Asian regulators need to step up to swaps challenge

Markets on the cusp of change require new supervisory capabilities

Asian derivatives markets could look very different in 2018, as the attraction of Hong Kong and Singapore as hubs for booking derivatives strengthens amid global regulatory change and Britain’s looming exit from the European Union.

The growing appeal should boost the Asian-Pacific region’s market share in the nearly $543 trillion global derivatives market. Banks such as HSBC, Standard Chartered and Deutsche Bank now largely book trades through London, but Brexit and the upcoming second Markets in Financial Instruments Directive have led to moves to decentralise their booking models, including the migration of Asia-based listed or over-the-counter derivatives transactions back into the region.

The shift, when it happens, will mark a major change from remote booking activities, where trades are made in one legal entity in an Asian country, while the risks are booked in another legal entity in the UK. This remote booking is intended to glean more favourable capital treatment and operational efficiencies.

While there are still a few more steps to be completed before the transition starts, the looming changes should encourage regulators in Hong Kong and Singapore to gear up quickly to ensure the integrity of the banking system and markets remains intact. Through increased local derivatives booking, supervisors could end up overseeing rather more systemic and complex risk than at present.

Advanced internal models for dealers are both a prerequisite to foster the Asian booking hubs, and also a useful tool to supervise them adequately. Internal models would lower capital requirements, and also push banks to up their game, because they are supposed to be able to calculate accurately the risks inherent in their derivatives portfolios down to the granular level.

In theory, the transition shouldn’t be that complicated. Global banks already employ models for calculating their derivatives exposure which are approved by regulators in major jurisdictions, such as UK’s Prudential Regulation Authority (PRA).

Yet, therein lies the catch as well. While banks may attempt to replicate their London booking models when they operate out of an Asian financial hub, concerns remain as to whether the regulatory standards in Asia will match those in the UK.

Regulators need to constantly monitor the internal models to ensure risks don’t build up. That requires proficiency in sifting through the banks’ models, which the regulators currently don’t fully possess given that local rules require banks to operate only using the standardised approach. Supervisors also need to build a strong team of quantitative analysts to study the models and suggest countermeasures to mitigate risks.

The PRA, for instance, is said to have a team of six quant analysts just to look at the banks’ models for derivatives booking. There will be more analysts overseeing other parts of the trading desk. Such talent globally and especially in emerging markets is in short supply. And, of course, regulators will be competing for such resources with the banks, which are also beefing up their teams ahead of the shift. This is not a contest the regulators will relish given the difference in pay scales.

The Hong Kong Monetary Authority has been hiring quant analysts and holding discussions with individual banks to explain its supervisory policies and processes for derivatives hubs. The Monetary Authority of Singapore looks to be a little ahead, with some analysts already in place. It wants financial institutions to demonstrate they have robust risk management systems and processes to measure and validate the accuracy and consistency of all relevant risk components.

The likelihood of two booking hubs in the region does offer a silver lining – the diversification of risk. It increasingly looks like Hong Kong would handle trades made in China and the North Asia region while Singapore would be a location for trades originating in South-east and South Asia regions.