Dear Readers,

This is my final derivatiViews column, as I am departing ISDA at year-end for the sunny confines of Florida and the thrills of the Rockies. I have enjoyed authoring these columns on key issues in the OTC derivatives markets with Bob Pickel since we started derivatiViews in July, and hope they have informed the debate in an objective and interesting manner. Bob and his Deputy CEO, George Handjinicolaou, will continue to produce derivatiViews on a regular basis in 2012.

In my last dispatch I thought it might be interesting to do two things. The first is to take a look at the progress made in making the OTC derivatives markets safer and more efficient. The second is to peer into the future to discuss the positive developments we expect and the concerns we have.

Here’s what has been accomplished. Great progress has been made in clearing and compression (tearing up of contracts). Multiple clearing houses are now in business. More products are eligible for clearing and clients of dealers are starting to clear. Volumes at LCH’s SwapClear exceed $300 trillion for interest rate swaps, over 50% of the entire market for the largest of all derivatives products. Another $138 trillion of interest rate swaps have been terminated through compression. Over $5 trillion of credit default swaps are in ICE’s clearinghouses while nearly $100 trillion of CDS has been terminated, either through clearing or compression. Clearing is established in Japan and Singapore as well as in Europe and the US. Finally, trade repositories are in place for credit, interest rate and equity products and are in development in commodities and foreign exchange. All in all, the market is safer and more efficient. We at ISDA like that.

How about the future? Here’s what we are optimistic about. Products such as FRAs will become eligible for clearing and help produce continued growth in clearing activities in 2012. Client clearing will develop more slowly but it will be significant over time. More CDS reference entities will become eligible for clearing but we anticipate that a majority of single-names will not have the liquidity needed to support clearing for years to come. Compression efforts will become more effective both in rates and credit products as economies of scale increase due to more support from more participants. Finally, the trade repositories will be up and running across all asset classes. We also hope a counterparty database will be commissioned. This venue could capture the derivative and collateral relationship of banks with their clients. It would provide an important means for the regulators to translate market risk into credit risk.

Now what of our concerns? We wonder if too much is being done by too many people in too many countries. We foresee a proliferation of clearinghouses both with respect to products as well as regions. Too many clearinghouses will lead to increases in exposure and capital due to the fragmentation of risk. Smaller and more numerous clearinghouses will reduce the benefits and efficiency of compression. Are we better off with 10 regional interest rate swap clearinghouses, each with $75 trillion of notionals, or with one large clearinghouse that might have $200 or 300 trillion of notionals? The chances of weaknesses in regulatory oversight are multiplied by the number of clearinghouses to oversee while larger clearinghouses may increase systemic risk

We also foresee a proliferation of trade repositories as more countries require domiciliation within their borders. How can we be sure the trade repositories will communicate with each other? Will all the data be captured? Will there be double-counting? Will regulators be able to get an accurate picture of risk that may be building up in the system?

We already have a proliferation of regulators. Each country seems to have multiple bodies doing the same thing. This proliferation has made the task of reform enormously difficult. It would have been much simpler if a single, small body of international regulators could work with us so we could address one piece of market infrastructure at a time rather than having everyone working on everything at the same time.

We have other concerns. Chief among them are extraterritorial threats. Will national regulators overreach and try to impose their standards on entities outside their borders? Will such efforts spur retaliation? This could get messy.

What will be the effects of new regulations that are designed to change the structure of the marketplace? We at ISDA believe strongly in the value of the market-making process for derivatives. Market-making is relationship-based, wrapped up in the client-dealer dynamic. We believe an impersonal exchange will not be the best means of executing large transactions at tight prices.

Finally, what about clearing and initial margins? We like clearing and variation margin for cleared and uncleared trades. But we are very concerned about the massive amounts of funds required to support initial margins. The amounts could run into trillions of dollars of “dead” funds. Are they justified? There has to be a better way.

We are proud of what ISDA has accomplished throughout its 26-year history. Recently, we have reaffirmed our commitment to serve the derivatives market and all participants. We have supported reform for our members around the world and coordinated industry – regulatory commitments globally. We believe our communication with members has improved and we have upgraded our research to provide useful analyses of market issues. I leave ISDA with great confidence in Bob and George, as well as our committed staff and Board. It has been a privilege to serve as ISDA’s CEO these past two years and I look forward to helping Bob and the Board in an advisory capacity going forward.

Connie Voldstad

Off to the Courts Again — as a Friend

Recently we provided some background to our decision to go to court over the CFTC’s position limits rules. As we noted, that was a first for ISDA. Never before had we sued a regulator, and it is not an action we take lightly.

The halls of justice are not, however, entirely unfamiliar territory to us. Over the last several years, we have had an active program of filing friend of the court, or amicus, briefs on a variety of issues. Most of these briefs relate to issues raised in litigation involving the ISDA Master Agreement or other ISDA documents. To be true to our mission of providing safe, efficient markets it is necessary at times to intervene in a court case and provide judges with the benefit of our quarter century of experience.

A case in point is our involvement in the case of Lomas v JFB Firth Rixson, Inc. in which hearings in the English Court of Appeal have just concluded. ISDA was granted permission to intervene in the Firth Rixson case at the original trial and in the Court of Appeal. The Firth Rixson appeal was consolidated with the appeals of three other cases that also dealt with related provisions of the ISDA Master Agreement. Our General Counsel, David Geen, observed the arguments in court, and he has worked with our counsel to present our view to both the trial court and the Court of Appeal.

Firth Rixson involves Section 2(a)(iii) of the ISDA Master Agreement, the so-called flawed asset provision. Under that provision a party’s obligation to make payments is contingent on there being no Event of Default or Potential Event of Default with respect to its counterparty. In Firth Rixson the non-defaulting parties had declined to terminate their ISDA Master Agreements with Lehman Brothers International Europe (LBIE) and had not made payments to LBIE in reliance on Section 2(a)(iii). At issue is the proper interpretation of the clause and (in one of the other cases) its compatibility with the anti-deprivation principle under English insolvency law.

We commented on the lower court ruling when it was handed down in December 2010. We found much to like in the decision of that court, but one aspect was surprising. The court held that a party’s “suspended” payment obligations may be extinguished on the last date of payment on the transaction. That’s at odds with market expectations. So we weighed in with the Court of Appeal to reverse that one aspect of the ruling and affirm the rest of the reasoning of the lower court.

The judicial process is, however, not only a means of resolving current disputes; it provides guidance for future evolution of ISDA documentation. Together with close-out netting and the single agreement concept, the flawed asset provision is one of the pillars of the ISDA Master Agreement. We firmly believe that it serves a useful purpose in default situations by allowing a non-defaulting party the time to consider how they wish to proceed in light of their counterparty’s default without having to make the periodic payments that come due under outstanding transactions. Still, we understand that there is also an interest, particularly in insolvency, in achieving finality so that the insolvent party’s estate can be wound up as expeditiously as possible.

In light of the experience of Firth Rixson and other cases, we are in the process of considering what type of time limit the market may wish to put on the ability to rely on Section 2(a)(iii). This is being done with active engagement of key regulators. We encourage those among our membership who have an interest in this issue to join the Section 2(a)(iii) Working Group on the Members’ Portal.

Why ISDA Has Resorted to the Courts

Last week ISDA and SIFMA filed a lawsuit in federal court challenging the CFTC’s position limits rule (see the joint press release and associated documents). This marks the first time the Association has ever sued anyone, much less a regulator. It was a step that we debated extensively. After all the progress ISDA and our members have made in creating safer, more efficient markets, we did not want to give anyone the impression that we are against meaningful regulatory reform. In the end, the decision to file the suit was one that our board strongly supported. It’s worth spending some time explaining how and why the lawsuit came about.

First, it’s clear that the CFTC has the authority to create position limits. That is in the Commodity Exchange Act, as amended by the Dodd-Frank Act.  But what we disagreed with was:

1) The majority of the CFTC found they were required to create position limits. We read the statute to mean that position limits should be put in place when the CFTC found them to be necessary and appropriate. The CFTC made no such finding. Indeed, one of the yes votes warned the limits might do more harm than good.

2) Despite a torrent of comments and numerous studies by academic and government bodies, the CFTC ignored the evidence in proceeding with the rule. Agencies are required by administrative law to consider comments.

3) There really was no cost-benefit analysis. We’ve seen this before and it is very unsettling, especially when this is also required by law.

Could we not have voiced our concerns with the CFTC? The truth is, we should have and we did. We joined thousands of other commenters and submitted several separate letters to the CFTC on position limits. When we filed the legal challenge, the position limits rule was in final form. The decision about the rule had been made. It was not going to be changed with further dialogue.

We felt the final rule was not only negative in and of itself; it also made a terrible model for position limits for other products and for developing other rules. We would very much like to see a good faith cost-benefit analysis of other rules as they are finalized. We point to our paper on electronic execution as the type of analysis that should be done.

But what effect will our lawsuit have? We hope to get an injunction on the effectiveness of the rule. We also hope to get instructions from the court to have the CFTC make findings that position limits are necessary, that they heed public comment, that they structure position limits that suit each commodity separately and that the cost of implementation does not exceed any supposed benefits. We’ll see how the court decides. In the meantime, we have reiterated our commitment to work constructively with global regulators, including the CFTC, to make recommendations, provide information and pro-actively work to get reform right.