Much has been written about the OTC derivatives clearing obligation, which is due by end-2012. However, what is perhaps less transparent is that the clearing mandate is about much more than clearing.

One of its primary features, for example, is reporting. The CFTC has issued a number of rules in this regard (Parts 43 and 45) which prescribe detailed reporting requirements. CFTC rules call for the electronic reporting of all swap data to Swap Data Repositories (SDRs) following execution of trades. Potential reporting entities are SEFs (Swap Execution Facilities), DCMs (Designated Contract Markets), DCOs (Derivatives Clearing Organizations), SDs (Swap Dealers), MSPs (Major Swap Participants) and swap counterparties who are neither swap dealers nor major swap participants (non-SD/MSP counterparties) including counterparties exempt from the clearing requirement.

SDRs must maintain all swap data reported to them in a format acceptable to the regulators. The CFTC has even specified the format in which such data will be reported. In order to enhance its ability to conduct effective market surveillance (and thus mitigate systemic risk and prevent market manipulation), the CFTC has specified data conventions such as Unique Swap Identifiers (USI), Legal Entity Identifiers (LEI) and Unique Product Identifiers (UPI). These unique identifiers are crucial for linking data together and enabling data aggregation across counterparties, asset classes and trades.

The industry welcomes all these regulatory initiatives. We have stated repeatedly that we fully support complete regulatory transparency. At the same time, we have expressed our reservations with respect to the interaction between public transparency and liquidity.

Regarding the data initiatives specifically: We welcome the CFTC’s efforts to provide more structure to the reported data through the introduction of USIs, LEIs and UPIs. As the Bank of England’s Andrew Haldane put it in his March 2012 speech, “Today’s financial chains mimic product supply chains of the 1980s and the information chains of the 1990s. For global supply chains and the internet, their fortunes were transformed by a common language… They are astonishing success stories…. A common financial language has the potential to transform risk management at both the individual-firm and system-wide level.”

Equally, we see a number of useful applications that could come out of the creation of this unique identifiers infrastructure. Apart from enhancing the ability of regulators to monitor activity and risk in the system, these developments are likely to revolutionalize the financial services industry and will, most likely, lead to the creation of another cottage industry specializing in applications from these data.

There are, though, some troubling aspects of the reporting requirement that could lead to potential issues for all involved, including the CFTC itself, let alone the industry which is working diligently to meet the July 16 date on which reporting becomes effective in the US.

• First, the CFTC, in order to prevent data fragmentation, requires that all data for a swap must be reported to a single SDR. Yet, the CFTC allows for the creation of several SDRs per asset class, creating the potential for faulty double reporting, overlapping of data, and most importantly, the potential need for an SDR for SDRs per asset class;

• Second, there are similar reporting initiatives in other jurisdictions, creating again the possibility for the requirement that the same transaction has to be reported to two different trade repositories in two different jurisdictions. This has to be avoided at all costs;

• Third, the data structure proposed by CFTC is a US regulatory initiative. It is hoped that it will be accepted by other jurisdictions around the world. Establishment of parallel data structures by other regulatory authorities would be an expensive calamity and would create a significant hurdle to achieving greater transparency.

We will be watching with interest developments in this regard as they promise to be exciting and potentially transforming for the industry.

ISDA members from around the world — nearly 1,000 of them from 31 countries —gathered in Chicago last week for our 27th Annual General Meeting. That’s a lot of cross-border activity! And it highlights precisely why one of the most important issues in the OTC derivatives market today is the need for international regulatory cooperation to address the issue of extraterritoriality, or ET.

ET was the subject of Bob’s remarks at the AGM. It’s an issue that ignites a lot of passion among our globally-active members. Concerns are growing about the potential impact of one regulatory regime reaching beyond the boundaries of its home jurisdiction. In Dodd-Frank the legal basis to reach beyond the borders is to avoid an adverse effect on the economy or financial condition of the US. The practical effects of that authority will depend on just how far those charged with implementing the law want to push their jurisdiction.

We have always believed that the ultimate resolution of the ET issue will depend on global regulators working together to resolve the issue of jurisdiction. This needs to be done in a way that preserves their legal authority while recognizing the role of other jurisdictions and regulators.

Harmonization of regulatory approaches, particularly on issues with systemic risk implications, and a concerted program of mutual recognition of regulatory regimes by global regulators are essential parts of the solution to ET. In this regard, it was helpful to hear from CFTC Chairman Gensler in his remarks to the AGM that he is working closely with global regulators and is confident that they will work towards a common approach. He reported that the day before he addressed the AGM, he was in Toronto with a group of global regulators discussing these very issues.

That’s all well and good, and we welcome that regulatory dialogue. What our member firms now face, however, is continued uncertainty regarding the reach of regulation, even as they face looming decisions to register or put in place extensive business conduct procedures.

Uncertainty is never a good thing in financial markets, as there are typically only two things to do in face of that uncertainty. One is to pull back and wait until such time as greater certainty is provided. On a firm level, that means missed opportunity. On a market level, that means less efficient, and probably less safe, markets when market participants pull back.

The other response is to try to anticipate various possible results. This can lead to costly, duplicative efforts with no guarantee that all that planning will prove effective once the rules are finalized.

Either path runs the risk of undermining what ISDA has worked so hard on over the course of the last three decades: safe, efficient markets. These markets enable the development and spread of innovative risk management tools across geographic borders.

We hope to know more soon about how global regulators will address these issues. And our members can be assured that, as we learn more about the future, we will pass that information on. As they say, knowledge is power.

As the OTC derivatives industry moves forward towards implementing the clearing mandate, it is becoming increasingly apparent that there is a need to maintain consistency between the bilaterally transacted OTC derivative world and the newly emerging cleared world. Failure to maintain consistency could prove problematic for all involved, including hedgers, market makers and CCPs. This might ultimately undermine the objective of policymakers and market participants: the creation of a safer, more robust system.

Regulators are creating another set of market rules which may or may not be consistent with the set of OTC derivatives market practices that have been developed over the past 30 years. Some concrete examples of this potential inconsistency include:

• In the bilateral world, collateralization of exposures is the norm. But posting of initial margin is optional subject to one counterparty’s credit view of another. In the cleared world, initial margin is mandatory, irrespective of the quality of the counterparty. The result is different quoted prices based on whether initial margin is posted, its level (when posted) and how it is calculated and traded off against default fund contributions.
• In the bilateral world, all aspects of an agreed trade — legal, credit, market and operational risks — are dealt with directly between the two transacting parties. In the cleared world, as many as four additional counterparties are potentially being inserted between the two transacting parties (a SEF, an FCM, a CCP and another FCM). Some of these parties are pure pass-through parties when it comes to risk, but some are not. Worse, one agreement is replaced potentially by a number of agreements, and apart from the increased complexity (always a red flag), there is an increased likelihood that the sum of this process is not comparable to or consistent with the initial contract.
• In particular, in the bilateral world, counterparty risk is all aggregated in the ISDA Master Agreements between the parties. Considerable effort has been spent to ensure legal enforceability of this agreement (and associated CSA) around the world through the netting and collateral opinions. In the cleared world, this is substituted with a set of agreements involving CCPs and in some cases other parties (FCMs). These agreements, apart from being inconsistent among CCPs, typically only cover a single product. Even in the best case of a single CCP per product (which is clearly not where we are headed), there is a considerable loss of netting efficiency. These agreements are asymmetrical (one way) and it remains to be seen to what extent these agreements are enforceable in a variety of jurisdictions. Worse, because of the above, these transactions are no longer fungible with their bilateral counterparts, giving rising to a host of unexplored risk, legal, accounting and capital considerations. Again, all these factors translate to different quoted prices.
• Bilateral OTC derivative portfolios are subject to elaborate capital requirements that have evolved. As transactions are moved to CCPs, capital is released but since CCPs are now taking up these risks, they have to put up capital which, in turn, determines clearing charges. Guess what? The methodology proposed for calculating required capital for the CCPs for these trades (the outdated current exposure method) is different from those for bilateral transactions. In fact, the charges are much higher than those prevailing for bilateral trades, acting as a disincentive for clearing as they make it too expensive, but also leading to inconsistent treatment of identical risks.

We’ll stop here as the purpose of this note is meant to be illustrative of the kind of inconsistencies that are emerging. The consequences from such inconsistencies are significant. Given the fact that a fair amount of OTC derivative business will continue to trade bilaterally, even after the clearing mandate is fully in place, inconsistency in practices between the bilateral world and the cleared world is likely to give rise to market fragmentation, lack of fungibility between cleared and uncleared products (with all the consequences for risk management) as well misguided incentives as to where to do business.

Are some Asian jurisdictions venturing down the path of “regulatory arbitrage” in order to lure derivatives business away from the (supposedly) more strictly regulated US and Europe? Some observers think so. But if you kick the tires on this claim by considering observable facts and actions, you will see this claim isn’t going anywhere.

The September 2009 G20 Summit in Pittsburgh laid out the path for OTC derivatives:

“All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”

The APAC G20 signatories – Australia, China, India, Japan and South Korea – are all on track to meet their mandatory clearing and reporting requirements. Hong Kong and Singapore are not G20 members and could have chosen the other path by not adopting G20 standards, but they’re opting in to G20 principles, not staying out. (For an update on Singapore’s thinking see a recent Asia Risk piece by our colleague, Cindy Leiw. Registration for free trial required.)

With the exception of Japan, APAC regulators have chosen not to address the G20 plank on exchanges or electronic trading platforms at this time. This makes sense given how much less liquid APAC derivative markets are than those in the west, and the “where appropriate” language in the G20 commitments, in our view, allows for this. The drafters of Dodd Frank and EMIR have chosen to make electronic trading platforms an important part of their regulatory reforms, but that does not mean that APAC jurisdictions should have to do so or stand accused of regulatory arbitrage. Asian jurisdictions will abide by global consensus reforms, not US or European domestic regulations.

Asian regulators have energetically participated in all global regulatory coordination bodies, including the Basel Committee, CPSS/IOSCO, ODRF, and the Financial Stability Board. They are actively engaging with US and European regulators on a bilateral basis to harmonize regulation and deal with extraterritorial issues. At ISDA we work with regulators one-on-one and also organized two regulator forums in 2011. APAC jurisdictions have all committed to adoption of Basel 3 standards, and in some cases such as China and Singapore, have even called for more stringent capital standards than those prescribed by Basel 3. Contrast this with the US, which never implemented Basel 2 and and has yet to decide whether to adopt Basel 3 standards.

Another fact not considered in the debate is that prior to the financial crisis, Asian derivative markets were already much more stringently regulated than western markets. CDS were not allowed onshore in China or India at that time and, even now, are only allowed in a controlled manner that has led to minimal volume. China, India and Korea also control the amount of leverage banks are allowed to offer to clients for hedging products which also puts a damper on trading volume. China and India are also likely to mandate clearing of FX forwards while the US and Europe will likely exempt them. This hardly smacks of regulatory arbitrage to us.

The final charge against Asian jurisdictions is that much is still pending. But that’s understandable given that the FSB has not finalized standards on mutual recognition of third country CCPs or LEI standards, CPSS/IOSCO has not finalized CCP risk management standards and rulemaking under Dodd Frank and EMIR remains a work in progress. Asian regulators are wary of enacting legislation before global standards are set as it could be difficult to amend legislation once passed. Their intention is to harmonize with global regulation, not to create arbitrage opportunities.

Regulatory arbitrage is easy to assert and hard to prove. All the more reason to keep our eyes on the road and focus on the facts.

Negotiators representing the European Commission, European Parliament and EU Council of Ministers recently reached agreement on the European Markets Infrastructure Regulation (EMIR), which sets out new European rules on clearing, bilateral risk mitigation and trade repository reporting. It is expected that the agreement will be endorsed by the European Parliament during the week of March 12-16; the Council of Ministers will also endorse it that month.

EMIR represents another milestone toward reaching the objective, set by the G20, of increasing transparency and reducing risk in the over-the-counter (OTC) derivatives markets. It aims to achieve risk reduction by requiring financial firms (as well as non-financial, subject to a threshold) to clear OTC derivatives “deemed” eligible (i.e., standardized) through CCPs, while it requires non-eligible OTC derivatives to be risk-managed under rules set out in the Regulation. It aims to achieve increased transparency by requiring the reporting of all derivatives (OTC or otherwise) to trade repositories (TRs).

The Regulation contains exemptions from the clearing requirements for non-financial companies, sovereigns, multi-lateral development banks, and other public sector entities that are fully guaranteed by their respective states. It also exempts pension funds for the next three to five years – pending creation, it is hoped, of suitable clearing solutions for such funds. Exempted from the clearing requirement are also intragroup transactions which meet certain requirements. Finally, EMIR also regulates CCPs and TRs, specifying the rules governing CCPs (e.g. in relation to risk management, capitalization, collateral and margin).

Many aspects of the legislation remain to be further defined and refined by ESMA and/or the various national regulatory authorities. Although the law is effective once it is published in the Official Journal, from a practical point of view, much of the detail will not be clear until ESMA (with the assistance of the other ESAs, or European Supervisory Authorities) thrashes out the details and the European Commission adopts relevant technical standards. The ESAs are expected to finish their work by end-September, with a further three months for the European Commission to approve them. At that point, the technical standards will come into force.

It’s clear that, given the uncertainty as to how exactly these standards will affect regulated firms, ESMA will need to deploy the scope it has been given in the main EMIR regulation to phase-in some aspects of the legislation (e.g. for clearing) for categories of counterparty. 
 
Following closely on EMIR’s announcement, ESMA has just come out with a 75-page discussion paper on draft technical standards. The topics to be clarified are organized around 83 questions and cover a wide variety of issues. Important questions, such as which OTC products are “deemed” eligible for clearing, remain open. Similarly, questions as to where such transactions will be cleared and as to the requirements of CCP authorization (and a lot of the detailed but important aspects of CCP governance, capitalization, and margining) also remain to be clarified. ESMA expects market participants to submit comments by March 19th.

ISDA has repeatedly stated its support for resilient and efficient markets. Regulatory infrastructure initiatives, such as clearing, contribute to these objectives. Moreover, ISDA supports a prudently managed transition to robust CCPs and, as such, it supports EMIR. It also supports the authority delegated to ESMA. Equally, though, we have expressed our concerns ‒ in a joint letter to EU Commissioner Barnier with other relevant trade associations ‒ that not enough time is being allowed for the proper consideration of these important issues.

Above all, we are concerned with the fact that large amounts of risk are in the process of being transferred to the CCPs without an adequate understanding of the sequencing involved, potential bifurcation of risk, and unwanted concentrations of risk in the newly formed (and untested) CCPs.

We are also concerned that parallel efforts in the US and European fronts may lead to an uneven playing field, giving rising to unwanted regulatory arbitrage, despite the stated objective by G20 to take action at the national and international level to raise standards together and “implement standards consistently in a way that ensures a level playing field and avoids fragmentation of markets, protectionism, and regulatory arbitrage.”

As we have highlighted in our letter to Commissioner Barnier, Danish Finance Minister Corydon and ECON Committee Chairman Bowles, it is essential that, as they approach critical rule-making mandates over the coming months and years, the ESAs are provided with the time and opportunity to succeed.

The process of regulatory reform in the US and in Europe can sometimes seem discordant. Multiple regulators, ministries, politicians and policymakers produce a cacophony of proposals, counter-proposals, bills, statutes, directives, regulations and rules. Still, no matter the static, we have, at this point, the structure of Dodd-Frank in the US and the developing structure of EMIR and MiFID in Europe to provide some tonality, if not harmony, on approaches to regulation.

If the final movement is approaching in the US and Europe, where are we in the development of OTC derivatives regulation in other jurisdictions, particularly in the Asia-Pacific region? Without a single government or common market, is there any hope that regulation across the region will be in the same key, even if everyone plays a slightly different tune?

We won’t know the full answers for awhile, but in the meantime we will make every effort to broadcast information to the membership as regulations are composed across the region. To that end, we have just published our Asia-Pacific Regulatory Profiles, which serves as a handbook to regulatory developments affecting OTC derivatives in key jurisdictions throughout the region.

This new publication provides information on key regulators, on important recent and upcoming milestones and lists ISDA submissions on regulations in 10 markets. Some jurisdictions are part of the G20 and are striving to make good on the September 2009 commitments on clearing, execution and transparency. Others, though not bound by those goals, are nevertheless looking to emulate them. Yet another group may be driven more by domestic considerations and other public policy goals.

One issue that our Asia-Pacific report highlights is the approach in each of the countries to utilizing CCPs and trade repositories. Many jurisdictions are pursuing local solutions for their domestic markets and trades in their currencies. We have written about this previously in derivatiViews, where we highlighted the potential for proliferation of these key elements of market infrastructure and the possible detrimental effect of that proliferation on reducing systemic risk. We continue to raise this concern with regulators throughout the region.

Our staff in APAC remains active on these issues in both the established as well as developing markets. We will be making a stop later this month in Singapore where we will meet with members and regulators. Singapore has just announced that it is conducting a review on the regulatory oversight of OTC derivatives and is seeking public comment. After Singapore we will then travel to Hanoi, which we have visited once before, to hold a session on OTC derivatives with the Vietnamese central bank and other regulators. And in jurisdictions like Hong Kong, China, India, Korea and elsewhere, we have an established cycle of visits and working group meetings.

Wherever we travel in the region or, for that matter, around the world, our tune will be one of pursuing regulatory reform that is driven by the need to develop safer, more efficient markets. Anything else is just noise.

As we enter 2012, the OTC derivatives industry will continue to be challenged by significant regulatory requirements on both sides of the Atlantic. One of the most important was set by the G-20 at their Pittsburgh Summit in September 2009: “All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.” 

The G-20 felt that systemic risk would be reduced if the bilateral nature of OTC derivatives contracts were to be replaced by a central counterparty through which transactions would be cleared.
 
We are now less than 12 months from meeting this important deadline. Yet much remains to be done.

The G-20 spoke about standardized OTC derivative contracts. Yet, the term “standardized” has yet to be adequately defined anywhere, nor have the criteria for defining a contract as standardized been established. Does the definition of a standardized product imply that it enjoys some degree of liquidity? If a product is standardized, but not liquid, can it be safely cleared? If so, under what circumstances and within what parameters?

This is not an exercise that we should underestimate. It goes to the heart of the G20 commitment. Moreover, it will help determine whether a meaningful reduction of counterparty ‒ and systemic ‒ risk occurs, or whether it will give rise to new unwanted risks that may actually increase systemic risk. 

These are difficult, relevant questions. But somehow, the model that seems to be driving the regulatory process is that of the equities or futures markets. These markets, however, are different from OTC derivatives. They are open to a widely dispersed set of participants, ranging from mom and pop investors (who are managing their investments and or retirement funds), to mutual funds, hedge funds with a wide variety of strategies, arbitrageurs, high frequency traders, algorithmic strategies, asset allocators, and so on. The result is deep markets in which a large number of trades of a relatively small amount of products take place, ranging from a few shares to large block trades involving millions of shares. The order-driven auction system, which does not rely on the provision of liquidity by any single participant, but “generates” its own liquidity through the preponderance of so many players, is an appropriate fit for those markets.
 
The OTC derivatives markets, on the other hand, are highly institutionalized. As such, they involve a relatively limited number of participants who typically trade not as frequently and in often lumpy ways. The result is a much less liquid market. In fact, with very few exceptions (such as the US dollar and Euro denominated interest rate swap markets), most OTC derivatives markets may involve less than a few hundred trades on a daily basis. In fact, as a recent NY Fed paper indicated, many single CDS names do not trade at all on daily basis.

So, to come full circle, it remains to be seen how the definition of “standardized” product will be developed and implemented in practice. Close attention can and should be paid to not just the features of the product, but also the liquidity of the markets in which it trades. Done correctly, the focus on clearing standardized products will reduce risk. Done incorrectly, it may create unwanted risks. This will take the form of large concentrations of risk in CCPs that can not be distributed or hedged, leading to increases in systemic risk.

Food for thought for all as we go forward in 2012.