Some Thoughts on Noble

Credit events in the credit derivatives market often spark a lot of debate, but the issues relating to a possible restructuring of a Noble loan have been particularly hotly debated by the industry. That’s resulted in plenty of column inches in the media, which is good: it’s important that these events are discussed and deliberated, and the issues are widely broadcast to the broader industry.

On the issue of Noble, however, there are a couple of important facts we think need to be clarified. First, the determinations on whether a credit event has occurred aren’t made by ISDA. They are actually made by industry Determinations Committees (DCs) each comprising 10 sell-side and five buy-side participants. These 15 firms vote on whether a credit event has occurred depending on the publicly available information, the criteria set out in the Credit Derivatives Definitions and the rules on governance set out in the DC rules. ISDA acts as secretary to the DCs and administers the process – we don’t have a vote and we don’t make the decisions.

Saying ISDA makes the decisions is akin to saying ICE Benchmark Administration (IBA) decides what the LIBOR rate should be. After all, it’s now called ICE LIBOR and is published on the IBA website. But IBA administers the process – the actual LIBOR rates are based upon submissions from LIBOR contributor banks.

Second, some of the stories imply that the DC rules failed to provide for the Asia ex-Japan DC’s decision to dismiss. That’s incorrect. As the DC statement of August 10 states, the DC felt it did not have sufficient information to determine the DC question one way or the other, because it was not able to get hold of the underlying loan documentation and details of the guarantee. Market participants crave certainty, and so the lack of public information on the Noble loan and guarantee has created confusion and frustration in the market. The rules do allow the DCs to dismiss a question, which requires an 80% supermajority vote, and provide for the bilateral triggering of contracts in the event a question is dismissed. Now, people can argue that a different outcome would have been preferable, but they can’t argue that the potential for a dismissal isn’t set out in the rules as they stand.

Credit market participants have not had to bilaterally trigger a credit derivatives contract for some time. The complexity, operational risks and potential for disputes that it creates was one of the reasons why the DCs were established in the first place back in 2009. ISDA’s members played an important role in facilitating the determinations framework, and, in our role as secretary, we’ve worked with each of the five regional DCs to improve the transparency and governance of the DC process. There’s likely to be plenty of feedback from market participants on changes that could be made to avoid bilateral triggering exercises in future. ISDA will pull that industry comment together, and will feed it back to the DCs. Where we can lead industry debate and propose solutions, we will. It’s in everyone’s interests for this market to work as safely and efficiently as possible.




VM Rules: Almost There

Six months ago, the industry was facing the possibility of real disruption. With the variation margin ‘big bang’ set for implementation on March 1, but with only a fraction of the necessary changes to documentation completed, there was a very material risk that a large part of the market wouldn’t be able to trade.

Fortunately, regulators across the globe provided forbearance that allowed parties to continue trading under their existing documentation, providing extra time for firms to continue the lengthy and complex process of amending or creating credit support annexes (CSAs) with in-scope counterparties. That extra time was critical, as final national rules had only been published just months earlier in some cases, leaving a very small window for firms to complete what was essentially a colossal repapering exercise.

With the forbearance set to expire in certain jurisdictions, including the US, on September 1, the industry is in a much better position than it was earlier this year. At the end of February, the estimated proportion of required CSA amendments that had been completed stood at one third. That had reached 90% by the week ending August 11. The 60-odd percentage-point increase represents tens of thousands of newly amended CSAs, each requiring hours and hours of complex bilateral negotiations with counterparties to agree the changes.

That doesn’t mean the job is done, and it doesn’t mean the industry is getting complacent. There’s still a tail of mostly smaller firms that needs to be worked through in the coming weeks and months. These include those counterparties that were operationally unable to support the new regulatory compliant terms until recently, or those cases where bilateral negotiations to amend CSAs have been particularly complex. ISDA will continue to monitor progress right through to September 1, and will share those results with regulators.

But there’s little doubt the extra six months was absolutely vital and averted what could have been a big problem on March 1. Regulators deserve credit for addressing the concerns by providing forbearance – and the industry has worked diligently to make the necessary changes during that time.

The question is what happens to those trades executed after March 1, in line with the regulatory forbearance, but where CSAs have not yet been amended? The industry is working on the basis that those trades will need to be unwound if they are not subject to regulatory compliant variation margin CSAs by September 1. Given firms lack a contractual mechanism to unilaterally force their counterparties to unwind, it will take time to negotiate the terminations – but firms want to be able to demonstrate they’ve been working to tackle the issue in advance.

The rollout of the variation margin requirements doesn’t mark the end of the non-cleared margin implementation effort. The European Union (EU) will bring physically settled FX forwards into scope of the non-cleared margin rules from January 3 – the only jurisdiction to do so – which will result in another wave of CSA negotiations. While a small number of so-called phase-two firms will post regulatory initial margin from September 1, a larger number of counterparties are set to follow suit in September 2018, 2019 and 2020. On top of that, ISDA is preparing to launch the next iteration of the ISDA Standard Initial Margin Model – ISDA SIMM 2.0. That goes hand in hand with the successful operation of the ISDA SIMM governance structure – the mechanism for industry feedback and regulatory review has worked as planned.

ISDA’s work will persist as the rules continue to evolve. That includes the monitoring of preparations for the EU FX and phase-three initial margin implementation deadlines, the development of any necessary documentation solutions, and ongoing updates to the ISDA SIMM. ISDA is committed to working with the industry to develop solutions to help firms with their compliance efforts.

The Legal Aspects of Smart Contracts

A lot has been said and written about the potential for smart contracts in the context of derivatives. On our part, we think smart contracts have the potential to unlock value in the derivatives market by offering significant cost and efficiency benefits.

But what exactly do we mean by a smart contract? Is it a fully digital version of the legal agreements we use in the derivatives markets today? Or is it a piece of software that can automate the execution of certain operational actions within those existing paper contracts, but without actually replacing them?

ISDA last week published a paper in conjunction with Linklaters that attempts to answer these questions. The paper delves into the definitions of smart contracts, outlines how they might be used in a derivatives context, and highlights the legal issues they raise.

We have a strong and tested legal framework for derivatives, the ISDA Master Agreement, which has been honed over more than 30 years. But translating that directly into a smart contract context isn’t straightforward. While certain operational clauses – those related to payments or deliveries, for instance – might lend themselves to being automated, others are more subjective or require interpretation or discretion, and will therefore prove more challenging.

ISDA is now taking a critical step in the process by reviewing and updating the ISDA documents and definitions, with the aim of standardizing and formalizing certain clauses to enable them to be more easily represented and executed by smart contract code. This work to future-proof our legal documents will start with the 2006 Definitions for interest rate and currency derivatives.

We’re also looking at how the existing Financial products Markup Language messaging standard could be used in the smart contract space. To lead these developments, a new ISDA legal working group has been set up specifically to focus on smart contracts and distributed ledger. This is in addition to another ISDA initiative to establish the common data and process standards to help drive interoperability of these new technologies.

As in the past, ISDA is working to educate the market, but also to establish industry consensus on the application of operational and non-operational (or discretionary) contract elements. There will be instances where specific elements of the contract can be fully automated, but other elements where natural human language must be applied. Our working groups will unpack these issues, and ISDA is committed to developing industry consensus so there is continuity across platforms.

That would unlock significant efficiencies for derivatives market participants. ISDA’s work to future-proof its documentation is a crucial step to making that happen.

Unlocking Value via Process Standards

At the end of May, I wrote a derivatiViews post laying out ISDA’s ambitious vision for the future of derivatives market infrastructure. The system as it stands is creaky, over-complicated and outdated, increasing cost and compliance burdens for all market participants. New technologies can alleviate many of these problems, but first we need a reform of current standards and practices.

I am happy to report that, in the short time since that blog was published, progress toward this goal has started to pick up speed. ISDA is working with the wider industry to solve one of the major infrastructure problems – the lack of commonality in market processes and events. There is no concrete, shared description of even the most basic market activities that we all take for granted, like posting margin or novating a trade. That means each firm has tended to develop its own policies and procedures for each event, and has represented them differently in internal systems.

When regulators introduce new rules, each institution goes away and implements the text by mapping it to its own internal systems, meaning each firm could view the same requirements through a slightly different lens, creating inconsistencies in how data is represented and what is reported.

ISDA has begun categorizing these core events and actions in the trade lifecycle into a common terminology that can be translated into standardized, machine-readable code. From here, they can be collected into a common domain model (ISDA CDM). This will offer market participants a common representation of fundamental industry processes and concepts – breaking down each event into a ‘before’ and ‘after’ state, and precisely defining the change that occurs between the two. Individual firms won’t need to spend time and effort on developing their own definitions of basic tasks – they can all simply pluck the same definition from the ISDA CDM. That will free up resources for activities that deliver added value to their clients.

It sounds simple, but it’s a huge task. Getting everyone to agree on a set of definitions, and encouraging widespread adoption, will be challenging. That’s why ISDA, with its reach across the market and history of introducing common standards, is the perfect organization to push this work forward.

In September, ISDA should have developed an initial CDM design, and will then decide the format and mechanism for its wider publication. Within the same time frame, we also expect to have expanded the supporting business case for adoption of the ISDA CDM.

The short-term benefits of such a CDM are numerous. When new regulations are introduced, supervisors can communicate their requirements by reference to the CDM and remove much of the current pain around interpretation. If the CDM needs updating, then this could be arranged through discussion with the market to ensure the model remains reflective of industry practice. This would improve consistency of implementation, and transparency.

In the longer term, the establishment of common definitions for key lifecycle events should help facilitate the implementation of shared data storage facilities, distributed ledger technologies and smart contracts. This will enable a single, central, secure representation of each trade, through which trade events can be automated via the standard processes contained in the CDM. This will eliminate the need for constant reconciliation between counterparties, which does so much to gum up current infrastructures.

We will shortly be releasing a whitepaper that will look at the use of distributed ledger and smart contracts from a legal perspective – this will set out the different smart concepts in play, and describe some of the legal and operational challenges involved in bringing them into use.

All of this will be done with a careful eye on compliance, and on optimizing new regulatory obligations. We will also keep the global regulatory community updated on our progress, and we hope to bring in their expertise to help overcome some of the possible hurdles in the road ahead.

As I mentioned in May, this is a bold vision, and will require plenty of tough decisions to be made by the industry. There are a host of operational and legal issues to overcome. But we can’t stay still and accept things the way we are now. We need to push forward and help design a derivatives market that is fit for the demands of the 21st century.