Keeping the Foot on the Pedal

Over the past week, regulators across the globe have responded to looming market disruption by providing flexibility to derivatives users in their attempts to meet a March 1 deadline for posting variation margin on their non-cleared derivatives trades. This flexibility was critical. With firms struggling to amend their collateral documents in time, there was a very real risk that derivatives users would have been unable to trade from tomorrow, as ISDA and others warned in a letter earlier this month.

Thanks to well-coordinated action taken by global regulators to provide forbearance, that danger has now receded. The exact nature of the relief differs jurisdiction to jurisdiction, but regulators have generally provided derivatives users with additional time to finish making the changes to their credit support annex (CSA) agreements.

Given most derivatives counterparties already exchange variation margin on their non-cleared trades, this additional flexibility will not lead to an increase in systemic risk. It will, however, ensure counterparties have more time to negotiate the complex changes to their outstanding CSAs to ensure these documents reflect new regulatory edicts on eligible collateral, settlement timing and haircuts.

That process of negotiation has been complicated and time-consuming, and the scale of the task has been overwhelming. The March 1 ‘big bang’ implementation date captures banks, asset managers, insurance companies and hedge funds, and involves updating more than 150,000 CSAs. The time scale in which to make those changes has also been impossibly short. Market participants had to wait for final rules from national authorities to know exactly what changes were needed and how to phrase the amendments to create legal certainty, but those rules were published a matter of months ago in some cases.

According to the most recent survey numbers from ISDA, only 15.31% of active and new CSAs had been executed by February 17. That represents a doubling from the week before, but indicated that a large proportion of the market wouldn’t have been ready by March 1.

The flexibility afforded by regulators gives the industry more time to get that work done, and will minimize market disruption and maintain market access for a variety of derivatives users. But that does not mean market participants will sit on their hands. The industry remains committed to completing the necessary work as quickly as possible, and ISDA will continue to monitor and report progress in the weeks ahead.

Summary of regulatory action:

IOSCO statement

Commodity Futures Trading Commission

US prudential regulators

European Supervisory Authorities

Financial Conduct Authority

Central Bank of Ireland

Australian Prudential Regulation Authority

Monetary Authority of Singapore

Hong Kong Monetary Authority

Office of the Superintendent of Financial Institutions

CFTC Action Welcome, But More Needed

For some time now, we’ve been warning that many derivatives users wouldn’t meet a March 1 deadline to amend their credit support annex agreements (CSA) in order to comply with new variation margin requirements. Yesterday’s announcement of a six-month transition by the Commodity Futures Trading Commission (CFTC) is therefore very welcome. It leaves the March 1 start date intact, but allows firms to continue trading while they finish the substantial work needed to amend their documents.

As our letter to regulators last week pointed out, sticking with March 1 without such transitional relief would have caused unnecessary market disruption. Most firms already post variation margin on their non-cleared derivatives trades, but face being shut out of derivatives markets unless they manage to amend their outstanding collateral documents. The scale of the task is huge – we estimate approximately 160,000 CSAs need to be updated. Despite a determined industry effort, CSA negotiations have proved to be hugely complex and time consuming. Last week, we disclosed our latest industry survey data, which showed only 4.43% of CSAs had been amended.

The CFTC has taken a practical approach to this issue. Its relief letter provides market participants with a six-month transition that enables firms to continue to access derivatives markets. During that six-month period, counterparties must show they are working hard to complete the necessary CSA amendments, and all swaps entered into from March 1 must be compliant by September 1, 2017.

This is similar to relief provided late last year by Australian regulators. Hong Kong and Singapore have also provided six-month transitions.

But while welcome, this relief needs to be complemented by similar action from other regulators. Unless a globally coordinated transition is agreed, there is a risk of market fragmentation, with counterparties shifting trading relationships to those entities or regions that have secured relief. Given the fact many counterparties have existing variation margin arrangements, this would cause significant disruption for no purpose.

We think all derivatives users should be able to access derivatives markets from March 1. As such, we urge global regulators to work together to provide consistency across jurisdictions.

Time Running Out

First, the good news. The number of credit support annexes (CSAs) that had been amended to meet new regulatory variation margin requirements more than doubled during the past week. The bad news is the overall proportion is still very low, at just 4.43%. With less than three weeks before deadline, it’s difficult to see how every one of the thousands of firms affected will be ready and able to continue accessing derivatives markets from March 1.

The market disruption this would cause is the reason why ISDA and a group of other trade associations, representing both buy and sell side, wrote to regulators earlier this week asking for a transition period. Under one possible scenario, the requirements would come into force as planned on March 1, but market participants would be able to continue trading while they finish their documentation updates. As with the forbearance provided by Australia in December, regulators could ask for trades conducted during that transition to be backloaded to the effective date, therefore keeping pressure on the market to amend their documents.

Seeing as most counterparties already post variation margin, this transitional period won’t lead to an increase in systemic risk. But denying a vast swath of market participants access to derivatives markets because they haven’t updated their documentation would create significant problems, with smaller end users likely the most affected. We think it’s important that all users of derivatives are able to continue to access derivatives markets to hedge from March 1 – hence the request for forbearance.

The obvious question is why progress has been so limited. The simple answer is that the legal and operational challenges of amending, replacing or executing roughly 160,000 CSAs is huge. The terms of those CSAs already in place with clients tend to be highly variable, which has required bilateral negotiations between each counterparty pair to agree the necessary changes. Despite determined efforts to get this done by the industry, supported by ISDA, the bespoke nature of many of these agreements has meant these negotiations have been complex and time consuming.

Once amended, these documents then have to be loaded into reference data systems and activated for trading. Operations staff are working hard to get this done, but the numbers are overwhelming. So far, just 12.29% of those CSAs that have been amended have been loaded up.

So, progress has been made, and derivatives users will continue to push as hard as they can. But March 1 looks extremely optimistic. As it stands, we think there is a material risk that a large proportion of firms won’t be ready. That could result in fragmentation, market disruption, higher prices and the inability for end users to put on hedges.

A Global Framework Should Still be the Goal

This week, ISDA hosted a symposium on the future of bank capital in Europe. It was a good time to convene a conference to discuss the latest European Commission (EC) proposals for revisions to the capital requirements directive and regulation. This event didn’t disappoint in terms of insights provided. Our speakers – including senior legislators, regulators and market participants in Europe – spent a lot of time discussing the current negotiations at the Basel Committee on Banking Supervision and the proposals in Europe.

At the start of the year, the Basel Committee announced it needed more time to finalize its latest raft of measures, amid a widely reported disagreement over the level of a proposed output floor. From a policy perspective, European regulators are uncomfortable with an output floor and the reduction of risk sensitivity it would cause – and this uneasiness came across loud and clear from our speakers, along with their support for internal models. There’s also currently uncertainty about the path the new US Administration will take, with media reports suggesting further negotiations at the Basel level may be put on hold until the changing of the guard is complete.

But what struck me was the genuine eagerness for a global agreement, and the hope that a compromise can be found by the Basel Committee that will work for everyone. It serves no one’s interest to have a Basel agreement that lacks global consistency and adherence, or – worse – creates a regulatory imbalance. This would undermine the Basel Committee’s leadership role.

In many respects, it seems to me that both Europe and the US want the same thing. It was clear from our speakers that European policy-makers want a common agreement that strikes a balance between financial stability and economic growth. In other words, the final rules should be risk sensitive to avoid a detrimental impact on market liquidity, and to ensure banks are able to continue to lend to the real economy and provide crucial hedging products to end users.

The EC has proposed revisions to its capital requirements directive and regulation that try to achieve that balance. The proposals contain targeted amendments to the Basel measures that will encourage clearing, ease the capital burden on market-making activities, and reduce the pricing impact on end-user hedging. These types of changes are necessary, as banks will play a crucial role in helping the European Union foster deeper and more liquid capital markets – a key objective of the capital markets union.

These high-level aims – financing the real economy, fostering economic growth, creating jobs and establishing an agreement that offers a consistent a level playing field – are in line with the objectives of the new Trump Administration.

Our speakers at the conference all talked about their desire to have a single global agreement. We agree that is important. A single capital framework means a level playing field, less complexity and lower costs. We would encourage the Basel Committee to consider its final rules with a focus on ensuring economic growth. We also encourage US regulators to consider the European revisions to the Basel measures as their starting point to ensure a more consistent and risk appropriate framework.