Over-the-counter derivatives providers or ODPs had been largely unregulated or self-regulated in South Africa until recently.
But in 2018, new regulations were brought into effect by the FSCA (Financial Sector Conduct Authority) under the auspices of the Financial Markets Act, 2012.
Forex Brokers SA did this report on new rules and how this could bring transparency to South Africa's Forex & OTC Derivatives industry.
FSCA’s new regulations now require all OTC derivative providers to apply for a license to continue their operations and report all their transactions to the trade repository.
These new regulations were enacted after extensive consultation with various industry stakeholders while keeping international best practices in mind.
FSCA announced its Conduct Standard 1 & 2 directives in 2018 and existing ODPs in SA were given a deadline of 8th August 2018 to apply for a license. The deadline was later extended to 14 June 2019 to give all providers time to review & apply.
The new regulations now also direct ODPs to undertake regular and continuous reporting of their trading activities to the FSCA and meet clearing requirements.
Need for ODP Licensing in South Africa
Unregulated trading in over-the-counter derivatives globally was found to be a large contributor to the global financial crisis in 2008.
As a fallout of this financial crisis, global financial market watchdogs realised the need for robust regulations that seek to protect financial market stakeholders and ensure the stability of the financial markets.
Due to the largely connected and interdependent nature of financial markets, there was a need for international bodies such as the G20 to get involved.
South Africa, as member of the G20, committed itself to improve the governance and oversight over financial markets, and especially over relatively new and untested financial products such as over-the-counter derivatives.
It has been observed that the nature of over-the-counter derivatives allows it to multiply any systemic risk in financial markets.
For example, in the US, the effect of subprime mortgage lending was amplified by large volume of derivatives trading by banks on mortgages as an underlying asset during 2007-2008.
In the aftermath of the 2008 financial crisis, many countries such as the US, European Union members, Singapore, Brazil, Japan started taking measures to prevent such an eventuality from occurring again.
The ODP licensing & twin-peaks model in SA are part of such an effort
The “Twin-peaks” model was first conceptualized and enforced by Australia in 1998. It played a major role in the stability of economy in Australia & Netherlands during the financial crisis of 2008.
The model calls for the establishment of two independent regulators with two different goals i.e.: -maintaining the stability of the country’s financial market and ensuring “good behaviour” by market participants along with protection of investors.
Major countries across the world including – US, United Kingdom & Portugal have implemented the twin-peaks model after 2008.
Following the same path, South Africa also implemented twin peak model in 2018 to re-organize its existing regulators and two independent regulators i.e.: Prudent Authority (under Reserve Bank) & FSCA (Market Conduct Authority successor to FSB) were formed to implement the new regulations & to oversee the conduct of the financial sector.
And ODP licensing is one of the major changes that were implemented by the new regulator (FSCA) since its commencement of operations on April 1, 2018.
The new regulations concerning ODPs are meant to ensure proper conduct by ODPs as well as protect investors who buy such derivatives.
Existing Rules and Regulations before ODP Licensing in South Africa
Before the new February 2018 regulations under the Financial Markets Act came into force, the over-the-counter derivatives market was partially regulated by piecemeal laws.
The Securities Services Act of 2004, Financial Advisory and Intermediary Services Act, 2002 & The Banks Act regulated the activities of financial entities in SA. But these Acts had no direct provisions that allowed for proper governance of ODPs.
While, JSE has had a provision for monitoring its members dealing in derivatives through electronic reporting system. But it didn’t apply to non-members.
Therefore, there was an absence of dedicated Regulation or authority to oversee the activities of ODPs.
How Does ODP Licensing plans to change the existing regime?
The new ODP licensing in South Africa provides for several new requirements for ODPs to follow.
Conducting Necessary Due Diligence - They need to conduct their due diligence on potential clients before such clients can be allowed to trade high-risk derivatives.
Since derivatives trades can lead to the potential of the entire invested capital, clients need to show their capital adequacy before participating in such trades.
Such high-risk derivatives are meant to be traded by sophisticated investors who understand the risk and can bear it.
Obtaining Licensing – Every ODP in South Africa must apply with FSCA and obtain a license to operate which also includes Capital Adequacy Requirements for providers.
Without a license, any over-the-counter derivatives providers dealing in SA will be deemed to be operating illegally.
ODP has been classified as provider who issues or sells over-the-counter derivative products i.e.: derivatives not listed on an exchange and includes entities who make or provide a market in OTC derivatives.
FX spot contracts & commodity derivatives settled physically have been excluded from this definition.
Entities that come under this definition now need to apply to obtain a license with FSCA.
Reporting Requirements – Every ODP that has been authorised by licensing must now report all their OTC derivatives transaction details to an authorised trade repository.
These transaction details include the names of the parties, the valuation of the transaction, the underlying asset of the trade, details of the derivative instrument itself, and the margin that has been maintained.
It is interesting to note that there are no authorised trade repositories in South Africa currently. They will likely come into place when FSCA publishes its Conduct Standard 3.
And the reporting activities for ODPs will likely begin once such trade repositories have been established by FSCA.
Impact of ODP Licensing on the Retail Forex and CFD Industry
The regulations have been designed to enable the FSCA to have a finger on the OTC derivatives market including - OTC FX & CFD providers. They can exercise oversight over all the trades that are being conducted and hold ODPs accountable for not following the existing or any future regulations.
The licensing requirements aim to ensure that only those entities that are considered fit for operating in the OTC derivatives can continue their business.
The ODPs must show necessary capital and operational expenditure that is necessary to comply with the new regulations. They must build systems that allow for real-time or daily reporting of the transactions being carried out by them. These systems need to be efficient enough to allow for accurate and timely reporting while being secure enough to prevent leakage of data.
Each ODP seeking a license must ensure that their internal processes comply with the FSCA’s Code of Conduct governing their behaviour.
Expected to bring Transparency & Increased Investor Protection
If implemented properly with proper regulatory oversight, this could be step-in right direction and will positively impact the whole OTC derivatives industry including - CFDs & Retail Forex Trading in South Africa.
It will bring transparency among the existing players in the industry and bring an end to malpractices like - keeping different books for losing & wining clients and signing up clients without knowledge of investing.
When the past conduct & transactions of the providers will be reviewed by FSCA’s reporting authority, many bad players will likely lose their license.
Though it's a big & difficult change for the providers; but in the long run, it should boost investor confidence and would increase the size of South Africa’s derivatives market.
This new regime provides a challenge as well as an opportunity for the service providers operating in South Africa’s OTC derivatives and FX industry. But time will tell how these regulations are implemented.
Disclaimer: The content of this article does not represent the opinions of Finance Magnates.
