derivatiViews: One Year On

We launched derivatiViews just about a year ago, and one need only look at the topics we have covered to get a sense of the issues we and the OTC derivatives industry have been facing. Let’s take the opportunity to reflect on some of those issues and also consider what lies ahead.

Of course, regulation and its implications have been a steady focus of derivatiViews. We have tried to be constructive in our commentary, recognizing the challenges that regulators face as they create a new regulatory regime. For instance, we acknowledged the notion under CFTC rules of the “legally separated, operationally comingled” approach to cleared margin segregation as a serious effort to balance a range of different views. Similarly, although we are still studying the details of the product definition rules, we recently noted the hurdles that the CFTC and the SEC had to clear to get to a final rule. The issues facing other regulators, particularly those in Asia, have been a periodic theme of our posts.

One development we wouldn’t have anticipated a year ago was that we would be in litigation against a regulator, specifically the CFTC. As we explained in December, this was not a step we took lightly, but we, together with our co-plaintiff, the Securities Industry and Capital Markets Association, believed that the way position limits had been considered in the rulemaking process, particularly the lack of consideration of the costs and benefits, cried out for scrutiny by the courts. As of this writing we are still awaiting word from the judge on the case. Regardless of the outcome on the case, we will remain engaged in the US, Europe and around the world in achieving a regulatory structure that works for everyone affected by derivatives. Which is pretty much everyone.

The continuing financial crisis in Europe provided ample opportunity for us to comment. We used this platform to further understanding about the role of CDS, the need to understand the legal terms and the importance of collateral in helping to reduce risk in these trades. When, in the end, the EMEA Determinations Committee decided that the forced restructuring of Greek debt constituted a credit event, we reflected on the many lessons learned and highlighted steps that we would take in light of that experience.

Halfway through this year it is also an opportunity to reflect on progress on our resolutions for the new year. We have remained actively engaged in capitals around the world on the issues affecting our industry. We are also in contact with global bodies, such as the Basel Committee, the Financial Stability Board and IOSCO, which play an increasingly important role in regulatory for this global business. We commented on the recent progress report by the FSB on progress toward the G20 commitments, which acknowledged the progress that has been made, particularly on clearing, and the significant work that remains to be done. It also acknowledged that market liquidity should be a consideration as countries consider mandates for execution, which had been the subject of a derivatiViews post from late last year.

We also remain focused on the steps necessary to increase safety and efficiency of our markets, including the many aspects of clearing, from documentation to margin to capital. In just the past few months we have remarked on the demands on collateral given the reliance on it in cleared and uncleared trades, the connectivity between the cleared and the bilateral world and the challenges of achieving meaningful consistency in data and reporting. Each of these issues has serious implications for the safety and efficiency of our markets.

We will continue to pursue our stated goals for the remainder of this year and beyond. And we will be prepared to address new developments that will no doubt drive our agenda. Whatever develops, please continue to check back here at derivatiViews for our take.

The Meaning of Swap

Musings about “the meaning of life” cross philosophies, cultures and centuries. Among the philosophical strands cited by Wikipedia that have contemplated this most basic of questions are utilitarianism and pragmatism together with stoicism.

More recently, the derivatives world has been contemplating the meaning of swap, a question that is central to existence in the post Dodd-Frank world. The CFTC and the SEC have now produced their treatise on this question* and it is one that we will all be studying in great detail over the coming days and weeks to see what answers it holds. And as with the meaning of life, we might be well served by looking at this final rule in a utilitarian and pragmatic way, while remaining stoic as we contemplate its implications.

The most immediate impact of the publication of the definition of swap is that the clock starts ticking on many rules that, by their terms, were not slated to become effective until the definition of swap was final. Reporting requirements will commence 60 days after the rule becomes effective (the date of publication in the Federal Register). Various timetables relating to clearing, including mandates for the clearing of certain trades, will now commence. There will be many clocks ticking over the coming months.

Congress left the agencies with the task of filling out the definition of these terms and it has been a long process to get to these final definitions. There is a case to be made that this definitional rule should have been one of the first rules finalized, and not one of the last. And, if Dodd-Frank had allowed the agencies to proceed on a more logical timetable, they might have adopted that approach. But the fire hose of rulemaking required by the law made it difficult for the agencies to take that more logical approach.

The swap definition is also one where the CFTC and the SEC had to come to agreement given the divided oversight of the OTC derivatives business mandated by the law. The market will benefit from consistency of their approach to this issue, so the additional time it took to get to the final, joint approach to the definition will hopefully prove time well spent. Still, the translation of the jurisdictional divide between the securities and futures world into the OTC derivatives creates challenges. One need only consider the experience with single stock futures over the past decade to get a sense of the regulatory challenges that can be created by something like a “mixed swap.”

One issue that remains open is the treatment of guarantees of swaps. Both agencies take the view that the guarantee would be considered part of the swap and, therefore, subject to its jurisdiction. But for now we must await further guidance on how they will treat the guarantee. Given the central role of the definition, how they address the guarantee issue may have implications for other parts of the agencies’ rulemaking, such as reporting and even registration.

There are many details in the final rule that will require a close reading of the rule and the possible need to approach the agencies for interpretive guidance. ISDA will be working with our members, both to assist them in understanding the rule and, where necessary, seeking that guidance. The meaning of swap, like the meaning of life, is best contemplated together with others who share the journey.
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* The CFTC defined the term “swap” and related terms; the SEC defined the term “security-based swap” and related terms.