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?

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