The Derivatives Information Age

We live in the information age, when the sources and volume of information are seemingly limitless. No longer do we need to rely on a few channels of information delivering an edited version of events. The Internet, social media and 24 hour news in today’s distributed information environment are a virtual fire hose of data, facts and events.

The deluge of material in this environment can be overwhelming at times. That’s why Internet search engines are so valuable. (Note: our interest in this paradigm stems in part from the fact that one of our close family members is a software engineer at Google.) It’s also why trusted brands that help users sort through the data are more important than ever.

OTC derivatives markets, like computing and information, are distributed as opposed to centralized business environments. There are many nodes in the global network of bilateral transactions that reflect, transmit and distribute important data – about the price of credit, counterparty credit risk and market trends – to others in the network.

While the value of distributed derivatives markets is clear, there’s also significant merit in centralized hubs of information that aggregate transaction and exposure data. That’s why ISDA and the industry are establishing trade repositories for OTC derivatives. Widely used for credit and rate derivatives, an equity repository has also been launched and others are under construction for commodity and FX derivatives. The information contained in these repositories will enable regulators to see where risks are building up and to connect the dots between counterparties.

This past week CPSS and IOSCO produced a consultative report regarding OTC derivatives data reporting and aggregation. ISDA will be commenting on the report, but at first glance we can say that it is a thorough discussion of the role of repositories and the challenges in making sure that the information provided is meaningful to those who may rely on it. Among the concerns highlighted, which we share, are:

• Transaction-based reporting may be necessary for some purposes, such as market manipulation. More important is to generate information that will help identify where risk is building up, which is more a function of counterparty level reporting.

• That’s why ISDA endorses the idea of a counterparty exposure repository that tracks and measures counterparty credit risk. Swap dealers in many jurisdictions routinely provide this information today to their prudential regulators. We believe this would be a much more efficient means of tracking counterparty risk than trying to obtain counterparty exposure from trade-level data.

• In fact, the CPSS/IOSCO report notes the difficulty of requiring that repositories collect valuation information for transactions on an ongoing basis as well as collateral and netting related to them. It urges further study, which makes sense as this would be an entirely new direction for repositories. The issues of counterparty credit risk, and the beneficial impacts of netting and collateral on that risk, also need to be analyzed further.

• Trading activity in the OTC markets is significantly different from trading in the exchange-traded equity and futures markets. The expectation for repositories should be tailored to reflect these differences. For example, given the far smaller number of trades done on any day the timing for delivery of the information and the level of detail may differ from exchange level reporting.

• Confidentiality of information provided to a repository remains a paramount concern for market participants, and the report acknowledges the importance of these concerns. Yet the recent disclosure by a US senator of information regarding trading activity provided to the CFTC on a confidential basis highlights the need to remain vigilant to ensure that proprietary information is not made public.

Our overarching concern about the derivatives information age reflects the experience of the broader information age. Will the ever increasing flow of data through the information fire hose make it more or less possible to identify the meaningful from the meaningless?

Do the Sums Add Up?

Earlier this month, ISDA published a short paper entitled Counterparty Credit Risk Management in the US Over-the-Counter (OTC) Derivatives Market. The paper used data prepared by the Office of the Comptroller of the Currency (OCC) to examine the extent of losses related to counterparty defaults from 2007 through the first quarter of 2011. During that entire period, the US banking system sustained losses of $2.7 billion on counterparty defaults on OTC derivative contracts. This includes nearly $850 million of losses in the fourth quarter of 2008, which is when we believe losses associated with Lehman were recognized. This leaves less than $2 billion of counterparty losses not related to Lehman.

We were surprised at these relatively small figures as we remembered large synthetic CDOs inflicting very large losses on financial institutions. The OCC data covered just banks so we looked harder. We found very substantial counterparty losses in non-bank affiliates of banks and broker-dealers outside the banking system. These losses were related to mortgage products and they verified our understanding of the market. We were, though, still surprised by the very small counterparty losses sustained by the banking system.

We then decided to model how these exposures and losses might be impacted by the clearing and margining regulations stemming from the Dodd-Frank Act. A portion of the losses were due to corporations that defaulted amid the troubles that followed 2008. These users will be exempt from clearing under most sets of proposed regulation. Another portion must have come from entities, such as hedge funds, that defaulted on mortgage and other complex products that could not be cleared.

The balance of counterparty losses were caused, most likely, by defaults of financial entities that will be required to clear their transactions under the new regulations, and the defaults occurred on these very same transactions. If these transactions had been cleared, then it stands to reason that counterparty losses by US banks would have been lower. This raises an interesting question:  how beneficial would clearing and initial margining have been for US banks?

The reason we ask this question is the pure cost of initial margin related to clearing. ISDA estimates that initial margin will amount to anywhere from $200 billion to $500 billion of collateral once clearing is complete. The “cost” of this collateral might be 50 basis points; it might be 100 basis points. That’s a minimum of $1 billion per year and a maximum of $5 billion per year. These estimates are global costs. Perhaps the cost to customers of US banks is $250 million to $2 billion per year. These costs need to be considered when contemplating the benefits of clearing and the need for initial margin.
So let’s consider what this means in light of the counterparty loss experience of US banks. As noted, we have a firm upper bound of $2 billion of costs (the counterparty losses not related to Lehman) that could be attributed to the absence of initial margin. But let’s make some assumptions. First, let’s assume half the losses were attributed to defaults by corporations. That reduces the losses caused by financial institutions to $1 billion. These losses were caused by a combination of:

  • no variation margin on clearing eligible products;
  • no or insufficient margin on products not clearing eligible; and
  • variation margin but no initial margin or insufficient initial margin on clearing eligible products.

It is impossible to quantify these respective losses but common sense indicates that a large majority came from lack of variation margin or from products that are not clearing eligible. We will hazard a guess and say those two causes accounted for 80% of the $1 billion of losses from the defaults of entities that would now be subject to clearing. That leaves $200 million as the benefit of initial margin over a period of four and a quarter years. Our numbers and analysis don’t have to be exact. We shake our heads and wonder: we spend hundreds of millions a year and save tens of millions?

Readers: are we missing something?

The Five W’s and How

One of the topics at our upcoming regional updates is “ISDA Documentation: Evolving in the Face of Change.” A combination of ISDA’s in-house legal team, outside counsel and experts from our member firms will discuss the ways in which our documentation is likely to change in the near term.

The evolving bit is nothing new. ISDA documentation has always been modified as necessary to reflect market, legal and regulatory developments. What is unprecedented is the sheer volume and scope of change that the industry potentially faces from regulatory initiatives around the world. When all is said and done, it will probably be the most comprehensive set of changes since European monetary union, when ISDA’s innovative protocol approach to amending documentation was first utilized.

A reporter learns to identify the “who, what, when, where, why and how” of any potential story. That is also a useful framework for thinking about likely changes to ISDA documentation. Unfortunately, we only know the “who, how and why” at this point. ISDA (the “who”) expects to develop a standardized set of amendments, implemented to the extent possible through a protocol (the “how”), in order to allow derivatives users around the world to make necessary changes to comply with new regulatory requirements (the “why”).

What’s not known yet are the “where, what and when.” Agencies in the US are still working their way through the numerous rules required to implement provisions of the Dodd-Frank Act. The European Parliament must first enact changes to market infrastructure and then turn to consideration of changes to how derivatives are traded. As we recently wrote in derivatiViews, regulators in the Asia Pacific region are considering their approaches to clearinghouses and repositories. Regulators are focused on the G20’s 2009 declaration that changes should be in place by the end of 2012, but with little more than a year to go, the list of what remains to be done is a long one.

As greater clarity is provided, ISDA stands ready to make the necessary changes to its documents. One recent initiative, undertaken jointly with the Futures Industry Association, was to produce a standardized document to facilitate customer clearing. It’s the work product of a group that included a cross-section of both buy- and sell-side participants. Our effort in this area continues through a joint working group to develop additional features to make the process of clearing a trade as seamless as possible and enhance clearing clarity. And, of course, we will make appropriate adjustments to the document to reflect final rules regarding client clearing.

Despite the significant market input into that document, we find ourselves having to focus efforts on defending the terms of that document from regulatory uncertainty, primarily over a set of provisions that are completely optional, only to be included in the case of agreement by the parties. ISDA will comment on the recent CFTC release, particularly because the right of parties to choose the terms of their agreement is so important. The interactions at the July CFTC meeting at which the proposal was approved made it clear that this will be a topic of substantial debate, a debate we welcome.

Change is a constant in the financial world. One of ISDA’s successes has been its ability to adapt its documentation as change occurs, and we expect to continue that success in the months and years ahead. In the meantime, ISDA has already been in touch with its members about how we can ease the transition to the new regulatory environment that the industry faces, and we are eager to hear suggestions from readers on this issue.

Questions…. and Answers

New York — ISDA has labored since its founding at making OTC derivatives markets safer and more efficient. We are naturally proud of our many accomplishments but the financial crisis showed we had much more to do. The industry’s recent progress — in reducing counterparty credit risk through clearing and portfolio compression, increasing regulatory transparency through trade repositories and strengthening operational infrastructure — reflects this commitment.

Further progress lies ahead and it’s important for our collective efforts to be focused on developing real solutions to real issues. Our recent study, Counterparty Credit Risk Management in the US Over-the-Counter (OTC) Derivatives Markets, contains some interesting data that should help to inform this effort. It indicates that the derivatives market might not have been as risky as some would believe.

We ask our readers the following questions. Did you know that:

  • US banks only incurred $2.7 billion in counterparty credit losses on OTC derivatives products since January 2007?
  • The total uncollateralized credit exposure among US banks relating to their derivatives activities is now only $109 billion?
  • Dodd-Frank will likely increase variation margin by no more than $30 billion with the banks, and another $20 billion or so for the few remaining non-bank dealers?
  • Credit losses on monoline exposures relating to sub-prime mortgages and executed outside the banking system dwarfed the counterparty losses at the banks? And that these products will remain outside Dodd-Frank?

ISDA has maintained for quite some time that the crisis was caused by bad residential real estate lending and investment. That’s where the losses were for the economy in general and that’s where they were for derivatives. We all know about AIG. We also should all know about the monoline insurers that rushed in to fill the void caused by AIG’s withdrawal from the sub-prime market. That entire industry virtually destroyed itself insuring super-senior tranches of sub-prime collateralized debt obligations. And, in doing so, it created tens of billions of losses in and outside of the global banking sector.

This could have been prevented. At a minimum, as the values of the insured products were declining, collateral should have been required. This was generally difficult if not impossible for insurance companies to do and it would have limited the amount of protection they could have sold. Instead, insurance companies were able to write sub-prime CDS protection and only had to post collateral once they had been downgraded to a certain level, if at all. It’s worth noting that today, virtually 100% of the remaining CDS market is regularly collateralized. It’s also worth noting that insurance derivatives are not subject to the provisions of the Dodd-Frank Act.

There was another element at work in the financial crisis that hasn’t received some of the notice that other contributing causes have received. Under the Basel II minimal capital requirements, banks could have purchased over $700 of super senior collateralized debt obligations for every dollar of common equity.

We wonder whether the facts from our study might point us in a more effective, efficient and economical direction than the current conventional wisdom would lead us. Do we really need hundreds of billions of dollars of initial margin to protect the system when there is only $30 to $50 billion at risk? Do we need to spend this money when the annual cost of prevention far exceeds the losses we have experienced coming through the stress test environment of 2007 to 2011? We think money is being spent unwisely and without the support of a cost benefit analysis. We will have more to say about making the derivatives markets safer in the weeks to come.  

We encourage members to email us at with their reactions to each View and to suggest new issues that might benefit from analysis and comment. 

Asia Pacific Workshop Highlights Need for Global Coordination

Hong Kong — ISDA recently organized a workshop here in Hong Kong for regulators in the Asia Pacific region. With over 40 representatives from 11 countries in attendance, we had an opportunity to share our views on key issues related to regulatory reform (press release from the event).

A major issue stems from one of ISDA’s core beliefs: derivatives are a global product, transcending borders and facilitating the free flow of capital between countries. As we observe regulatory reform around the world, it leads us to ask, “Do we face the prospect of a less global, more fragmented marketplace?” Unfortunately, the answer is that we might.

The G20 in Pittsburgh in 2009 set out the task for global regulators in addressing reform of the OTC derivatives business. Having been handed the assignment set out in those G20 principles, rule makers around the world have been working for the past two years to implement them. Agreeing on high-level principles is a far different task from working through the nitty gritty of national laws and regulations.

Consistency of regulation has its merits, but it is rarely fully achieved and should not be seen as an end in itself. We always expected there to be variations in how the G20 principles would be translated into local laws. And we certainly did not expect these changes to be cost-free. We are more than familiar with patchworks of laws and regulations. For over 25 years we have been dealing with a variety of legal regimes for derivatives and for enforceability of contracts and collateral arrangements.

What has struck us as far from desirable is the duplication and fragmentation of the market infrastructure that may arise as many jurisdictions pursue their own course. We are seeing a proliferation of proposed clearinghouses and trade repositories, with the potential for conflicting rules on where a trade must be cleared and overlapping requirements for where it must be reported. Uncertainty and duplication are never good for business, and that is particularly true of the derivatives business.

The potential for proliferation was a major topic at our Asia-Pacific workshop. We also heard the regulators’ concerns about ensuring that they have some authority or control over transactions affecting their jurisdiction (such as trades in their currency) and the ability to access information regarding certain trades or their regulated institutions. Their concerns are particularly acute in a crisis situation, when accurate, timely information is needed most.

We appreciate the concern of regulators in getting the information they need, which is why we have been supportive of trade repositories. We also understand their particular interest in certain cleared trades. We wonder, though, whether the fragmentation of the marketplace that is the end result of infrastructure being replicated in jurisdiction after jurisdiction will serve the goal of safe, efficient markets that is so important to ISDA and its members.

It is time to come full circle on the debate on OTC derivatives regulatory reform through reengagement at the international level to coordinate the regulatory response for this global business. ISDA, together with eight other financial trade associations, recently wrote to US Treasury Secretary Geithner and EU Commissioner Barnier raising this very point (read the letter). We urge global regulators, through their various international forums such as the G20, the Financial Stability Board, CPSS/IOSCO, the OTC Derivatives Supervisors Group and the OTC Derivatives Regulators’ Forum, to make the safety and the efficiency of markets paramount. And ISDA is committed to be there as a resource, just as it was recently here in Hong Kong.