Report Card Time

In many parts of the world, schools have come to the end of their terms, which makes it a nervous time for students: they are waiting for the report card to arrive. We at ISDA empathize, as we too have been waiting for a report card. It came this past Friday, in the form of the Financial Stability Board’s Third Progress Report on Implementation of OTC Market Reforms. The report measures progress toward the G20 commitments to reform OTC derivatives markets, agreed upon at the 2009 meeting in Pittsburgh.

So how did the OTC derivatives markets do?

Pretty well. As the report states:

Since the FSB’s previous progress report in October 2011, encouraging progress has been made in setting international standards, the advancement of national legislation and regulation by a number of jurisdictions and practical implementation of reforms to market infrastructures and activities.

One part of the report – the FSB’s discussion of exchange and electronic platform trading and market transparency – was especially encouraging. It elaborates on a recommendation to consider costs and benefits from their October 2010 report by explicitly adding that, “Authorities need to take action to explore the benefits and costs of public price and volume transparency…. including the potential impacts on wider market efficiency, such as on concentration, competition and liquidity.” We can’t say that the FSB has read our cost-benefit analysis of the Dodd-Frank requirement for SEF execution, but that sounds very familiar to the cost concerns that we raised in that study.

The biggest takeaway is that much remains to be completed by the end-2012 deadline to achieve the G20 commitments. The FSB leaves no doubt that they will be closely watching and driving for progress in the months ahead.  As it states:

For the next progress report, the FSB intends to put additional focus on the readiness of infrastructures to provide central clearing, platform trading and reporting of OTC derivatives, the practical ability of industry to meet the requirements and the remaining steps for industry to take.

The report acknowledges that the largest markets in OTC derivatives – the EU, Japan and the US – are the most advanced in their progress. It also recognizes that other jurisdictions are understandably waiting for those three regions to finalize their approaches before committing to a particular path of reform. It urges all jurisdictions “to aggressively push ahead to achieve full implementation of market changes by end-2012 to meet the G20 commitments in as many reform areas as possible.”

That’s the assignment for the public sector. But the FSB also has some assignments for the private sector, ones that we at ISDA are actively engaged in. Market participants are urged to address standardization, clearing, trading on organized platforms and reporting to trade repositories. Check, check, check and check – those are on ISDA’s agenda as well.

In short, the report card was delivered, but there will be no extended summer break for the OTC derivatives industry or all of us here at ISDA.

Collateral Damage

Of all the regulatory changes that have been proposed or implemented, the biggest potential game changer for the OTC derivatives markets are the collateral requirements that will now be imposed on all derivatives transactions.

Collateralization is, to be sure, common practice and an integral risk management tool in the OTC derivatives market today. The growing number of cleared OTC derivatives trades (more than 50% of the IRS market, for example) are subject to both initial (IM) and variation (VM) margins. The terms of collateralization are governed by the Credit Support Annex (CSA) to the ISDA Master Agreement.

To put this in context, collateralization of OTC derivative trades was something that was left to negotiation between two parties who would, based on their assessment of each other, customize and set terms accordingly. Those terms could (or not) include an initial margin (in most cases not), a requirement to post collateral if the mark-to-market exceeded certain levels (threshold amounts), and the type of collateral, frequency of collateral calls, and others.

However, in a broad swipe, new regulations across geographies make collateralization mandatory. More OTC derivatives will be required to be cleared, meaning that counterparties will now need to post IM and VM for them. Similar rules are soon to be unveiled by a group of global regulators, led by the US Federal Reserve Board, for transactions that are not suitable for clearing. By all indications, such collateralization requirements are likely to be more severe than those cleared, if nothing else to induce further use of clearing, and also because such transactions are likely to be less liquid and/or less frequently traded, requiring more collateral.

The effective result of these regulatory developments is a mandatory and massive “risk-off” move. Going forward, all participants in the derivatives markets “will not be allowed” to take the credit risk of their counterparties – be they CCPs or bilateral. The default choice will be no credit assessment, a presumption that the counterparty is not creditworthy, and thus a requirement for full collateralization.

We have written in this column before about the massive increase in new collateral that this regulatory initiative leads to (estimates range anywhere from $0.5 trillion to $2.7 trillion). Whatever the estimate, it is likely to be large (we are talking trillions, with a “t”), and comparable in size to the “quantitative easing” (QE) programs undertaken by major central banks recently. This QE-sized requirement, however, works in the opposite direction of the actual QE, and is likely to have adverse effects on the real economy. That’s because it requires that top quality assets and/or cash be “parked” and remain unutilized, as opposed to being plowed in the real economy (by banks), invested elsewhere (by asset managers) or used for productive purposes (by corporations). In this respect, it is interesting to note that at a time when the markets are likely to face increased demands for quality collateral, the central banks, through their QE programs, have been removing from the market such “quality” collateral (in the form of government, mortgage and other high quality bonds).

In addition, the market faces a lot of practical issues in implementing mandatory collateralization practices on this scale. These issues are likely to further exacerbate the shortage of collateral. In the aftermath of MF Global, confused and worried market participants demand (justifiably so) extra security for the collateral they post. There are demands for full segregation, custodian arrangements with third parties, even demands for no re-hypothecation (should we start marking the banknotes that we deposit as collateral?). CCPs, responding to these concerns, have started offering a variety of “segregated” solutions but the devil is in the details and much attention needs to be paid in understanding what these offerings entail. Further complicating matters is the lack or harmonized practices around the world when it comes to solvency law, as well as the fragmentation in the securities depository systems, particularly in Europe.

So, while a lot of attention is being paid to the question as to whether the market will comply with clearing and other requirements by 2012 year-end, the real elephant in the room is whether the marketplace will come up with the all the collateral that is required, and if it does, what the liquidity implications for the real economy will be. And these events will be coming at a time when other similar “risk-reducing” regulatory initiatives are in the making in the form of increased capital requirements (Basel III) with implications for the capacity of the banks to provide liquidity to the secondary markets, or simply lend money to the real economy.

We may get what some wish for: a completely “de-risked” economy. But at what cost?

The Stats Tell the Story

Is the OTC derivatives market larger or smaller than 5 years ago? How much progress has the industry made in central clearing? By how much does netting reduce credit exposures?

If these and questions like them are of interest, have a look at the latest edition of ISDA’s Market Analysis. The paper integrates market data from a variety of sources – the BIS, clearinghouses and ISDA itself, to name a few – to show the impact of clearing, netting, compression and collateral on notional amounts and risk exposures in the over-the-counter (OTC) derivatives markets.

Take the first question above: the size of the OTC derivatives markets. If you look at notional amounts published by the BIS, you can see the size of the market increased by about 11% over the past five years. On an adjusted basis, however, the market declined by 9%.

What accounts for the difference? Two things. First, our analysis eliminates double-counting of cleared swaps. Clearing increases volumes (as one swap between counterparties is transformed into two swaps between each counterparty and the clearinghouse), even as it is designed to reduce risk. It’s worth noting that the cleared volume of interest rate swaps totaled 53.5% of IRS outstanding at year-end. That’s the highest percentage yet and it’s a 151% increase over year-end 2007. Second, our analysis also excludes FX transactions (as they are in many ways unlike other OTC derivatives).

So on an adjusted basis, the market has declined. Why? One of the key factors is compression. Over the past decade or so, compression has reduced notionals outstanding by a little over $200 trillion, including some $120 trillion in interest rate derivatives and $80 trillion in credit default swaps. Compression is clearly one of the biggest factors driving changes in the volume of derivatives outstanding.

So far we’ve talked about notionals, which measure activity but not risk. Gross market value (GMV) reflects that risk by measuring the cost of replacing contracts. As the BIS reported, GMV increased for the period ending December 31, 2011 from mid-year 2011. Netting (a subject close to ISDA’s heart given our role in ensuring it helps firms reduce risk) lowers credit exposure to 14.3% of GMV and 0.6% of notionals. Collateralizaton reduces credit exposures to an even lower level.

We think these statistics tell an interesting story, even if it is not the tale that is often told. But that’s why we started the Market Analysis in the first place. We hope it leads to a more informed view of the key trends shaping the global OTC derivatives market.

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For further insight, listen to yesterday’s derivatiViews post, a short interview with ISDA CEO Bob Pickel about the Market Analysis.

On Balance, Net Reporting Makes Sense

Are European banks more active in the OTC derivatives markets than US banks?  A look at their balance sheets might lead you to think so. For example, reporting under IFRS, Deutsche Bank’s total assets amounted to $2.1 trillion, of which 40% (or $863 billion) were derivatives. Bank of America, by contrast, has $2.2 trillion in assets, of which derivatives constitute just 4%.

How can this be?

The difference, of course, lies in the accounting treatment of derivatives. US GAAP accounting standard setters have consistently agreed that derivatives be reported on a “net” basis instead of on a “gross” basis on the face of the balance sheet. Historically, the Europe-based International Accounting Standards Board (IASB) has permitted significantly less balance sheet offsetting than the US-based Financial Accounting Standards Board (FASB). (Note: the table below shows the actual derivatives outstanding of some US and European banks as of year-end 2009.)

ISDA believes that net presentation, in accordance with US GAAP, provides the most faithful representation of an entity’s financial position, solvency, and exposure to credit and liquidity risk. Individual derivative transactions that are subject to enforceable master netting agreements should be eligible for netting in the balance sheet on the basis that such financial statement presentation is most faithfully representative of an entity’s resources and claims and provides the most useful information for investment decisions.

The fact is, netting is recognized for legal, regulatory and regulatory capital purposes. The treatment of netting under US GAAP ensures the accounting practices regarding netting are appropriately aligned with this state of affairs. The IFRS approach, in our view, creates distortions and misperceptions in the treatment of derivatives.

This matters, particularly in today’s environment, where OTC derivatives are castigated for reasons both fair and foul. The gross presentation, for example, fuels critics who believe that too much financial activity serves no useful purpose or that it diverts resources from more productive activities.

To help clear the air, ISDA recently published a paper, Netting and Offsetting: Reporting Derivatives Under US GAAP and Under IFRS. It really helps to explain an issue that’s important but all too often misunderstood.

Table 1