Honey, I Shrunk the Market

The OTC derivatives market knows that 2012 will be a transformational year for the industry. By year-end, the industry has to meet the challenging objective, laid out by the G-20, of trading all “standardized” derivatives transactions on electronic platforms, where appropriate, and clearing them through central counterparties (CCPs).

Increasingly, this task is looking extremely ambitious. ISDA made its views known in a letter to the European rule-making bodies. Market participants and regulators need time to think through the issues and prepare solutions to the challenges posed. Rushing through them can only lead to increased risks and unintended consequences. 

We have written before on some of these issues. Many of them emanate from the fact the supervisors are attempting to regulate a global marketplace with a series of “national” or “jurisdictional” regulatory initiatives – Dodd-Frank in the US, EMIR and MiFID in Europe, as well as other initiatives elsewhere (Japan, Canada, Hong Kong, Korea, Australia and others).

The OTC derivatives market, however, is perhaps the clearest example of a global market that has emerged over the past three decades. Unlike most of the underlying “cash markets” – which have grown locally and have been in existence for decades if not for centuries – the youth of the OTC derivatives market has enabled it to build its international foundations from the beginning. The ISDA Master Agreement is used by almost all participants to document transactions ubiquitously, and is perhaps one of the few – if not the only – document with global acceptance and application. Most OTC derivative trading books are global, feeding on demand and supply of client flows from all over the world. The integrated technology they use allows them to “see” and manage the same book as it passes through time zones and locations. Most banks that deal in OTC derivatives typically have a single global back-office where all the transactions, occurring around the world, are processed. The industry has built single data repositories where virtually all worldwide OTC derivatives transactions are captured by product.

Attempting to shrink this global industry and make it fit “national” or “jurisdictional” definitions presents a monumental task and an equally monumental risk. It gives rise to a myriad of risk management, operational, legal and technological issues that the industry and the regulators are only beginning to come to grips with.

An example from the US dollar interest rate swaps (IRS) market helps illustrate some of the issues that arise. It is well known that Fannie Mae and Freddie Mac are massive receivers of fixed rate IRS to compensate for the prepayment risk that exists in the large mortgage portfolios that they hold. This risk, to a large extent, is offset by European or Japanese corporate hedgers (in addition to the US), which are typically fixed rate payers. Attempting to clear such transactions can potentially lead to massively unbalanced positions in the respective CCPs, resulting in (and creating) a bifurcation of risk (in an otherwise risk-neutral position) and the need to post potentially different (and incremental) amounts of initial margins. Similar examples can be drawn from the CDS, commodities and equities OTC derivatives markets.

Worse, these “national” or “jurisdictional” regulatory initiatives are incompatible both in content and in the timeframe in which they are being rolled out. The CFTC in the US has a head start, having issued a number of rulings, but even that Commission is behind its own stated schedule. The SEC is further behind in its rulemaking, although it is supposed to work jointly in some cases with the CFTC. The situation is even more challenging in Europe where EMIR (the European equivalent of Dodd-Frank regarding clearing) is just now being finalized. ESMA – which is supposed to follow with its own rules – has not started the process either. And this is on clearing alone. The introduction of electronic trading platforms is likely to be another transforming event for the industry’s structure, the effects of which are only beginning to be discussed.

And while all this is happening, the end-2012 deadline is casting its shadow. There is increasing realization that there is simply not enough time to deal with all these issues. And if things are rushed so that deadlines are met, the likelihood increases substantially that mistakes will be made, risks will be overlooked, or simply that ill-conceived rules will be put in place with unintended consequences.

LSOC it to Me

The derivatives world is full of acronyms. CDS, IRS, CCP, CVA. The list goes on. ISDA itself is an acronym, and a relatively popular one at that.

Well, we can now add another acronym to the mix:  LSOC. If you haven’t heard it yet, you are likely to, in the cleared swap world of the future in the United States. LSOC stands for “legally segregated, operationally commingled.” Under rules adopted by the CFTC (acronym alert!) last week, it is the basis for the complete legal segregation model, which determines how margin for cleared swaps will be held for the benefit of customers of a futures commission merchant (or, to cite another acronym, an FCM).

ISDA has been supportive of the LSOC approach since the very early days of the CFTC’s deliberations on customer margin for cleared trades. It is an approach to margin that bears similarities to the way that collateral has traditionally been held in the OTC derivatives business. The legal rights to collateral in OTC trades are clear under the widely-used ISDA credit support annexes backed by the legal opinions obtained by ISDA. Operationally, collateral provided for OTC trades may be commingled or even in some cases rehypothecated, but the legal rights of the provider of credit support are protected by the terms of the documentation.

The process followed by the CFTC in reaching its final rule last week is an example of effective dialogue among the CFTC and various interested parties. Soon after the Dodd-Frank Act (we’ll spare you the acronym) was passed, several market participants raised concerns with the CFTC that they could potentially find themselves less protected in margin arrangements for cleared swaps than for non-cleared OTC swaps, where they had  negotiated third-party custodial arrangements. They wanted to take advantage of the risk reduction offered by clearing their trades, but they did not want to forego the degree of protection for margin that they had so carefully negotiated for the collateral in their OTC trades.

Through an advanced notice of proposed rule making, proposed rules, roundtables and an ongoing dialogue with ISDA and other market participants, the CFTC worked this issue extensively. Swap clearing is a pillar of national and international approaches to regulatory reform, and margin and its treatment is a linchpin of clearing. It was important to get this right so that customers would not have to be concerned about the protection of their margin as they moved to the cleared swap world.

LSOC seeks to strike a balance by recognizing that while full legal segregation of collateral can provide the highest degree of protection, it can also create operational challenges where a third-party custodian is involved. Complete segregation through a third-party custodian also comes at a cost and some customers may take the view that the extra protection is not justified by that cost. Clear, robust legal rights are essential. If those are in place, greater flexibility on the operational side is acceptable. Maintaining legal segregation while allowing for commingling of margin for operational reasons—the LSOC approach in a nutshell—was the best result.

The CFTC will continue to consider the approach to margin in both the cleared swaps and futures worlds as the market builds experience with LSOC and more details are discovered regarding what happened at MF Global. ISDA and the industry will also assess its experience with LSOC and the other rules adopted by the CFTC last week. The dialogue that has been established through the CFTC’s consideration of LSOC will serve the CFTC and the industry well for the future.

The long and short of it is that LSOC is a good step in the right direction.

Standardize This

As we enter 2012, the OTC derivatives industry will continue to be challenged by significant regulatory requirements on both sides of the Atlantic. One of the most important was set by the G-20 at their Pittsburgh Summit in September 2009: “All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.” 

The G-20 felt that systemic risk would be reduced if the bilateral nature of OTC derivatives contracts were to be replaced by a central counterparty through which transactions would be cleared.
 
We are now less than 12 months from meeting this important deadline. Yet much remains to be done.

The G-20 spoke about standardized OTC derivative contracts. Yet, the term “standardized” has yet to be adequately defined anywhere, nor have the criteria for defining a contract as standardized been established. Does the definition of a standardized product imply that it enjoys some degree of liquidity? If a product is standardized, but not liquid, can it be safely cleared? If so, under what circumstances and within what parameters?

This is not an exercise that we should underestimate. It goes to the heart of the G20 commitment. Moreover, it will help determine whether a meaningful reduction of counterparty ‒ and systemic ‒ risk occurs, or whether it will give rise to new unwanted risks that may actually increase systemic risk. 

These are difficult, relevant questions. But somehow, the model that seems to be driving the regulatory process is that of the equities or futures markets. These markets, however, are different from OTC derivatives. They are open to a widely dispersed set of participants, ranging from mom and pop investors (who are managing their investments and or retirement funds), to mutual funds, hedge funds with a wide variety of strategies, arbitrageurs, high frequency traders, algorithmic strategies, asset allocators, and so on. The result is deep markets in which a large number of trades of a relatively small amount of products take place, ranging from a few shares to large block trades involving millions of shares. The order-driven auction system, which does not rely on the provision of liquidity by any single participant, but “generates” its own liquidity through the preponderance of so many players, is an appropriate fit for those markets.
 
The OTC derivatives markets, on the other hand, are highly institutionalized. As such, they involve a relatively limited number of participants who typically trade not as frequently and in often lumpy ways. The result is a much less liquid market. In fact, with very few exceptions (such as the US dollar and Euro denominated interest rate swap markets), most OTC derivatives markets may involve less than a few hundred trades on a daily basis. In fact, as a recent NY Fed paper indicated, many single CDS names do not trade at all on daily basis.

So, to come full circle, it remains to be seen how the definition of “standardized” product will be developed and implemented in practice. Close attention can and should be paid to not just the features of the product, but also the liquidity of the markets in which it trades. Done correctly, the focus on clearing standardized products will reduce risk. Done incorrectly, it may create unwanted risks. This will take the form of large concentrations of risk in CCPs that can not be distributed or hedged, leading to increases in systemic risk.

Food for thought for all as we go forward in 2012.

ISDA’s Resolutions for the New Year

As I re-assume the ISDA CEO role, let me first express my appreciation to Connie Voldstad for his two years of service to ISDA. He was very astute at understanding the many strengths of the organization while also identifying ways to make it even stronger. Where he could effect positive change, he did.  I very much enjoyed working with Connie and our members and our markets benefitted from his time here.

ISDA’s focus in the coming year or so will cover three broad areas, specifically, regulatory developments, infrastructure improvements and new opportunities and markets.

Regulations are a constant variable, if the reader will permit such an oxymoron. We know that we face significant regulatory developments in the coming year, but there is still an incredibly high degree of uncertainty about how those developments will shake out. We will remain actively engaged in policy issues wherever our members are focused. While that primarily includes the U.S. and Europe, we will also engage with policy makers in other parts of the world.  ISDA has a unique expertise that we will use to inform policy debates, whether they involve implementing the G20 commitments or addressing netting issues.

The industry, even in the face of uncertainty about regulatory outcomes, is pushing forward to increase the safety and efficiency of our markets. Some of this is driven by commitments to regulators or in anticipation of new regulations. But much is driven by the need to increase efficiency in an increasingly competitive world. By delivering across our areas of expertise, ISDA will work to remain at the center of those developments, working side-by-side with our members and regulators.

The agenda for developed products and markets is incredibly full, sometimes overwhelmingly so. But if we were to divert our attention and resources entirely to those efforts, we might miss a promising opportunity or development. And so we will remain engaged in new markets and monitor developments in new products. In the early part of this year, I plan to travel to Latin America and to Vietnam to discuss how derivatives usage can be encouraged in those markets.  Many of my ISDA colleagues will be reaching out to other areas as well.

As we move forward in 2012, I am extremely pleased to have George Handjinicolaou once again serving as my Deputy CEO. George’s experiences in the past couple of years — he saw the developing situation in his native Greece firsthand – make him a valuable partner for me and a valuable resource for ISDA. I am looking forward to sharing this derivatiViews forum with him in the future.

All the best to our readers for 2012.  We appreciate the active engagement and support of our members, guided by the involvement and leadership of our Board and staff.

We look forward to hearing from you.