A MIFID brainteaser: define liquidity

What do we mean when we say a financial instrument is liquid? That it trades 100 times a day? Ten times a day? Less than that? It’s a question the European Securities and Markets Authority (ESMA) currently has the unenviable task of trying to answer for all non-equity instruments as part of its efforts to draw up detailed rules for the implementation of the revised Markets in Financial Instruments Directive (MIFID) in Europe. Unenviable because a lot is riding on getting the definition spot on – continued market liquidity at current levels for one.

The definition is crucial to much of what is in MIFID and the associated Markets in Financial Instruments Regulation (MIFIR). Liquid instruments will be subject to strict pre- and post-trade transparency requirements, as well as potentially having to comply with an obligation to trade on a regulated market, multilateral trading facility, organised trading facility or equivalent third-country venue.

Under ESMA’s May 22 proposals for post-trade transparency, for instance, information on price, volume and time of trade would have to be made public within five minutes of a transaction in a liquid instrument taking place (although deferrals exist for trades that meet yet-to-be-decided size-specific and large-in-scale thresholds). If an instrument is deemed to be illiquid, however, publication of the most sensitive information is deferred until the end of the following day.

ESMA does have some guidance on how to approach the liquidity definition within MIFIR. A liquid instrument is one where there are “ready and willing buyers and sellers on a continuous basis”. MIFIR also sets a variety of criteria that should be used to determine this: average frequency and size of transactions over a range of market conditions; the number and type of participants; and the average size of spreads, when available.

On a hunch, it seems likely the most standardised parts of the over-the-counter derivatives market may meet these liquid instrument parameters. A study conducted by analysts at the Federal Reserve Bank of New York, based on three months of interest rate derivatives transaction data from 14 large global dealers in 2010, found the most popular interest rate swaps traded up to 150 times each day – a frequency that would presumably meet the continuous buying and selling requirement under MIFIR. However, plenty of instruments barely traded: the New York Fed reported more than 10,500 combinations of product, currency, tenor and forward tenor over the three-month sample, but found approximately 4,300 combinations traded only once during that period.

ESMA’s proposals are meant to weed out these kinds of infrequently traded instruments from the post-trade transparency requirements, with regulators recognising that an overly broad regime could deter dealers from facilitating client trades in less liquid products, causing a further decline in liquidity. ESMA suggests looking at a minimum number of transactions and the number of trading days on which at least one transaction occurred within a certain time frame, alongside the other criteria on average transaction size, number of market participants and spread size.

The critical element in all of this is where the thresholds will be set. ESMA hasn’t yet started its analysis of derivatives data, but it took an initial stab at setting some possible numbers for bonds within its proposal, suggesting six possible combinations. For the minimum number of days on which at least one trade takes place over a year, it suggests a threshold of 120 or 240 days – in other words, the instrument must trade at least once every other day or once a day. That’s combined with a minimum-number-of-trades-per-year threshold of 240 or 480 in all but one of the six scenarios, equating to an average of just one or two trades a day.

It’s clear the choice and combination of thresholds can dramatically alter the proportion of trades classed as liquid. In two of the ESMA scenarios, where the minimum number of trades per year and average daily volume are fixed at 480 and €100,000, respectively, increasing the minimum number of trading days from 120 to 240 reduces the universe of bonds classed as liquid from 4.71% to 1.61% and lowers the percentage of volume captured from 86.67% to 62.90%.

This same kind of analysis will also be performed for OTC derivatives once ESMA has collected the relevant data – and ISDA is working to help pull that information together. In setting the thresholds, it’s likely ESMA has a figure in mind with regards to the percentage of traded volume in each instrument it wants to apply the liquidity requirements – in fact, it says as much in its proposal, noting that it will combine expert judgement with a coverage-ratio-type approach when setting thresholds. Given US regulators set a coverage ratio of 67% for the purposes of the Dodd-Frank rules, it’s not beyond the realms of possibility that ESMA will target a similar level.

The question then is whether the thresholds required to reach this percentage coverage level truly reflect continuous buying and selling activity, as per MIFIR’s requirement. The challenge for ESMA will be in balancing a desire to apply the new transparency rules to a large enough portion of trading volume in each market with thresholds that reflect real liquidity, based on an objective analysis of the data.

All told, a lot of work for both market participants and regulators – and a matter of months to do it in.

Three months left and counting down….

European derivatives users are keenly waiting to discover what derivatives products are likely to be subject to the first clearing mandates, with the European Securities and Markets Authority (ESMA) expected to release its first consultation paper on the topic within weeks.

The process picked up steam back in March, when Swedish clearer Nasdaq OMX was authorized as a central counterparty (CCP) under the European Market Infrastructure Regulation. From the moment ESMA was notified of the approval by the Swedish regulator on March 18, the clock started ticking on a six-month window for ESMA to conduct a public consultation and submit draft regulatory technical standards to the European Commission (EC) for each authorized class of derivatives product it recommends for a clearing mandate.

Since then, four other over-the-counter derivatives clearing houses have been authorized – most recently, LCH.Clearnet Ltd on June 12 – and the current thinking is that ESMA will group together the products it thinks may be suitable for the first clearing obligations, possibly into a single consultation to begin shortly. Furthermore, while the derivatives classes so far authorized for clearing across the five CCPs include interest rate, foreign exchange, equity, credit and commodity derivatives, it is anticipated that ESMA will prioritize the most liquid interest rate and index credit derivatives classes in the first instance.

That approach would seem to make sense, given the six-month window for ESMA to hand its rules to the EC for endorsement is rapidly disappearing. Already, the time set aside for the industry to respond to the consultation is likely to be limited – the first post-consultation draft regulatory technical standards are due to be handed to the EC in less than three months. Those rules will then be reviewed by the EC before being handed to the European Parliament and Council of the European Union for approval.

The good news is that the products likely to be proposed for mandatory clearing first are those where there is already a high level of voluntary clearing and where there is an existing clearing obligation in the US – in other words, the instruments the industry is most familiar with clearing. That may help smooth the consultation process.

But there is still uncertainty about the detail of how the first mandates will be implemented in Europe, meaning every second given to the short consultation process will count.

Frontloading is one such issue where much of the detail will only be spelt out in the consultation paper. ESMA proposed a possible approach in a letter to the EC on May 8, in which the frontloading obligation – the requirement to retrospectively clear existing trades once the clearing mandates begin – would only apply for transactions that occur from the time the regulatory technical standards come into force until the end of any phase-in.

This proposed methodology removes much of the uncertainty that had previously existed, but doesn’t completely eliminate the pricing complexities for end-users during the phase-in period. The switch from non-cleared to cleared would come with an array of potential fee, capital, funding and discount-rate implications, all of which would need to be considered and understood at the inception of any trade during the frontloading period. End-users would also need to find clearing members to commit to clearing at a certain point in the future, which some may be unwilling to do. The fact the date of the switch to clearing would be known in advance under the May 8 ESMA proposal makes that calculation slightly less complicated, but there are still a number of variables that would need to be considered.

Ultimately, the minimum remaining maturity – a level to be set by ESMA that will allow contracts with a time to maturity below this threshold to avoid the frontloading requirement – will be critical in determining the impact. But this will only be fleshed out in the regulatory technical standards. The hope is that market participants will have enough time to absorb, understand and comment on the implications.

This all makes for another busy summer for ISDA and its members.

An Outstanding Question

The semiannual over-the-counter (OTC) derivatives statistics published by the Bank for International Settlements (BIS) have long been closely scrutinised as a reliable barometer of the derivatives market. And the latest figures, released last month, have thrown up some headline numbers that have troubled some commentators.

The overall size of the OTC derivatives market climbed to $710 trillion in notional outstanding at the end of 2013, from $693 trillion six months earlier. This increase, coming on the back of a sharp rise in the first half of last year, has kindled warnings that regulators aren’t doing enough, or that they’ve taken their foot off the regulatory reform pedal.

Nothing could be further from the truth, and a closer analysis of the data explains why. First, though, let’s just recap on what notional outstanding actually represents. It simply measures the total face value of all trades that currently exist, regardless of whether certain trades can be offset or netted against each other. As such, it’s not an accurate reflection of the amount of risk being transferred, the payments that are exchanged between counterparties, or the maximum loss that would be incurred should every outstanding derivatives contract be closed out – a point regularly acknowledged by the BIS in its studies.

In contrast, gross credit exposure – which measures the gross market value of outstanding derivatives after legally enforceable netting is taken into account but not considering the impact of collateral – actually fell from $3.8 trillion in June 2013 to $3 trillion six months later. Including the collateral that counterparties have posted to each other would reduce that exposure even further.

But even recognising what notional outstanding represents, and the limitations of what it tells us about derivatives risk exposure, there are some technical issues that need to be kept in mind. Most significantly, the BIS figures count each cleared trade twice: one between counterparty A and the central counterparty; and one between counterparty B and the clearer. A single $10 million trade between two parties subsequently cleared therefore becomes $20 million in notional outstanding for the purposes of the BIS data.

To adjust for that, the outstanding notional volume of cleared trades (themselves adjusted for double counting) would need to be subtracted from total notional. Looking at interest rate derivatives alone, approximately $226 trillion in cleared notional at the end of 2013 would need to be subtracted from the $584 trillion in interest rate derivatives notional, leaving $358 trillion. That’s more or less unchanged from the adjusted interest rate derivatives figure six months earlier. In other words, new regulation, and in particular, the push for greater amounts of centrally cleared trades, is the driver behind much of the apparent increase in notionals.

Nonetheless, a lot of work is being done to reduce the size of these figures. Compression has already reduced the outstanding notional of cleared and uncleared derivatives by $453 trillion as of April 2014, according to figures from Stockholm-based TriOptima. Industry efforts are under way to build on that – in part to reduce the operational burden for dealers, but also encouraged by regulations like the leverage ratio under Basel III, which sets capital based on gross notional, rather than net risk, exposures.

Far from taking their foot off the pedal, then, regulators have introduced rules that are very much driving these numbers. With clearing leading to double counting of notional, and compression cutting back on gross exposures, it’s difficult to know which way the next BIS numbers will run. One thing’s for sure, though – the notional figures reported won’t be an accurate reflection of risk.





End-user angst in Munich

Munich angstIn the years since the financial crisis, an important point about derivatives has often been overlooked: they serve a genuine need by helping real companies to hedge very real risks. This point came across loud and clear in a recent survey of end-users conducted by ISDA: 86% of respondents said over-the-counter (OTC) derivatives were either very important or important to their risk management strategies. This was also a recurring theme at ISDA’s annual general meeting (AGM) in Munich earlier this month, where a succession of end-users and academics stressed the economic benefits of derivatives and their value to the real economy.

These end-users generally feel the financial system is on a sounder footing today than before the financial crisis, largely as a result of regulatory changes. But enthusiasm for specific regulations varies significantly. For instance, trade execution rules got a thumbs down from investors, despite the fact these rules were meant to help those users, primarily by ensuring greater transparency. In that aim at least, regulators appear to have succeeded: 74% of respondents thought electronic trade execution would have a positive affect on transparency. But more than half felt it would have a negative impact on ease of use, while 39% and 36% thought it would have a detrimental affect on price and liquidity, respectively. That’s a higher proportion than those who thought the impact would be positive.

Another key area of end-user concern is a lack of regulatory harmonisation and the resulting fragmentation of markets. Nearly half of survey respondents thought the market was splintering along geographic lines – a finding backed up by other ISDA research. This point was also picked up by end-user speakers at the AGM, who talked of their efforts to minimise cross-border problems by reorganising their operations to ensure non-US entities avoid trading with US dealers. The result, they argued, was less liquidity and higher costs for certain products – something reflected in the end-user survey, which found 83% of those who had witnessed some level of fragmentation believe it had led to higher costs.

For the most part, though, many end-users – and corporates in particular – have been sheltered from the direct costs resulting from new regulation. Corporates are largely exempt from mandatory clearing requirements and from forthcoming uncleared margin rules, excusing them from having to stump up initial and variation margin on their hedges – money they believe would be better spent on investment and research and development.

But there are other indirect costs: dealers are subject to higher capital charges for uncollateralised trades via new credit valuation adjustment (CVA) rules. While European banks are exempt from having to apply this CVA charge for trades with corporate customers, other banks aren’t – and those capital charges are likely to be passed on. Dealers will also look to hedge any client transaction, and these offsetting trades will almost certainly require margin to be posted against them. The dealer would need to fund that margin, creating a cost that may well be handed down to the client.

End-user speakers at the AGM claimed not to have seen any marked increase in price so far, suggesting dealers are largely absorbing these costs at the moment. They did, however, say they had seen some banks pulling back from certain markets and products. In other panels, dealer representatives acknowledged banks now have to pick and choose, with higher capital and leverage costs forcing them to concentrate on those areas where they have an advantage or where they can meet return-on-equity hurdles.

That’s already having an impact, with liquidity diminishing significantly in certain markets, affecting the ability of end-users to manage their risks efficiently. One buy-side speaker said some customised products were either no longer available or were trading “by appointment” only. That’s a big problem, as tailor-made, bespoke contracts fulfil a real need by allowing firms to closely offset their risk. Any reduction in the availability or increase in costs for these products could encourage some companies to hedge less, some speakers warned – a result that would lead to increased earnings volatility, less certainty in cashflows and – ultimately – less investment, less job creation and lower economic growth. That fear was voiced forcefully by a number of AGM end-user speakers.

That scenario thankfully doesn’t appear to have played out yet. The end-user survey found that 79% of respondents plan to increase their use of OTC derivatives or keep their hedges at the same level during the second quarter of 2014. But higher costs, fragmented markets and less liquidity could eventually take its toll, depriving end-users of an important risk management tool.

That’s an unintended consequence no-one wants to see. Could we end up with less safe, less efficient markets? That’s the concern that was voiced over and over again in Munich.

The euro swaps surprise

As surprises come, it should have been a non-event. On March 18, Swedish clearing house Nasdaq OMX announced it had been authorised as a central counterparty (CCP) under the European Market Infrastructure Regulation (EMIR), the first in Europe to get the regulatory nod of approval. Clearers had to submit their applications by September 15 last year, and national authorities had a six-month limit to consider them once they were confirmed as complete, meaning the authorisation was well in line with the schedule outlined by the European Securities and Markets Authority (ESMA).

Nonetheless, the announcement caught the market completely unawares, and has led to a situation where European derivatives users are unsure how to price and risk-manage euro-denominated interest rate swaps, the largest segment of the interest rate derivatives market.

How did this happen?

It all boils down to the oddly named and much misunderstood frontloading requirement under EMIR. Frontloading is a bit of a misnomer – it actually refers to a requirement to backload certain derivatives transactions to a CCP, specifically those trades conducted between the point in time ESMA is told a clearing house has been authorised to clear certain derivatives classes and the start of a clearing obligation for those products.

The problem arises because it’s uncertain which trades will be captured by this requirement, and when. Once ESMA is notified of a CCP authorisation, it has six months to conduct a consultation and draw up regulatory technical standards for each class of products it thinks may be suitable for mandatory clearing. The European Commission (EC) then has up to three months to endorse the standards, before they pass to the European Parliament and Council of the European Union, which have up to two months to accept the rules if they haven’t been modified by the EC and up to six months if they have. The rules are then published in the official journal, and come into force 20 days later.

According to a time line published by ESMA last year, the earliest a clearing mandate will come into effect after a CCP is authorised is nine months; the latest is 16 months. But there could be phase-ins written into the rules that extend the start date beyond that.

This all matters because Nasdaq OMX doesn’t just clear the smaller Scandinavian currencies – it also clears euro interest rate swaps. That means the clock is now ticking, and any euro swap transacted by a European participant from March 18 onwards may need to be backloaded to a CCP at some unknown time in the future.

This creates some real risk management headaches for European derivatives users. Should individual trades now be treated as cleared, non-cleared, or a mixture of both? It’s virtually certain a clearing mandate will apply for euro interest rate swaps at some point, but it’s not clear when. The situation is even less clear for other, less liquid products – ESMA may decide after its consultation period that some instruments are not yet suitable for mandatory clearing, particularly if they are only cleared by a single CCP.

Market participants had hoped regulators would provide further clarity on frontloading before the first CCPs were authorised. Without this guidance, derivatives users can’t be sure whether any single trade will ultimately be subject to frontloading or not. That’s why the approval of Nasdaq OMX came as such a shock.

Further clarity will come at some point. But the sooner the better. Until it does, uncertainty will continue to hamper risk management in the euro swaps market, making it more difficult for end-users in Europe to implement the hedges they need.

Progress, of a sort

Eight months on from the much-heralded “path forward” agreement that set a roadmap for how US and European regulators would deal with cross-border regulatory issues, the fruits of the new cooperative approach have started to emerge. In February, the Commodity Futures Trading Commission (CFTC) issued conditional no-action relief allowing US entities to continue trading on European multilateral trading facilities that haven’t registered as swap execution facilities, so long as those platforms meet requirements that are identical to those applied in the US.

It may not have been exactly what some European venues were hoping for, but this represented notable progress. At one point last November, following two clarifications by the CFTC that seemed to extend US rules further than ever before, it looked like the path forward would become a road less traveled.

There’s still a huge number of cross-border issues that need to be tackled – among the most urgent, Europe’s equivalence determinations for US central counterparties (CCPs). Under the European Market Infrastructure Regulation (EMIR), European banks would not be allowed to act as clearing members of any CCP in a non-equivalent jurisdiction, while Europe’s Capital Requirements Regulation prevents them from applying the lowest possible 2% risk-weight for cleared exposures at those venues. Together, these rules could have a devastating impact on the business of any non-equivalent clearing houses.

A comparison between US and European clearing rules throws up a number of seemingly intractable inconsistencies – for instance, a one-day margin period for futures contracts under US rules less onerous than the two days required under EMIR. Nonetheless, some have speculated that the new-found spirit of cooperation between US and European regulators may allow a compromise to be reached.

That doesn’t answer what happens elsewhere, though. Trades conducted between US and European entities account for a large portion of the cross-border universe, but there are plenty of transactions involving counterparties from other jurisdictions too – Australia, Hong Kong, Japan, to name but three. Some regulators have set out broad parameters for equivalence or substitutability determinations, but these are imprecise and lacking in detail.

Generally, regulators agree that foreign rules should be deemed equivalent if they pursue the same outcome. But beyond a pretty clear global consensus on central clearing and reporting – both key Group of 20 (G-20) objectives and initiatives supported by ISDA and the derivatives market – the desired outcomes differ from jurisdiction to jurisdiction. Dodd-Frank, for instance, covers everything from trading, clearing, reporting and business conduct rules to broader bankruptcy and resolution proceedings. EMIR covers clearing and reporting, with trade execution covered by the revised Markets in Financial Instruments Directive, but many other countries with smaller derivatives markets have opted to tackle clearing and reporting only.

The risk is that some national regulators will approach each outcomes-based equivalence determination as a broad, like-for-like comparison of their own regulatory and legislative framework. That tactic would likely doom any equivalence process to failure. Rather, regulators need to focus on whether the core objectives set by the G-20 are being met, taking foreign legal regimes and local market practices into account.

The trouble is getting to this point, as well as having a mechanism in place to deal with any disputes. The International Organization of Securities Commissions has suggested it may be able to play a role here, drawing up a set of principles – perhaps similar to those published by ISDA last year – and intermediating in equivalence determinations. This could involve peer reviews, colleges of supervisors and regulatory visits, comparable to what the Basel Committee on Banking Supervision has in place for Basel III. It seems like a good idea, and could do much to resolve potential problems and ensure the global derivatives market continues to be just that: global.

The road to reporting consistency

road aheadEurope is about to take another big step on the road to over-the-counter (OTC) derivatives reform with the start of mandatory reporting on February 12. From that date, all derivatives conducted by European firms will need to be reported to regulators via a repository authorised by the European Union, bringing further transparency to the market – a goal that ISDA fully supports.

It hasn’t been an easy journey, though. The major derivatives dealers have been reporting to repositories for some time, well before the mandates came into force, and market participants had to meet reporting obligations under the Dodd-Frank Act last year. But European derivatives users have had to get to grips with a set of rules very different to those implemented in the US. For one thing, both counterparties to the trade have an obligation to report, creating all manner of challenges over who generates the unique trade identifier (UTI) for each transaction and how it is communicated to the other counterparty in time to meet the T+1 reporting time frame. Firms can delegate their reporting to a dealer or to a third party, but they still retain the obligation to ensure those reports are accurate. Any mistakes by the delegated party and the counterparty is on the hook – a potential liability many are uncomfortable with.

The scope of the rules is also much, much broader, capturing all asset classes without any phasing and both OTC and exchange-traded derivatives – the latter inclusion requiring huge amounts of work to adapt the systems and processes developed for Dodd-Frank. This had to be completed in a relatively short amount of time too: it was only confirmed the reporting mandate would apply to exchange-traded derivatives from day one in September 2013.

A number of technical issues have also plagued preparations. There has been little regulatory guidance on a system for UTI generation, leaving the industry to develop its own proposal. That proposal hasn’t been formally endorsed by regulators, however, causing some counterparties to develop idiosyncratic approaches. On top of that, only a fraction of the derivatives user base has applied for a legal entity identifier, a 20-digit code essential for continued trading of derivatives from February 12.

The reports themselves are also proving challenging. Several required data fields are unique to European rules, such as the type and version of any master agreement used – and this information is not currently supported by middleware providers. A lack of guidance over whether to report data subject to strict privacy laws, how to treat uncleared trades that are subsequently cleared and therefore split into two new transactions, whether the notional amount field should be updated over time, and how to deal with complex and bespoke trades where firms may use different booking models have all added to the challenges.

But there are bigger issues here: the sheer volume and inconsistency of data collected by global repositories all over the world. Commodity Futures Trading Commission commissioner Scott O’Malia frequently raised concerns last year about a lack of consistency in how US firms are reporting data and differences in how the various repositories collect their information. This is likely to get worse as more reporting mandates come online, all with their own, unique requirements, and new domestic repositories are authorised.

An initiative championed by the Financial Stability Board (FSB) will hopefully pull together all this data in a consistent format, enabling regulators to get a clear view of the market and spot a build-up in systemic risk – the original intent of the original Group of 20 mandate. The FSB published a consultation document on February 4, which outlines some of the potential models for data aggregation. But until a viable mechanism is up and running, no-one will have the full picture. Given the time, expense and resource that everyone – dealers, end-users and infrastructure providers – have put into meeting the mandates, it is disappointing a global framework for consistent data reporting wasn’t put in place by regulators from the start.

ISDA has tried to help throughout the process, proposing that the ISDA taxonomy be used as the basis for product identifiers and coordinating work on the industry UTI proposal. A further initiative will also help increase transparency, with the launch of a new portal (see screenshot below) that pulls together information currently available on interest rate and credit derivatives in a easy-to-digest and transparent format. You can access the ISDA SwapsInfo website by clicking here.

SwapsInfo for IRD

Market fragmentation is becoming a reality


The global nature of the derivatives market has long enabled users to manage their risk efficiently. This is something ISDA has championed throughout its history, and it’s been our single biggest concern over the past few years. Thankfully, the Group of 20 (G-20) nations shared this concern when setting their roadmap for derivatives reform in September 2009.

Nonetheless, derivatives users have been warning for some months now that the rollout of the US swap execution facility (SEF) regime, and the extraterritorial reach of those rules, would lead to market fragmentation, with separate pools of liquidity emerging for US and non-US persons. Evidence is now emerging that this is indeed the case.

Research published by ISDA clearly shows that European dealers have been opting to trade euro-denominated interest rate swaps with other European counterparties since the start of the SEF regime on October 2, 2013. Based on the volume of trades cleared at LCH.Clearnet, approximately 90% of European interdealer activity in euro interest rate swaps is now being traded with other European firms, up from roughly 75% before October. That tallies with an earlier survey published by ISDA in December, which found 68% of respondents had reduced or ceased trading activity with US persons since the SEF rules came into effect, while 60% had noticed a fragmentation of liquidity.

So, why are these rules affecting the trading habits of European dealers? It can all be traced back to the last-minute inclusion of footnote 88 within the final SEF rules, agreed by the Commodity Futures Trading Commission (CFTC) last May. That footnote essentially required all multiple-to-multiple trading platforms to register as SEFs, even if the products they offer aren’t subject to a trade execution mandate – an inclusion that sent a number of venues scrambling to submit their applications before the October 2 deadline. Combined with that was uncertainty about final interpretive guidance on the cross-border application of Dodd-Frank, published in the Federal Register on July 26. While the treatment of SEFs wasn’t explicitly covered, a number of non-US electronic trading platforms interpreted the guidance to mean they would need to register with the CFTC if any US person – including foreign branches of US banks – traded directly or indirectly on their venue.

Given the complex registration process, and the need for SEF customers to sign lengthy end-user agreements, a number of non-US platforms decided it was simply easier to ask US participants to stop trading on their platforms, or to split their businesses between US and non-US liquidity pools. The latest ISDA research shows this has become a reality.

Less clear is how this has affected over-the-counter derivatives markets. A fragmentation of liquidity could lead to less efficient pricing in certain markets, as well as greater volatility – something the G-20 stated it wanted to avoid in September 2009. According to the December ISDA survey, 46% of respondents said the fragmentation had led to different prices for similar types of transactions, but this trend may become more pronounced over the next month. While trading platforms have had to register as SEFs since October, US derivatives users haven’t been obliged to use them – they could continue to trade by phone or via single-dealer platforms. That will change on February 15, when the first trade execution mandates come into force. From that point, US participants will be required to trade those interest rate derivatives subject to made-available-to-trade determinations on registered SEFs or designated contract markets. Non-US entities won’t – and will probably continue not to want to.

Global regulators have talked a lot about the need for cooperation to ensure a consistent application of the new regulatory framework, and to avoid fragmentation and less efficient markets. This latest evidence suggests fragmentation is happening, and that can’t be a good thing.

Why regulatory transparency doesn’t get the “all-clear”

A recent speech by Benoit Coeuré, a member of the ECB Board of Executives, sheds some light on a key issue in the OTC derivatives markets: regulatory transparency.

It’s an issue on which ISDA and market participants have spent a lot of time and resources – largely to good effect, as the trade repositories we helped establish gave policymakers a clear view of risk in the system.

Recent developments, though, threaten to undermine progress that has been made.

Mr. Coeuré asks an important question about transparency in his speech: “Does…the supervisor responsible for the supervision of a large cross-border financial institution at a consolidated level have direct and immediate access to information on OTC derivatives transaction that encompass all transactions entered into by all entities of this group? Is the information accessible, in other words can it be easily aggregated across trade repositories and jurisdictions?”

He then goes on to say: “My answer would be a clear no!”

And we agree.

Mr. Coeuré went on to discuss privacy laws, blocking statutes and indemnification clauses in several jurisdictions which restrict access to the detail of OTC derivatives transactions; the inability to aggregate data across trade repositories and jurisdictions; and differences in the type and level of information required for reports across jurisdictions. He ultimately broke the problem into three main issues: information gaps, data fragmentation across trade repositories and jurisdictions and obstacles impeding authorities’ access to data.

As the ECB official points out, the Financial Stability Board, assisted by the CPSS and IOSCO, has only very recently begun a feasibility study on various approaches to address shortcomings in the global regulatory reporting landscape (a global repository aggregator being one approach).

These problems were predictable, and were predicted. The OTC derivatives market has been a global one from its inception. The only way to capture this activity is single centralized trade repositories by asset class. Proliferation of trade repositories – within different regions and globally – leads to fragmentation and possible duplication of the information gathered. As such it undermines the very efforts of the regulators to capture and comprehend the risk exposures that market participants want to provide and that regulators want to get.

We believe there is a lesson here. Regulators will have heard ISDA and various market participants ask “What is it you want to achieve?” when addressing regulatory proposals and wishes. This is not a rhetorical question. Regulatory (or quasi-regulatory) processes where there is a real, interactive debate with industry and other interested parties – such as those which first enabled development of trade repositories – are healthy, and achieve results. They create shared understanding of regulators’ goals, and help everyone to build towards them.

There’s still a lot of work to be done on derivatives regulation – on global reporting taxonomy, for example (which must involve an open and interactive dialogue between regulators and industry). We want to solve these problems too, and want to be able to help regulators to do so.

Should I stay or should I go?

Everyone knows that two of the busiest days around the office are the day before you leave on vacation and the day you return. For some of us at ISDA today is getaway day, but that doesn’t mean there isn’t time to spare a few thoughts on the current state of the derivatives markets.

We had something of a “July Surprise” with the announcement on July 11 that peace was at hand between the CFTC and European regulators on cross-border derivatives regulation. We viewed that announcement, as many people did, as a positive development and a serious attempt to advance the discussion of global regulation of a global business.

As is often the case with broad pronouncements, however, the detail is in the detail, to coin a phrase. The next day the CFTC provided its final guidance on cross-border issues and additional time for compliance under an exemptive order. It is clear from the detail that the process of determining substituted compliance is going to be a critical one. It will be important to get both the substance and the process right. You will be hearing more from ISDA on this in the days ahead.

The CFTC work plan for derivatives is largely complete, with the finalization of the cross-border guidance and the publication earlier in the summer of SEF rules and related rulemaking. We will continue to work through the implementation challenges our members face, including the third wave of mandatory clearing in early September, but the drumbeat of deadlines is fading on the US front.

But don’t think it will be a vacation from here on out — far from it. Still, at least there will be a change in locale — Europe in particular, but all over the globe as well.

Europe is considering its approach to mandatory clearing and our various product steering committees are reviewing ESMA’s discussion paper. Confirmations and portfolio reconciliation face mid-September deadlines. And the European approach to the G20 commitment on execution will be hashed out over the course of the Fall through the consideration of the Markets in Financial Instruments Regulation in the trilogue process. We will be actively engaging with policy makers to identify areas with particular market sensitivity.

Globally, we are expecting approval by the G20 of the proposals on margin for uncleared derivatives. We have written extensively, both in derivatiViews and in submissions to regulators, about our significant concerns with the proposed initial margin requirements. It seems clear that initial margin in some form and quantum will be required, so we are also working on the development of a standard initial margin model to facilitate the introduction of any initial margin that might be required. Whatever the G20 decides will need to be implemented at national levels, so this issue is going to be on the front burner for months to come.

There are other things that await your return from vacation — major regulatory capital proposals, consideration of benchmarks, new credit derivative definitions, to name a few. In a few weeks, as summer ends (or winter for those of you in the southern hemisphere), and you feel the need to quickly get up to speed on all the developments affecting derivatives, consider attending our annual regional conferences in New York or London in September or in Asia in October. Details are on our website.

Wherever you may be headed—or even if you are staying put—safe travels and we look forward to your continued involvement and support.