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.