Speaking the Same Language

Much has been written about the OTC derivatives clearing obligation, which is due by end-2012. However, what is perhaps less transparent is that the clearing mandate is about much more than clearing.

One of its primary features, for example, is reporting. The CFTC has issued a number of rules in this regard (Parts 43 and 45) which prescribe detailed reporting requirements. CFTC rules call for the electronic reporting of all swap data to Swap Data Repositories (SDRs) following execution of trades. Potential reporting entities are SEFs (Swap Execution Facilities), DCMs (Designated Contract Markets), DCOs (Derivatives Clearing Organizations), SDs (Swap Dealers), MSPs (Major Swap Participants) and swap counterparties who are neither swap dealers nor major swap participants (non-SD/MSP counterparties) including counterparties exempt from the clearing requirement.

SDRs must maintain all swap data reported to them in a format acceptable to the regulators. The CFTC has even specified the format in which such data will be reported. In order to enhance its ability to conduct effective market surveillance (and thus mitigate systemic risk and prevent market manipulation), the CFTC has specified data conventions such as Unique Swap Identifiers (USI), Legal Entity Identifiers (LEI) and Unique Product Identifiers (UPI). These unique identifiers are crucial for linking data together and enabling data aggregation across counterparties, asset classes and trades.

The industry welcomes all these regulatory initiatives. We have stated repeatedly that we fully support complete regulatory transparency. At the same time, we have expressed our reservations with respect to the interaction between public transparency and liquidity.

Regarding the data initiatives specifically: We welcome the CFTC’s efforts to provide more structure to the reported data through the introduction of USIs, LEIs and UPIs. As the Bank of England’s Andrew Haldane put it in his March 2012 speech, “Today’s financial chains mimic product supply chains of the 1980s and the information chains of the 1990s. For global supply chains and the internet, their fortunes were transformed by a common language… They are astonishing success stories…. A common financial language has the potential to transform risk management at both the individual-firm and system-wide level.”

Equally, we see a number of useful applications that could come out of the creation of this unique identifiers infrastructure. Apart from enhancing the ability of regulators to monitor activity and risk in the system, these developments are likely to revolutionalize the financial services industry and will, most likely, lead to the creation of another cottage industry specializing in applications from these data.

There are, though, some troubling aspects of the reporting requirement that could lead to potential issues for all involved, including the CFTC itself, let alone the industry which is working diligently to meet the July 16 date on which reporting becomes effective in the US.

• First, the CFTC, in order to prevent data fragmentation, requires that all data for a swap must be reported to a single SDR. Yet, the CFTC allows for the creation of several SDRs per asset class, creating the potential for faulty double reporting, overlapping of data, and most importantly, the potential need for an SDR for SDRs per asset class;

• Second, there are similar reporting initiatives in other jurisdictions, creating again the possibility for the requirement that the same transaction has to be reported to two different trade repositories in two different jurisdictions. This has to be avoided at all costs;

• Third, the data structure proposed by CFTC is a US regulatory initiative. It is hoped that it will be accepted by other jurisdictions around the world. Establishment of parallel data structures by other regulatory authorities would be an expensive calamity and would create a significant hurdle to achieving greater transparency.

We will be watching with interest developments in this regard as they promise to be exciting and potentially transforming for the industry.

Where does ET end?

ISDA members from around the world — nearly 1,000 of them from 31 countries —gathered in Chicago last week for our 27th Annual General Meeting. That’s a lot of cross-border activity! And it highlights precisely why one of the most important issues in the OTC derivatives market today is the need for international regulatory cooperation to address the issue of extraterritoriality, or ET.

ET was the subject of Bob’s remarks at the AGM. It’s an issue that ignites a lot of passion among our globally-active members. Concerns are growing about the potential impact of one regulatory regime reaching beyond the boundaries of its home jurisdiction. In Dodd-Frank the legal basis to reach beyond the borders is to avoid an adverse effect on the economy or financial condition of the US. The practical effects of that authority will depend on just how far those charged with implementing the law want to push their jurisdiction.

We have always believed that the ultimate resolution of the ET issue will depend on global regulators working together to resolve the issue of jurisdiction. This needs to be done in a way that preserves their legal authority while recognizing the role of other jurisdictions and regulators.

Harmonization of regulatory approaches, particularly on issues with systemic risk implications, and a concerted program of mutual recognition of regulatory regimes by global regulators are essential parts of the solution to ET. In this regard, it was helpful to hear from CFTC Chairman Gensler in his remarks to the AGM that he is working closely with global regulators and is confident that they will work towards a common approach. He reported that the day before he addressed the AGM, he was in Toronto with a group of global regulators discussing these very issues.

That’s all well and good, and we welcome that regulatory dialogue. What our member firms now face, however, is continued uncertainty regarding the reach of regulation, even as they face looming decisions to register or put in place extensive business conduct procedures.

Uncertainty is never a good thing in financial markets, as there are typically only two things to do in face of that uncertainty. One is to pull back and wait until such time as greater certainty is provided. On a firm level, that means missed opportunity. On a market level, that means less efficient, and probably less safe, markets when market participants pull back.

The other response is to try to anticipate various possible results. This can lead to costly, duplicative efforts with no guarantee that all that planning will prove effective once the rules are finalized.

Either path runs the risk of undermining what ISDA has worked so hard on over the course of the last three decades: safe, efficient markets. These markets enable the development and spread of innovative risk management tools across geographic borders.

We hope to know more soon about how global regulators will address these issues. And our members can be assured that, as we learn more about the future, we will pass that information on. As they say, knowledge is power.