What is a derivative?
Although ‘derivative’ is a commonly used term, there is often confusion over what a derivative actually is. A derivative is a type of financial instrument whose price is determined by reference to one or more underlying assets, such as shares, currencies or interest rates. Derivatives may either be traded on an exchange, or off-exchange. Off-exchange derivatives are commonly known as over-the-counter (OTC) derivatives, and are traded and negotiated between two parties without going through an exchange or other intermediaries.
Increased regulation on the horizon
Earmarked as a contributor to the 2008 financial crisis, OTC derivatives were one of the financial instruments identified by the G20 summit as needing increased regulation. Different jurisdictions have approached the regulation of OTC derivatives in their own manner, for example European Market Infrastructure Regulations in the EU, and the Dodd-Frank Act in the US. In South Africa, regulation has been addressed in the Financial Markets Act, 2012 and its draft regulations.
Over a series of blog posts, we will consider the regulation of OTC derivatives in South Africa.
Mandatory central clearing
In an effort to avoid a repeat of the financial crisis, one of the G20 recommendations was that all OTC derivative transactions be centrally cleared. Central clearing is a process in which OTC derivative transactions are cleared by a single (central) counterparty (CCP), to reduce individual risk. A CCP could be a clearing house licenced in terms of the FMA or an external clearing house. Each party in the transaction enters into a contract with the CCP so each party does not take on the risk of the other defaulting.
Using a CCP is a new requirement. As the regulations are still in draft form, the central clearing requirement is not yet in effect in South Africa and we do not yet have any licensed CCPs.