How Are We Doin’?

Former New York City Mayor Ed Koch was famous for asking New Yorkers “How am I doin’?” The response gave him a quick job rating from his constituents. Sometimes it was a cheer, sometimes a boo.

With the publication this week of a series of final rules from the CFTC, it might be timely to ask “How are we doin’?” This set of rules covers a range of issues, including confirmations, valuation, portfolio reconciliation, dispute resolution and compression. In short, it’s a laundry list of what ISDA and our members have been focusing on in recent years to deliver safe, efficient markets.

And we’re happy to report that, on balance, the final rules would seem to us to elicit more cheers than boos.

For example, one important issue involves an extension of the time period for compliance with a set of external business conduct rules. This extension was important for purely practical reasons as much remains to be done by market participants to amend their contracts to address these rules. The process of doing so began with the recent launch of the Dodd-Frank Protocol and ISDA Amend, a joint ISDA-Markit initiative that automates part of the required compliance. We already have over three dozen adhering parties and we expect that number to grow substantially over the next month or so. But even with the efficiencies provided by those processes, mid-October was looking like a stretch to get everyone—buy side, corporates, pension funds and others—on board. So the extension was much needed.

In other portions of the release, ISDA’s comment letters are cited as the basis for changes in the final rules. Our positions, of course, were not adopted across the board and some concerns remain, but many critical parts of the rules reflect a reasoned approach to achieving regulatory goals. For example, the CFTC decided not to apply the rules retrospectively, something we advocated. On disputes, the difference in valuations must exceed 10% before dispute mechanisms are triggered and reports of disputes to the regulators are required if the dispute exceeds $20,000,000. The time periods for resolving disputes have been extended although they are still shorter than we advocated or have been working toward in our ongoing collateral committee efforts.

Also, the release acknowledges the successful efforts undertaken with the OTC Derivatives Supervisors Group, led by the New York Fed, to address issues such as confirmation backlogs and portfolio reconciliation. In executing its legislative mandate, the CFTC must put its own stamp on these issues while building on the real progress made through ISDA’s and the industry’s efforts with the ODSG.

The CFTC also acknowledges in several instances the central role played by ISDA documentation, the global standard for documenting derivatives. That’s an important consideration, particularly as we proceed with many amendments to the documentation driven by the Dodd Frank Act. The CFTC does not explicitly endorse ISDA documentation because it points out parties can—and do—negotiate variations to those terms. We are, after all, dealing with privately negotiated bilateral contracts.

Finally, the rules indicate that the CFTC will not view failure to comply with documentation and confirmation requirements as a violation of the rules or the Dodd Frank Act so long as procedures are in place to comply and there is a good faith effort to follow those procedures. This is a practical approach, and it is encouraging that the CFTC is motivated to encourage compliance and appears not to be constructing traps for the unwary.

We and our members will continue to study these final rules to identify implementation challenges and concerns. We look forward to a constructive dialogue on these issues in order to foster safe and efficient markets.

And in the meantime, feel free to let us know how we’re doin’.

Liquidity Is King

While it is summertime, the livin’ is not (always) easy. The EU regulatory process continues unabated and with the publication of a first complete Compromise Text on MiFID 2/MiFIR earlier this summer, the journey to trading obligations and platforms in the EU has well and truly begun. The process will take another step forward with the ECON Committee vote in the European Parliament, scheduled (after a postponement) for late September.

One of the big questions that remains unanswered in the MiFID/MiFIR debate – and that explicitly needs to be addressed before its resolution – relates to liquidity.

There are two aspects to this issue. One has to do with the use of liquidity as a benchmark or trigger for determining whether a rule applies to a particular obligation. The second has to do with the impact of the rules on the liquidity of traded financial instruments.

First things first: On the subject of a liquidity trigger, at what point should a financial instrument or market be considered liquid enough to support particular regulatory obligations? Such obligations might include those related to mandatory central clearing of OTC derivatives; mandatory trading of derivatives on regulated venues; or pre- and post-trade public transparency. That question is at least in focus in the MiFIR debate. Much less attention is being paid to an equally important question: when does an instrument or market stop being liquid enough to support those obligations; and how do you suspend them?

This is not just an academic discussion. Various provisions in the MiFID/MiFIR proposals reference liquidity as a trigger for particular obligations (notably the trading obligation and pre-trade transparency requirements).

Moving now to the second issue, the impact of the proposed rules on liquidity: To what extent could additional regulatory obligations increase or impair the existing liquidity of a particular financial instrument or a market as a whole? To be fair, some policymakers show awareness and sensitivity to this issue.

In the continuing dialogue over the proposed rules (particularly over the trigger issue), it is important that policymakers consider the potential for liquidity to vary over time. To put it bluntly, there is no market where permanent liquidity can be guaranteed (or, by the same token, mandated). This might reflect changes in market conditions in general, or simply the nature of the individual product.

Changes in liquidity levels could be inherent to the product in question, with liquidity falling in the period after the conclusion of the contract. For example, an ‘off-the-run’ credit index contract is likely to be significantly less liquid than the ‘on-the-run’ equivalent. And, even for an on-the-run index, the five-year maturity will be liquid where, say, the four-year is not. Changes in liquidity levels could also reflect external factors, such as weakening in the supply of credit. For this reason, it is important that the market infrastructure is sufficiently flexible to accommodate any change in liquidity.

In addition, given the potential for liquidity to change, liquidity triggers should also typically be two-way, i.e. the trigger should not only define when a particular regulatory provision applies, but should also define when the provision ceases to apply. Ideally, it should be possible to suspend particular obligations immediately, to ensure that markets continue to function (albeit with less turnover) during times when liquidity is stressed.

It has long been our view that legislative reform should support liquidity in the interest of systemic resilience, should protect the funding requirements of corporates and sovereigns and should advance the principle of strong risk management. And to that end, we support linking obligations to liquidity in appropriate circumstances. However, liquidity triggers:

• Must consider the various factors that collectively constitute liquidity;
• Must be forward-looking;
• Must be two-way so that obligations can be disapplied when necessary.

There are many welcome and positive developments in the Compromise Text. However, where the European Securities and Markets Authority (ESMA) is given the task of determining or applying a liquidity trigger, then its mandate should be such as to allow it to consider all relevant factors.