We’re Ready to Help

The initiative to develop a globally consistent standard for a derivatives product identifier has been rumbling on for a while now. This is something in which both the regulatory community and the industry have a big stake. Regulators want to be able to aggregate data in order to fulfill their mandate to monitor and assess risk – a uniform product identifier makes that a lot easier. The industry wants consistency in order to avoid a situation where multiple identifiers emerge for different purposes – a nightmare scenario where complexity would go through the roof and costs would rise.

So, everyone is agreed this is a good idea. The question is what standard should be used. The European Securities and Markets Authority (ESMA) has thrown its weight behind the ISIN, and has mandated its use for certain reporting obligations under the revised Markets in Financial Instruments Directive. Other regulators haven’t yet shown their hand. That’s because the Committee on Payments and Market Infrastructures (CPMI) and International Organization of Securities Commissions (IOSCO) are working to finalize technical guidance on a common product identifier, which is expected before the end of the year.

That would appear to leave regulators with a stark choice: either CPMI-IOSCO recommends an ISIN-based identifier; or ESMA changes its approach to match the standards published by CPMI-IOSCO; or we’re left with a fragmented system of multiple identifiers.

There’s been a lot of discussion about whether and how ISINs can be used as a derivatives product identifier, and ISDA has played a full part in that. We’ve worked extensively with the International Organization for Standardization (ISO) and the Association of National Numbering Agencies (ANNA) to develop a multi-tiered ISIN framework for regulatory and business purposes, and have offered to provide the intellectual property associated with ISDA terminology and definitions free of charge to make this work.

We believe it’s possible for regulators and the industry to work together to agree a consensus approach that uses the ISIN. For that to succeed, however, it’s imperative that the identifier framework meets some key principles – and ISDA published a paper outlining those principles in May.

Among the most important is the need for open governance. Specifically, we think it’s crucial that derivatives market participants play an active part in development of the standard and its ongoing governance.

As it stands, ISINs can only be allocated by infrastructures approved by ANNA, and each one is the exclusive provider of ISINs in its local market. Given the absence of competition in selecting and designing the infrastructure, it’s important the governance framework reflects the views of market participants – the actual users of the ISIN – and not just those with a commercial interest in the infrastructure. Open governance is the only way to ensure the identifier works across jurisdictions and supports both regulatory and business purposes.

We would urge regulators to take advantage of the expertise and experience of the derivatives industry to ensure we have a single derivatives product identifier that suits regulators and the industry alike. It’s in all of our interests to make this work.

Beware the Code Freeze

Europe has picked up the pace of its approval process for rules on the margining of non-cleared derivatives. The latest thinking is that the European Parliament will wrap up its non-objection this month, prompting the market to reassess the likely date the rules will come into force. Depending on what the Council of the European Union (EU) does, it’s possible the largest EU phase-one banks could be posting initial and variation margin from early January.

We welcome the push to harmonize implementation schedules with those in the US, Japan and Canada. The margin requirements were originally intended to be rolled out according to a globally consistent timetable – a plan we supported. That fell by the wayside when the European Commission announced in June it would delay its rules until 2017 – a move that was later followed by Australia, Hong Kong, Singapore and India. So, we think realigning Europe with the US and others as soon as possible is a good thing.

There is a fly in in ointment, though. Many banks enforce an end-of-year code freeze that prevents them from making any changes to systems and models. Introducing far-reaching margin rules during this freeze could pose risks. Worryingly, it could hamper the ability of banks to make fixes to newly installed collateral systems and processes if something goes wrong.

We think a mid-January implementation for the EU would be safer from an industry perspective. Those few extra weeks would mean the code freeze would be finished and any emergency IT fixes that need to be made can be made.

Go too far beyond mid-January, however, and we start approaching another hurdle: the March 1, 2017 rollout of variation margin requirements. This deadline will affect a much wider universe of firms, and will involve thousands of counterparties having to make changes to thousands of outstanding collateral agreements at once. This on its own will pose major resource issues for the industry. If combined with the delayed European phase-one requirements, it could stretch capacity to breaking point.

So, we’re probably looking at a window of between mid-January and early February for the European rules to come into force. That gives enough time to get past the code freeze, but means there’s a tiny bit of breathing space before the variation margin requirements are introduced. We think this gives the best chance for the margin rules to be implemented in Europe without disruption.

No End to ISDA SIMM Work

No sooner had the first deadline for the posting of margin on non-cleared derivatives passed than attention had begun to switch to the next set of hurdles. There are some big challenges ahead – not least, the March 1 deadline for variation margin, which will capture a much wider universe of derivatives users. But meeting the implementation timetable isn’t the only thing the industry has to think about. Keeping the ISDA SIMM in line with regulatory requirements and ensuring it continues to reflect market conditions is another major preoccupation.

The ISDA SIMM – a common methodology for calculating initial margin – has been widely adopted by the largest, so-called phase-one derivatives users since the margin rules were rolled out in the US, Japan and Canada on September 1. But that doesn’t mean the job is done. Firms had to obtain approval from US regulators prior to using the ISDA SIMM on September 1. The approval letters began to arrive in August, but asked for phased updates to the methodology during 2017 as a condition for using the ISDA for certain product types.

That work is already under way, and the first round of modifications is due at the start of next year. In fact, many of the required enhancements had actually been earmarked by the industry for action once the initial September 1 deadline was out the way – for instance, further development of the treatment of cross-currency swaps. After all, the ISDA SIMM was never intended to be a static model, built once and then left for users to get on with it. It was always recognized that regular updates and recalibrations would need to be made.

The ISDA SIMM itself is relatively simple, designed to be used by the widest possible audience. Users need to determine their own sensitivity inputs for specified risk factors, but other parameters – risk weights, correlation and risk buckets – are centrally defined to help ensure consistency. Along with dealing with regulatory requests, these parameters need to be regularly reviewed and recalibrated.

As promised at the inception of the ISDA SIMM, this will all be done through a transparent governance framework, comprising an ISDA SIMM Governance Forum, which is open to all ISDA members that are subject to the initial margin requirements, and an ISDA SIMM Governance Executive Committee, which takes the decisions over alterations. These two entities are supported by ISDA staff and are overseen by the ISDA Board of Directors.

This governance committee will oversee an annual recalibration of these parameters and will conduct a yearly methodology review will ensure the model continues to perform as it should. A key part of this process will be feedback from users. By reporting difficulties with reconciliation or significant margin shortfalls, market participants will give the governance committee the right information to judge the performance of the model and make changes as necessary. Persistent or material shortfalls that are common to ISDA SIMM users could trigger an update outside the annual recalibration process.

The really important thing is making sure everyone continues to use the same version of the model. So, once vetted by regulators, any methodology changes will be published, and an appropriate time will be given to make the updates. The last thing anyone wants is to get to a situation where everyone is using different versions of the same model.

This all means the ISDA SIMM will continue to be a heavy lift. With the first regulatory enhancements and the first annual recalibration due next year, and with new users adopting the methodology in September 2017, there’s no time to sit back and relax. But the governance framework ISDA has put in place will ensure the necessary changes are as transparent and painless as possible.