ISDA’s Vision for a Smart Future

ISDA has a long history of creating solutions for the derivatives industry. The Master Agreement and countless protocols and definitions have contributed to a safer, more efficient market for derivatives users.

Now we face perhaps our biggest challenge to date. Due to tactical regulatory drivers and a lack of historic planning, many basic, vital processes in our market have become unbearably complex and inefficient. This needs to change – and ISDA is focused on working with the industry to produce new standards and ensure the derivatives market is building firm foundations for the future.

In my remarks at ISDA’s recent annual general meeting, I outlined a vision for a derivatives market structure that is more efficient, driven by common data, processes, legal standards and automation. This won’t happen overnight, so the industry needs to start planning for the longer term now. We need a wholesale rethink of the way the market is connected, how trade flows are managed, and how data is created and shared between participants. ISDA is committed to helping in this task, and we will do what we have always done – bring the industry together, find consensus and hammer out solutions.

The root of the problem can be traced back to the succession of requirements introduced as part of the post-crisis reform agenda. The industry has been focused intensely on meeting successive deadlines for clearing, trade execution, reporting, compression and collateral exchange. There has been little time to think about how all of this can best work together. As a result, processes and workflows are over-complex, duplicative and costly to maintain. The absence of a common approach means counterparties need to constantly reconcile details of a trade to reduce the potential for inconsistencies. This is sapping the energy and resources of all concerned.

Technology is the key to greater efficiency and creating value for our members – an issue on which there was broad consensus during our annual general meeting. For the potential of fintech to be fully realized, a strong foundation of common standards and processes must be constructed. Only then can innovators and entrepreneurs take new technologies forward with the confidence they will be interoperable.

In an ISDA white paper published in September, we set out the steps we think are needed to create those strong foundations. A critical aspect is the development and implementation of common data standards to ensure everyone can communicate the economic terms of a trade consistently across the lifecycle. ISDA has published principles governing product standards, and we have begun work to define appropriate product taxonomies. We’ve also been working with regulators to develop a suitable trade identifier framework, and will continue to feed into this process.

In addition, we need standards for processes – an agreed set of definitions for specific lifecycle events or actions, which could be encoded as common domain models that are available to everyone. This would not only aid interoperability; it would also provide a transparent and consistent view of how each step in the process works. This would help oversight and rule-making and simplify regulatory implementation, as specific changes to an affected common domain model could be recommended in order to comply.

Once that’s complete, we can develop smart contracts that provide an automated legal framework for derivatives, based on the standardized data and processing hierarchy. Here, the existing Financial products Markup Language framework could be leveraged and extended to support self-executing transactions – in fact, we’ve already rolled out a proof of concept of this.

Finally, we can’t ignore all the good work that ISDA and its members have contributed on the legal front. ISDA will work to future-proof our legal documentation by developing solutions to update and automate our product definitions, as well as exploring various smart contract applications.

These aren’t just ideas. We’re working with the industry – sell side, buy side, technology firms and lawyers – to put them into practice today. There are a lot of opinions out there, but achieving consensus on new standards is something ISDA has plenty of experience in, dating back to the development of the ISDA Master Agreement 30 years ago.

The goal we have set is a fundamental overhaul of the derivatives markets. This will bring increased automation, make it more cost efficient, and enable opportunities for innovation. This goal is ambitious, but ISDA and its members have the desire to bring about the necessary change to ensure the vitality of these markets in the future.

Certainty is Good for the Economy

It is often forgotten – or ignored – that derivatives serve a real economic purpose. They help companies manage risk, which creates certainty and stability. That stability gives those companies the confidence to invest, borrow, grow and hire. That contributes to economic growth.

ISDA recently put together a short video, along with a fact sheet, to highlight a few examples of how derivatives help companies run their businesses better.

Examples include companies using derivatives to lock in the cost of issuing debt to finance new investments. Exporters using derivatives to create certainty in the exchange rate at which they can convert future overseas revenues. Pension funds using derivatives to protect the value of pensions for future retirees. Food producers using derivatives to hedge crop and livestock prices. And banks and mortgage providers using derivatives to manage the risk from their loan books, enabling them to keep on lending.

In each case, these entities are using derivatives to create certainty. No one can predict how markets will move in future, but being able to lock in a foreign exchange or interest rate that a firm is comfortable with enables that company to better plan for the future. That’s incredibly valuable.

Now, let’s be clear: we think derivatives markets need to be safe and efficient, and the trading of these products needs to be accompanied by sound risk management. That’s why we have supported regulatory efforts since the crisis to improve transparency and mitigate counterparty credit risk. As a result of those measures, the financial system is more resilient than ever before.

But the bottom line is that derivatives continue to be used by a whole range of companies because they’re useful – because they help them manage risk. If they didn’t find them beneficial, they wouldn’t use them.

But don’t just take our word for it. Here are a couple of public statements from regulators in the US and Europe charged with reforming how derivatives are traded.

“[L]et us again be reminded of the essential role of global derivatives markets: to help moderate price, supply and other commercial risks – shifting risk to those who can best bear it from those who cannot. Thus, well-functioning global derivatives markets free up capital for business lending and investment necessary for economic growth – economic growth that still remains far too meager on both sides of the Atlantic.”

Acting CFTC chairman J. Christopher Giancarlo, ISDA Annual General Meeting, May 10, 2017

“Most Americans do not participate directly in the derivatives markets. Yet these markets profoundly affect the prices we all pay for food, energy, and most other goods and services. They enable farmers to lock in a price for their crops, utility companies and airlines to hedge the costs of fuel, exporters to manage fluctuations in foreign currencies, and businesses of all types to lock-in their borrowing costs. In the simplest terms, derivatives help businesses throughout the US economy manage risk.”

Former CFTC chairman Timothy Massad, Economic Club of New York, December 6, 2016

“Derivatives are a key part of our financial markets and account for hundreds of trillions of euros in volume. Under the right conditions, they contribute to financial stability, by allowing market participants to redistribute risk among each other. For example, they allow exporters to fix their prices despite fluctuating exchange rates, and banks to offer fixed-rate mortgages even as interest rates move.”

Valdis Dombrovskis, vice-president, European Commission, May 4, 2017

And here’s just one public statement from an association representing derivatives end users. There are plenty more out there in the public domain.

 “The use of derivatives to hedge commercial risk has key economic benefits. It allows businesses – from manufacturing to healthcare to agriculture to energy to technology – to improve their planning and forecasting, manage unforeseen and uncontrollable events, offer more stable prices to consumers and contribute to economic growth.”

Letter from Coalition for Derivatives End-Users, January 26, 2016

Safe AND Efficient Markets

Those of you who made the trip to Lisbon last week for our 32nd annual general meeting – or followed our updates and live streaming on Twitter – will know that several key themes dominated the event. But most can be grouped under a single word: efficiency.

This plays directly to ISDA’s mission statement to promote safe and efficient markets – a mission that is driving our focus on the future and our commitment to develop innovative new solutions. Attention from regulators and the industry in recent years has understandably been on the first of those – safety – but efficiency is just as important. Without it, costs rise and access to risk management tools diminishes.

There’s no doubt the financial system is now safer, more transparent and more resilient as a result of the post-crisis Group of 20 reforms. We think that progress is important and must be maintained. But we also think the regulatory framework can be made to work better by cutting complexity, eliminating duplication and removing unnecessary compliance burdens. As I pointed out in my AGM opening remarks, and as discussed in our panel discussion on public policy, there are many examples of complexity in the rules that result in higher costs for derivatives users and ultimately discourage trading, investment and hedging.

The reporting rules are a case in point. Most jurisdictions now have reporting rules in place, but the data that’s required to be reported and the form it has to be sent can differ significantly. In the US, for instance, Commodity Futures Trading Commission and Securities and Exchange Commission rules diverge on required data fields and the format of submission. This creates unnecessary duplication and inconsistency, without having any obvious benefit from a systemic risk-reduction perspective.

Fortunately, both European and US regulators are now reviewing their rules with an eye to making refinements where necessary. We welcome these initiatives, and believe eliminating pointless complexity and duplication is an important requisite for efficiency. Achieving greater cross-border harmonization and conducting thorough impact studies before all the rules come into force to understand their effect on the entire derivatives ecosystem are also important.

Looking at the regulatory framework is just one element of the drive for efficiency, though. We also need to remould the derivatives data and processing infrastructure to ensure it is fit for the future. The regulatory reform of derivatives markets has resulted in an array of new requirements and infrastructures – clearing houses, trading platforms and trade repositories – but the succession of deadlines has caused firms to take a tactical approach to compliance. The tight time frames haven’t given participants much time to think about the bigger picture.

The result is a lack of common standards and processes, and the need for constant reconciliation between counterparties. This inefficiency increases the cost and complexity of running a derivatives business.

A vital part of the answer is to develop a consistent data and process hierarchy. By using common data standards for products and trades, and agreeing standard processes that are encoded as common domain models, the industry can ensure the foundations for future growth are on a firm footing – as well as pave the way for the use of innovative new technologies like smart contacts.

ISDA published a white paper last September that set out the improvements in data and processes that are needed, and we’re committed to leading that effort. We’re keen to work with all participants – traders, technology firms and lawyers – to make this a reality, in the same way ISDA worked with the industry 30 years ago to achieve consensus on the ISDA Master Agreement.

As discussed on our technology panel at the AGM, the challenges are significant. But we need to be bold in developing a re-ordered, more efficient workflow. The continued efficiency of the derivatives market depends on it.

At ISDA, we have our eyes firmly fixed on the future, and we’ll look to bring the industry together to forge a consensus on the path forward. By drawing on our legal, data and technology expertise, the aim is to create the standards and processes needed for the market to function efficiently for the next 30 years.

Thanks to the 750 or so members who joined us in Lisbon and helped make the event a great success. Thanks also to the financial media who attended. We especially appreciate the global policy-makers – Svein Andresen (Financial Stability Board), J. Christopher Giancarlo (Commodity Futures Trading Commission), Steven Maijoor (European Securities and Markets Authority) and Kay Swinburne (European Parliament), among others – who provided their perspectives on key regulatory issues in the global derivatives markets.