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Commentary

Governing Global Derivatives: G7/G20 Progress, Problem, Possibilities

Chiara Oldani, University of Viterbo and G7 Research Group
March 20, 2017

The decision of British votes to leave the European Union, the election of Donald Trump as U.S. president and a growing mood of nationalism, populism, nativism and closure in Europe, the United States and Japan all raise profound challenges to the consensus on openness and international cooperation that have guided Group of Seven (G7) or Group of Eight (G8), European Union and global governance in the recent past.

These changes directly assault the efforts needed to generate economic growth and employment through macroeconomic policy coordination, global financial regulation, and trade and investment liberalization. On one side, President Trump stated he will eliminate the Dodd Frank Wall Street and Consumer Protection Act. On another, the exit of the most relevant financial market from the European Union reduces the strength of the European regulatory effort.

Financial stability directly influences growth and the changing financial regulation might reduce it, by promoting beggar-thy-neighbour policies and races to the bottom on regulation.

The G7 never took a direct position on over-the-counter (OTC) derivatives, except at the G8's L'Aquila Summit hosted by Italy in 2009: "We commit to vigorously pursue the work necessary to ensure global financial stability and an international level playing field, including on compensation structures, definition of capital and the appropriate incentives for risk management of securitisation, accounting and prudential standards, regulation and oversight of systemically important hedge funds, standardisation and resilience of OTC derivative markets, establishment of central clearing counterparties for these products, and regulation and transparency of credit rating agencies."

Progress

Contrary to the G7, the members of the Group of 20 (G20) believe that OTC derivatives played an important role in building up systemic risk in financial markets before 2007 and in spreading volatility throughout global financial markets during the subsequent global financial crisis. In fact, after 2009 G20 members did a substantial job in harmonizing global financial regulation, especially by closing the gaps on OTC derivatives trading, which were considered to be one of the roots of the financial crisis. The need for deep harmonization was confirmed at the G20 finance ministerial meeting in Baden-Baden on 17-18 March, 2017.

Problem

What has been left out of the G20's global regulatory effort is trading by non-financial operators. Non-financial operators include governments, local administrations, municipalities and non-financial firms. Such trading has been exempt from the new regulatory framework because of the relatively small size and supposedly simplistic nature of the products, but the deep interconnections in the financial system can create the conditions for a domino effect, which can alter global financial stability.

The reduced coordination among the US and Europe in financial regulation after 2017 could affect financial stability, by allowing a race to the bottom on regulation and safety.

Possibilities

The Bank for International Settlements (BIS) provides interesting statistics on OTC derivatives, but does not provide any detail on sovereigns. Some countries publish the data on their trading, but on a voluntary basis. This lack of transparency should be reduced in order to safeguard financial stability.
The incentive to central clearing OTC derivatives contracts is very small for non-financial operators, such as sovereigns, because of the high costs associated to clearing.

Solution

In March 2017, the G20 finance ministers and central bank governors asked the Financial Stability Board to report to the leaders at their summit in Hamburg on 7-8 July 2017 on the progress of the financial sector regulatory agenda. On that occasion, the G20 governments should consider introducing common harmonized accounting criteria to report OTC trading to enhance transparency and to reduce market inefficiencies and systemic risks.

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Chiara Oldani is professor of monetary economics at the University of Viterbo and director of the G7 Research Group's Rome office. She is a member of the scientific committee of the Fondazione Ugo La Malfa, a research associate at the Centre for Applied Macroeconomic Analysis at Australian National University and the director of research at the Rome-based Assonebb. She was a visiting scholar at CIGI in 2014, the Cambridge Endowment for Research in Finance at the University of Cambridge in 2007 and the Wharton School at the University of Pennsylvania in 2005. She has taught at Luiss Guido Carli University and the Italian Society for International Organization in Rome. Chiara's research currently focuses on over-the-counter financial derivatives and the complex web of counterparty risk, widely considered a major precipitating factor of the global financial crisis. She has published dozens of academic papers and book chapters, both in English and Italian, on topics including Greek sovereign risk, derivatives and fiscal policy, and the global financial crisis. She has a Ph.D. in monetary and financial economics from Tor Vergata University and an M.Sc. in economics from the University of Warwick.

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