Screwdriver, Not Sledgehammer

Build a car engine from scratch, and it’s a fair bet that it won’t be purring the first time it’s switched on. That doesn’t mean the engineer has failed, and it doesn’t mean the whole thing needs to be smashed up. It’s just likely to need fine-tuning and refinement before the engine is really performing as it should.

A similar thing can be said of financial regulation. Draw up a whole new framework for derivatives clearing and reporting when nothing like that has existed before, and it stands to reason that not everything will work out quite as it’s meant to. The easy thing to do would be to say that the legislation is set in stone and to move on. The more difficult approach is to take the time to tinker under the bonnet and make it as good as it can be.

That’s why Europe deserves credit for taking a cold, hard look at existing European regulation to see what’s working well and what’s not, and thinking about how it can be made better. This requirement for a review was baked into the European Market Infrastructure Regulation (EMIR) legislation, and the European Commission last week published an initial report, incorporating feedback received as part of the EMIR review and so-called ‘call for evidence’ on European financial regulation.

The report highlights a number of areas that require further review, including an assessment of whether the rules have a disproportionate impact on non-financial corporates and small financial entities. Such a review makes sense, as these firms may not pose systemic risk, yet they face significant compliance costs in meeting the rules, which could limit their ability to invest and/or lend.

For instance, European rules currently require both parties to a transaction to report each new derivatives trade. This is out of line with the approach taken by many other regulators, which typically take an entity based approach, where sole responsibility for the accuracy of reported data is assigned to one counterparty – usually the dealer for a bilateral transaction. The dual-sided mechanism within European rules creates cost and complexity for little apparent gain.

According to research conducted by ISDA, the aggregate cost for end users in meeting Europe’s dual-sided reporting requirements is estimated to be in excess of €2 billion. Despite this, data quality is poor. A lack of clarity around what needs to be reported and how, and differences in reporting requirements between repositories, means pairing rates are low – around 60%. We think moving to an entity based approach would not only reduce cost for end users, but would actually improve data quality and consistency.

There were also positive noises on clearing. Notably, the EC highlights the importance of a mechanism to promptly suspend the clearing mandate. As it stands, this can only be achieved following the approval of regulatory technical standards, but this takes time. A market shock that impacts liquidity or the failure of a clearing house would require a much faster response – which is acknowledged in the report.

The highly controversial frontloading requirement is also flagged for review. ISDA has long raised concerns about the operational complexity of this rule – which is unique to Europe – and the European Securities and Markets Authority has already made several adjustments to it. We think the challenges caused by this requirement far outweigh any possible benefits, and removing it would not reduce the effectiveness of the incentives to clear within EMIR.

Access to client clearing for small financial institutions with limited derivatives activity is another area highlighted by the EC (an issue examined by ISDA in a recent research report). This has been largely attributed to the impact of the Basel Committee on Banking Supervision’s leverage ratio, which does not allow clearing-member banks to recognize client collateral as risk reducing in the leverage ratio exposure calculation. The EC has proposed changes to this approach in its revised Capital Regulations Regulation and directive proposals, which is intended to reduce the cost of offering client clearing services.

So, what’s the next step? The EC has recommended a legislative review of EMIR next year, as well as a look at the relevant technical standards linked to the legislation. We welcome that approach, and think other jurisdictions should consider doing something similar. The chances of getting everything 100% right first time on such a far-reaching piece of legislation are small. Regulators and legislators should not back away from reviewing what they’ve done to ensure everything is working as they intended.

Getting Smart

Complying with new financial regulation has led to the layering of new processes and systems onto existing infrastructure. With a number of new links in the chain – electronic trading, clearing, reporting, margining – derivatives operations have become increasingly complex and unwieldy. No wonder, then, that distributed ledger and smart contracts have excited so much interest. These technologies offer the tantalizing prospect of revolutionizing the way derivatives are booked and managed, automating and streamlining a complex, overburdened system and cutting operational costs.

That’s the vision, anyway. Getting there will be difficult. The term ‘smart contract’ is fairly broad, but is generally taken to mean converting the terms of a trading relationship into shared executable code to automate certain actions or obligations. The intention is to increase efficiency and reduce costs through mutualized processes. Establishing the extent to which such coding should be used – whether it should be adopted for all aspects of a trading relationship or just in some specific areas – is going to be a major debate.

Any transition to smart contracts won’t be easy, either. The industry can’t just smash up the old infrastructure and switch to a new one overnight. To allow trading to continue without hindrance, there will have to be a slow, step-by-step process of change and improvement.

ISDA will play an active part in this evolution. Smart contracts will require standards, and this is an area where ISDA has a long track record, dating back to the publication of the ISDA Master Agreement. We’ve been looking into this issue for some time, and we held our first industry roundtable on the topic earlier this month. At that meeting, we considered how Financial products Mark-up Language (FpML) might be used as a basis for derivatives smart contracts.

FpML is an open source messaging standard for derivatives based on the ISDA taxonomy, and is already widely used in the industry. Using existing standards like FpML as a starting point may be a crucial shortcut to the rollout of industry standard, platform-agnostic smart contracts.

The roundtable was attended by technology experts, law firms and industry participants, and close cooperation between each of these groups will be crucial if smart contracts are to get off the ground. During the meeting, ISDA showcased a proof-of-concept smart interest rate swap contract based on FpML, and much of the discussion focused on how to connect all the various moving parts of a typical derivatives trading relationship together. Should a smart contract be placed on a distributed ledger platform? How does this technology operate within existing legal frameworks, nationally and internationally? Should the legal language of the various ISDA product definitions or legal documentation be folded into the design? How will increased automation affect termination rights and the management of counterparty defaults?

We need to develop answers to these knotty questions, and ISDA will be pushing ahead with more industry discussion in the New Year and beyond – so watch this space. We will be drawing on the breadth and depth of our membership, including sell-side, buy-side and law firms, as well as infrastructure and technology service providers to validate different concepts and technology solutions. The key is to gather the right experts with appropriate domain knowledge to contribute to the design. While others will take on the purely technological challenges, such as scalability and security, ISDA will host the discussion around legal standards and application, and contribute to the development of data standards and code. We are perfectly placed to hold this project together.

This project is part of a wholesale review of derivatives market infrastructure. In September, ISDA released a whitepaper that called for greater standardization in documentation, data and processes.

It won’t be quick and it won’t be easy. But the need for change is obvious, and it’s incumbent upon the industry to work together to make improvements in the most efficient and consistent way.

VM Rules: Take Action Now

It might only be November, but people already seem to be turning their minds to what’s in store for 2017. There’s likely to be a lot on the agenda, but one date looms large for the derivatives market: the March 1 implementation of variation margin requirements for non-cleared derivatives. That’s not surprising: the scale of the task is massive, and firms need to take action now in order to stand a chance of being ready in time.

Many market participants already post collateral to cover price changes on their derivatives trades, so you’d be forgiven for asking what all the fuss is about. The answer is that the rules make variation margin posting compulsory on all non-cleared trades, and set strict requirements on the type of collateral that can be posted, the frequency of the margin calls, and the required timing for settlement, among other things.

Crucially, these regulatory changes mean derivatives users will have to modify their existing collateral support agreements. And seeing as the March 1 deadline captures a broad swath of financial institutions – asset managers, pension funds, insurance companies, hedge funds – it will mean thousands of counterparties will need to change or set up thousands of agreements in a very short space of time. This will represent a repapering exercise on a scale and under a timetable never before attempted.

So, what do firms have to do to get ready? An important first step is to understand whether and when each trading relationship will be subject to margin requirements, and what rules will apply. To help with that process, ISDA has developed a self-disclosure letter that enables market participants to exchange the necessary information, covering the US, European Union, Canada, Japan and Switzerland. In order to speed up the exchange of information, this was incorporated into ISDA Amend – an online tool developed by ISDA and IHS Markit – on October 28. This is something each firm could – and should – get started on now.

The next step is to start revising and/or setting up new documentation. ISDA has now published a variety of revised credit support documents under various legal regimes, but the real challenge is how to make those changes without the grueling task of having to bilaterally negotiate with every single counterparty.

In response, ISDA has developed a variation margin protocol that will enable firms to quickly and efficiently amend existing contracts or set up new agreements that comply with variation margin requirements. The protocol was published for the US, Japan and Canada in August, and we expect to publish European Union provisions soon following publication of final European rules on October 4.

The protocol for those jurisdictions will be available on ISDA Amend later this month, which will eliminate much of the manual work of notifying counterparties and reconciling the various elections made. Once that is up and running, market participants will have a little more than three months to onboard all their counterparties.

The timeline is even more challenging for those jurisdictions that have yet to publish final rules. In an article published in Risk recently, I estimated it would take four and half months to develop a protocol and build it into ISDA Amend from the point the rules are finalized. If regulatory timelines don’t allow for the building of an automated industry solution, then firms will have to bilaterally negotiate changes with each counterparty – a hugely time-consuming and resource-intensive task.

Even with the protocol available, the variation margin deadline will pose a massive challenge for the industry. Over the past two months, we’ve held a series of conferences across the globe focusing on the margin rules. The comments from those who attended made clear that many firms are seriously worried about their capacity to agree the necessary changes with every one of their counterparties.

The message is very clear: start to prepare for March 1 now. Understand what the rules will mean for you; look at your outstanding contracts; and start getting in touch with your counterparties. Any firm that leaves it much longer may find it is unable to trade from March 1.