Infrastructure Investment

Speak to anyone who knows a thing or two about the infrastructure that the modern world is built on – roads, rail, power generation and supply, etc – and they will tell you that often the biggest obstacle to its improvement is the ‘legacy’ issue. Once a system is in place, built at great cost and effort, transitioning to improved technology can be challenging.

This is a headache that the derivatives market now faces. Much of the infrastructure used in the handling of data, the processing of documentation, the execution and confirmation of trades and the exchange and management of collateral, is over-complex, needlessly duplicative and inconsistent.

Let’s face it – old systems were developed for old problems. With the financial reforms at various stages of implementation, our members are looking for new solutions to automate and streamline the massive reporting, trading and clearing requirements and new collateral management requirements in the derivatives space. To support our members and address the operational challenges and complexity head on, ISDA itself has reorganized its working groups to focus on developing solutions for critical infrastructures that are now embedded in the fabric of the derivatives market. For instance, we see tremendous potential to move collateral management from faxes, email and Excel spreadsheets to a more automated and streamlined process.

ISDA is in an ideal place to help guide this change. At our core, we are a standards body. We have brought the market together to establish the ISDA Master Agreement and the ubiquitous Credit Support Annex (CSA). Today, we are leading the market to bring a standardized approach to non-cleared margin rules with the ISDA Standard Initial Margin Model (SIMM). We are developing new CSAs to comply with the updated segregation requirements, and we are putting together a globally-applied resolution stay protocol to harmonize resolution regimes. Looking ahead, there is an opportunity to future-proof the legal documentation process through smart contracts, and to develop industry operational standards to facilitate the processing of trades throughout the trade lifecycle. Additionally, so much more can be done to modernize and upgrade the process by which we exchange collateral by driving standardization and automated efficiency.

ISDA has canvassed its members on these issues, and turned their proposals into a whitepaper that will lay out some proposed steps toward reform. We have been engaging with members and fintech / regtech firms to identify problems and recommend solutions. To give you a preview, our paper will focus on three specific areas.

  • Data: Agreement on formats and identifiers would significantly benefit market participants and regulators. In particular, a robust, granular, multi-use product identifier with strong governance on an open-source infrastructure would remove many systemic inefficiencies and further promote transparency.
  • Documentation: Despite a plethora of standard documents published for industry use, it is an unfortunate fact that many documents are still customized between transacting parties. The benefits of this customization are now being questioned, and there are opportunities for further standardization to drive more efficient processing, both within firms and across the market. We are committed to future-proofing the essential ISDA documentation through ‘smart contracts’ that will facilitate the automation strategies being developed by distributed ledger and block chain firms. ISDA has a lot to offer to speed the adoption in this space.
  • Duplication: There is a huge opportunity to cut down on the complexity and multiplicity of business processes required to support the same functions within or across asset classes. Standard processing models can facilitate the extension of Financial products Markup Language (FpML) in order to remove cost and inefficiency and provide a solid base for further evolution.

This isn’t about levelling existing infrastructure and starting from scratch. It is about finding a more efficient, less costly way of operating vital processes, and making sure that new, beneficial technology can be brought to bear without adding further burdens to an already over-stressed system.

ISDA will continue to encourage and facilitate discussion on these issues among traditional and new operators in the derivatives market. Our membership is exceptionally broad, and our door is always open to new firms and new ideas. This is a challenge that will be overcome, above all, by cooperation and collaboration, and ISDA will always provide a platform for this to take place.

Change Leverage Ratio’s Tax on Risk Management

Brexit may have overshadowed events over the past month, but it doesn’t mean everything else has just stopped. A huge amount of work is ongoing, from preparations for forthcoming margining requirements to flagging new straight-through processing rules. The capital space has been particularly busy with nine consultation responses filed in a matter of weeks, covering topics from internal models to the net stable funding ratio.

Our response to the Basel Committee on Banking Supervision’s consultation on the leverage ratio was one of the most recent. In it, we reiterate our concern about the impact of the leverage ratio on client clearing. This is an important topic, not least because the Group-of-20 specifically wants to encourage more clearing.

At its heart, the issue is fairly simple: we believe segregated initial margin posted by clients is not a source of leverage for banks, as it cannot be used to fund their operations. Rather, it is meant to cover any losses by a defaulting client – in other words, client initial margin is intended to reduce the exposure related to a bank’s clearing business. Despite this, the leverage ratio doesn’t currently recognize this exposure-reducing effect, which means the capital required to support this business is unnecessarily high. This makes the economics of client clearing more challenging for clearing-member banks.

Importantly, the Basel Committee said when launching its consultation in April that it would collect data to study the impact on client clearing – a step we welcome. ISDA has already pulled together some preliminary information, which indicates that not recognizing client initial margin has a significant effect on the leverage ratio exposure of client cleared transactions. This data will be further developed and submitted to the Basel Committee.

But it’s not just cleared transactions that are affected by this. A similar argument applies to bilateral non-cleared trades: segregated initial margin posted by customers should mitigate exposure, as it is intended to cover the losses racked up by a defaulting counterparty.

ISDA supplied data on this segment too, in response to a request from the Basel Committee for information on bilateral derivatives with counterparties. This issue will become increasingly important – and will have an increasingly large impact on capital requirements – as margining rules for non-cleared derivatives are rolled out.

Under those rules, initial margin has to be segregated and – like collateral posted for cleared transactions – cannot be used by a bank as a source of leverage. Exact requirements differ from jurisdiction to jurisdiction, but they all strengthen the protection given to initial margin, and ensure it is segregated from the margin collector’s proprietary assets. For example, under final margin rules published by the US Commodity Futures Trading Commission, initial margin must be held by a third-party custodian to ensure it is available to the non-defaulting entity in the event of a counterparty default. The custodian – which cannot be affiliated to either counterparty – cannot rehypothecate the margin.

Given this margin cannot be used as a source of leverage, and is intended to mitigate exposure, we believe initial margin received should be recognized as exposure-reducing in the leverage ratio calculation.

We very much welcome the fact the Basel Committee has reopened the leverage ratio for consultation – that kind of flexibility is important when regulators are implementing new rules virtually from scratch. We hope the points we raise will be considered and that the leverage ratio is made stronger as a result.

Read our response to the leverage ratio consultation by clicking here.

Brexit – Two Weeks On

Like many people, I woke up on Friday June 24 expecting to hear the UK had voted to remain in the European Union (EU). The final polls had suggested the Remain campaign was ahead, and sterling had begun to rally the day before. A prominent member of the Leave campaign had all but conceded late on the Thursday night. As I went to bed, early results from Gibraltar and Newcastle were in favor of remaining. Like many people, regardless of how they voted, I was therefore caught by surprise when I switched on morning news.

The vote by the UK to leave the European Union (EU) is a momentous event, and will have significant ramifications on the political, economic and financial landscape in both the UK and the EU. In the immediate aftermath, financial markets have been volatile, and the political fallout severe. Two weeks after the vote, there is considerable uncertainty about the ultimate form of any negotiated exit.

But there are some things we already know for sure. For one thing, the UK continues to be part of the EU, and will remain a member for some time yet. Once the UK government serves formal notice of its intention to withdraw via Article 50 of the Treaty on the Functioning of the European Union, it will have at least two years to negotiate a settlement. During that time, existing European regulations and treaties will continue to apply – as this statement from the UK Financial Conduct Authority makes clear.

We also know that the referendum vote to leave the EU will not, by itself, have any immediate consequences on the legal certainty of derivatives contracts, nor will it require any contractual change. Nothing will fundamentally change in the immediate term. That’s not to say derivatives users shouldn’t begin to consider future implications. To help with this process, ISDA has published analysis that highlights potential issues that counterparties will need to consider, including the impact on the choice of English law as the governing law for an ISDA Master Agreement.

Now the UK has voted to leave, ISDA will convene applicable working groups and hold a series of industry calls to ensure market participants are prepared for future developments. The first of those calls took place last week, in partnership with law firm Linklaters. This webinar briefing set out issues touching on passporting rights, the impact on clearing, trade reporting and margining, and legal and documentation. Close to 4,000 people listened in.

The overriding message was that little will fundamentally change in the near term: those UK firms subject to the European Market Infrastructure Regulation (EMIR) and the forthcoming revised Markets in Financial Instruments Directive and regulation will continue to have to comply at the moment. However, the implications post-Brexit will depend on the exit model that is agreed between UK and EU authorities at the end of the two-year negotiation period. That will determine whether, for example, passporting arrangements will continue to apply, and whether EU entities subject to the clearing obligation under EMIR will be able to clear through UK central counterparties.

ISDA’s top priority is to work with UK and EU authorities – as well as other affected jurisdictions – to resolve any cross-border differences and harmonize rule sets. Our goal is to ensure that we have consistent regulation to support deep pools of liquidity and risk management for our membership.

It is clear there is a lot of work to do in the months and years ahead. There is a lot of uncertainty. It’s vitally important we have a deliberate and organized process to provide financial, legal and operational certainty going forward.

For more information:

ISDA webinar on Brexit

ISDA analysis on implications of Brexit

ISDA statement on referendum vote