Have EU derivative policy reforms since the 2008 financial crisis been designed effectively?
| Date | 20 January 2021 |
| Published date | 20 January 2021 |
| DOI | https://doi.org/10.1108/JFRC-09-2020-0085 |
| Pages | 256-279 |
| Subject Matter | Accounting & finance,Financial risk/company failure,Financial compliance/regulation |
| Author | Charles Fergus Graham |
Have EU derivative policy reforms
since the 2008 financial crisis
been designed effectively?
Charles Fergus Graham
Department of Economics, University College London, London, UK
Abstract
Purpose –In response to the 2008 financial crisis, the European Union(EU) comprehensively restructured
its derivative regulation. A key component of this new framework is a reporting obligation for every
derivative trade. As the reportingrequirement does not involve public disclosure of the information,existing
academic analysis on reporting regulations to-date, which focusses on public disclosure, is limited in
predicting the effectiveness of the reform.This paper aims to assess whether the reform has been designed
effectivelybased on the regulatory setup in the UK.
Design/methodology/approach –Framing the reporting regulation as a moral hazard problem with
asymmetric information,this paper uses a game-theoretical approach to evaluatewhether the new derivative
reporting obligation effectivelyinduces firm compliance. I also discuss potential extensions of the derivative
reporting model, withparticular emphasis on how the framework could account for heterogeneous firmsand
differentregulatory tools.
Findings –Based on the theoretical analysis,this paper finds that while firms are unlikely to comply fully
with derivativereporting requirements, it is possible to induce relativelyhigh firm compliance. Although this
does not mean we are immune from another financial crisis, the derivative reporting requirements should
equip EU regulatorsto monitor a more transparent and securederivatives market.
Originality/value –This paper provides a theoretical foundation for further study of post-crisis
derivatives reforms. In particular, the implications of the model point to an empirical strategy to test the
accuracyof the model.
Keywords EU, EMIR, Financial crisis, Regulation, Derivatives, Game theory,
European Market Infrastructure Regulation
Paper type Research paper
1. Introduction
Derivatives are financial contracts whose value depends on an underlying asset. They are
primarily used to reallocate risk exposures between economic agents. The derivatives
market is divided into exchange-traded derivatives (ETDs) and over-the-counter (OTC)
derivatives. ETDs are standardisedcontracts, traded through an intermediary counterparty
that guarantees the trade if either counterparty defaults (Chui, 2012). OTC derivatives are
agreed bilaterally and canbe customised extensively.The size of the global OTC derivatives
market was estimated to be $640tn in 2019 (BIS, 2019), which is almost eight times the
The author would like to thank Professor Cloda Jenkins, Professor Martin Cripps, Dr Frank Witte and
Dr Dunli Li from University College London, as well as Anne-Laure Condat and Carmel Deenmamode
from the Financial Conduct Authority and Daniel Nandwani, Murali Satchithananda, Samuel Asher
and Aparna Arya for helpful discussions, feedback and guidance at various stages of this paper. This
work was completed as part of the author’s BSc Economics dissertation at UCL. No external research
funding has been received for this paper.
JFRC
29,3
256
Received7 September 2020
Revised22 November 2020
Accepted11 December 2020
Journalof Financial Regulation
andCompliance
Vol.29 No. 3, 2021
pp. 256-279
© Emerald Publishing Limited
1358-1988
DOI 10.1108/JFRC-09-2020-0085
The current issue and full text archive of this journal is available on Emerald Insight at:
https://www.emerald.com/insight/1358-1988.htm
global GDP (World Bank, 2019). In 2016, the sizeof the global ETD market was estimated to
be around 10% of the global OTC derivatives market. Similarly, the European derivatives
market is mainly OTCderivatives (European Commission, 2017).
While providing flexibility, OTC derivatives can create complex hidden networks of
interdependence, obscuring the scale and location of risks (European Commission, 2012).
According to the official EU report on the 2008 financial crisis, the lack of transparency in
the OTC derivatives market is widely considered a significant contributor. The report
explains that the explosive growth of the highly complex OTC credit derivatives market,
combined with the lax regulatory framework, led to widespread uncertainty as to both the
size and nature of credit risks globally. As counterparty exposures to OTC derivative risks
were unknown, liquidity markets dried up, furtherintensifying the effects of the collapse of
the sub-prime housing market (De Larosiereet al.,2009). Before the 2008 financial crisis, the
derivatives market was largely self-regulated, led by banks and industry bodies (Ayadi and
Behr, 2009).
Following this EU report, the global G20 committed to improving the transparency
and regulatory oversight of the OTC derivatives marke t.I n Europe, this resulted in the
European Market Infrastructure Regulation (EMIR). Under EMIR, there are three main
requirements: clearing, margining and reporting. Standardised derivatives should be
cleared through a central counterparty, which guarantees the trade if either
counterparty defaults. Any non-cleared derivatives must be margined; the
counterparties must exchange collateral as insurance against counterparty credit risk.
Finally, both counterparties are required to report details of the trade to allownational
authorities to monitor and reduce systemic risks associated with the derivatives market
(European Commission, 2012).
To understand the chosen literature reviewed in the next section, it is important to
explain the reporting requirement in more detail. For every agreement, amendment or
expiry of a derivatives contract, both counterparties are required to report details of who
they are trading with and the nature of the trade. The dual nature of reporting is for data
quality purposes and reduces the incentiveto omit trades. Firms can choose to delegate the
reporting obligation to the other counterpartyor a third-party. The delegating firm remains
responsible for the accuracyof the reports. There are over 100 fields in each report, although
not all fields are applicable to each trade.Reports are submitted to a trade repository, where
the data is aggregated and stored. The nationalregulator for each EU country can access the
data to monitor the derivatives market and individual firm exposures (European
Commission, 2012). In the UK, for example, the financial servicessector is regulated by the
Financial Conduct Authority (FCA). Unlike most reporting regulations, the information
reported is not disclosed publicly. This fundamentally changes the underlying regulatory
mechanism and incentives.As of May 2020, the only UK enforcement case againsta firm for
EMIR reporting non-compliance was against Bank of America Merrill Lynch International
(BAML) in 2017 for failing to report almost 70m trades. The FCA imposed a £34.5 m fine
[Financial ConductAuthority (FCA), 2017a].
Given the effects of the 2008 financial crisis, which are partially due to the lack of
transparency in the derivatives market, it is important that the chosen policy measures in
response are effective in preventingsimilar crises. However, as I will explain in Section 2.2,
the effectiveness of disclosure policies in financial regulation is unclear. My research
question is the following:
RQ1. Does the regulatory mechanism underlying EMIR reporting requirements create
sufficient economicincentives for firm compliance?
EU derivative
policy reforms
257
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