GLOBAL - Reforms of OTC derivatives markets around the globe are having a profound impact on how derivatives are used and will raise particularly challenging questions for sovereign institutions due to their inconsistency, one asset manager has claimed.

According to a report by BNY Mellon - entitled 'Sovereigns in Search of Solutions: OTC Derivatives Reform: Direct and Indirect Impacts' - a number of inconsistencies in the application of key OTC reform provisions remains between regulations in Asia Pacific, Europe and the US.

The asset management firm claimed that this inconsistency could raise "important" issues for sovereigns regarding their obligations and the potential cost of compliance.

Jai Arya, head of BNY Mellon's sovereign institutions group, said: "Sovereigns are generally regarded as low-risk counterparties, and as such have not generally been required to provide collateral.

"With global regulatory reforms, however, precisely what is in and out of scope with respect to sovereigns remains murky."

Arya went on to say that 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," he said.

A number of new pieces of legislation are currently underway to centralise and manage counterparty credit risk and increase transparency by pushing derivatives trades into central clearing.

While Washington is currently implementing the Dodd-Frank Act, Brussels is working on the introduction of the European Markets and Infrastructure Regulation (EMIR).

In Asia, certain jurisdictions such as Japan, Australia and Singapore have also initiated proposals to implement the G-20 commitments agreed in Pittsburgh in 2009, which stipulated that, by the end of 2012, all standardised OTC derivative contracts traded on exchanges or electronic trading platforms would be cleared through central counterparties.

The G20 leaders also agreed at the time that OTC derivatives would be reported to trade repositories and non-centrally cleared contracts subject to higher capital requirements.

In November 2010, the Singapore Exchange launched the first central-clearing platform for OTC financial derivatives in Asia.

Meanwhile, the Hong Kong Monetary Authority and Securities and Futures Commission in Hong Kong have issued a consultation on a proposed regulatory regime for OTC derivatives that would establish a clearing house for derivatives transactions and create a trade repository for data collection.

In its report, BNY Mellon said a common approach would ultimately 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.

Nadine Chakar, head of Derivatives360SM at BNY Mellon, added: "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 collateralisation."

The report also notes 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.

"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, for example," Chakar said.

"The de facto exclusion of US financial institutions as potential counterparties could have a very negative impact on derivatives pricing, liquidity and risk management."
According to BNY Mellon, sovereigns engaged in cleared derivatives markets will need to consider the costs and benefits of each direct CCP membership and the appointment of futures commission merchants to clear on their behalf.

"Even if mandatory execution, clearing and reporting requirements are not imposed on sovereigns," the report says, "the indirect impact on bilateral derivatives pricing could be sufficiently material to warrant a detailed analysis of the relative costs and benefits of voluntarily adapting to central clearing or two-way collateral arrangements."