckless lending practices of American banks triggered the global financial crisis of 2007. The crisis itself did not have a direct impact on South Africa[3]. The G20, rather than resolving to tighten the lending practices of banks that were responsible for the crisis, decided that the OTC derivatives market should be formally regulated in all 20 member countries. South Africa had no part in the subprime lending crisis, nor was the country directly affected by it. Nevertheless, in conformance to the G20 resolution, SA’s National Treasury issued two Policy documents together with Ministerial Regulations and Board Notices under the Financial Markets Act No. 19 of 2012 for the formal regulation of the SA OTC derivatives market. The question remains, though, has a case been made for the formal regulation of the SA OTC derivatives market?

 

The nature of financial derivatives

  1. Derivatives are hugely effective and efficient risk management tools. The primary function of these financial instruments is to efficiently facilitate the redistribution of risk between economic agents. This is done by transferring risk from those who are risk-averse to those who are better able, or willing, to bear such risk. This risk may emanate from fluctuations in interest rates, foreign exchange rates, commodity prices or equity prices. The use of a derivatives contract is not the only way to transfer risk – it is just more efficient. Risk may also be transferred by entering into a standard transaction in the market in which an asset is traded – the underlying cash market. However, such a transaction typically involves transaction costs greater than those incurred by entering into a derivatives contract. A transaction in the cash market also typically requires the investment of principal by way of actually purchasing the asset. The higher transaction costs and the investment of principal make the cash market a less efficient means of transferring risk. A far more efficient way of doing this is made possible by the ability of derivatives to unbundle the risks inherent in an asset or a transaction, thus making the various risk components more manageable. This allows a market player to choose the particular type of risk he or she wishes to be exposed to, and the types of risk the person prefers to avoid or offload. Derivatives instruments have always fulfilled a very valuable function in financial markets by:
  • allowing corporates to hedge their risk.
  • reducing funding costs or locking in future borrowing costs.
  • contributing to the expansion of investment products by way of the creation of structured products.
  • ensuring greater price discovery.
  • overcoming regulatory barriers that restrict access to certain investment instruments or funding sources.

 

  1. Derivatives contracts come in two forms – standardised contracts and non- standardised contracts. Standardised contracts, examples of which include futures contracts and some option contracts, are usually traded on exchanges (e.g. the South African JSE) and are accordingly formally regulated. Non-standardised contracts, which make up the bulk of all derivatives contracts traded[4], are not traded on formal exchanges, but rather over-the-counter and are thus referred to as OTC derivatives. These contracts have historically not been formally regulated.

 

Justification for the formal regulation of OTC derivatives

  1. The G20 argued that the formal regulation of the OTC derivatives market will offer    counterparty risk protection and reduce systemic risk. This argument assumes such protection does not already exist in the OTC market. While this market may not be formally regulated, it is self-regulated. For instance, standard documentation (the Master Agreement with its relevant Annexures) issued by an industry body, the International Swaps and Derivatives Association (ISDA), is typically used to enter into contracts in the OTC derivatives market. These documents are commonly used to record the terms and conditions, as well as the close-out netting of OTC derivatives transactions. Dealers use this standard agreement to conclude contracts with other dealers and with end-users. One great benefit of the Master Agreement is its potential to mitigate default risk on outstanding transactions by way of the close-out netting provisions. These provisions allow a non-defaulting party to accelerate and terminate all outstanding transactions and net the current market values of the transactions so that a single amount is owed by, or owed to, the non-defaulting party.  Counterparty risk protection thus does exist in the OTC derivatives market.

 

  1. Another apparent justification for the formal regulation of the OTC derivatives market is that, while derivatives traded on formal exchanges offer counterparty risk protection by way of the margining requirement, this form of protection does not exist in the trading of OTC derivatives. The margining requirement comes in two forms – the initial, or original, margin and the variation margin. The initial margin may take the form of a cash deposit, collateral or guarantee (a third-party commitment). Futures contracts traded on formal exchanges are typically marked-to-market on a daily basis, which means that losses and gains arising from daily market movements must be settled on a daily basis. This is done by posting what is referred to as the variation margin. Players in the OTC derivatives market have increasingly demanded the posting of collateral to provide protection for the potential default of a counterparty. Where collateral is not demanded it is often because of the creditworthiness of the counterparties which enjoy a high credit rating (e.g. one bank dealing with another). The creditworthiness of the counterparties in these cases tends to provide them with sufficient comfort that they do not consider it necessary to demand collateral.

 

Conclusion

  1. Having addressed the issue of risk, what remains to be said is that while the formal exchanges offer standard and inflexible contracts, the OTC derivatives market offers the kind of contracts which cater to the unique objectives of parties – contracts which require customisation, flexibility. It may therefore not be appropriate for the OTC derivatives market to be tarred with the exchange-traded derivatives market brush by expecting the OTC market to be as formally regulated. Besides, the SA financial market is already well-regulated – so are the banks which are the major dealers in OTC derivatives contracts. Also, SA has not quite seen any of the major derivatives-related disasters experienced in other jurisdictions. Simply because some of the G20 members believe that OTC derivatives should be formally regulated because these instruments wreaked havoc on their financial markets does not mean SA, although a member of the G20 club, should tag along when the case for such regulation in this country does not appear to exist.

 

[1]According to International Monetary Fund (IMF) data, for 2017, SA’s gross domestic product (GDP) amounted to $349.29 billion with a population of 56.7 million. This compares as follows to the GDP and population of the other BRICS members: Brazil – GDP for 2017, $2.05 trillion, population 209.28 million; Russia – GDP for 2017, $1.52 trillion, population 143.98 million; India – GDP for 2017, $2.61 trillion, population 1.33 billion; China – GDP for 2017, 12.01 trillion, population 1.40 billion.

[2]Together these countries represent two-thirds of the world’s population, 85% of global GDP and 75% of global trade.

[3]There are those who argue, though, that South Africa was certainly indirectly affected by the crisis.

[4]OTC derivatives contracts constitute more than 80% of all derivatives contracts traded in the global market, including the SA market.