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ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues each week in derivatiViews.

Trading rules need to work together

Cross-border fragmentation is one of the biggest concerns for ISDA and its members. A split in global liquidity pools means lower trading liquidity, regulatory arbitrage, duplicative compliance requirements and, ultimately, higher costs for end users. To avoid this happening, it’s vital that regulators develop and implement each set of rules based on a common set of principles – and ISDA has looked to help guide this process by formulating principles on central counterparty recovery, data reporting and, most recently, the centralized execution of swaps.

The truth of the matter, though, is that markets are already fragmenting – and that’s a real problem. Up until late 2013, for example, roughly a quarter of the euro interest rate swaps market was traded between European and US dealers. Now, this market is almost exclusively traded between European dealers, with many US entities locked out of this liquidity pool.

The reason can be traced back to the introduction of US trading rules in October 2013. Under the swap execution facility (SEF) regime, any electronic trading platform that provides access to US persons is required to register as a SEF. Many non-US platforms have chosen not to, which means US persons, including foreign branches of US banks, cannot trade on these venues. At the same time, non-US persons – not yet required by their home regulators to transact on electronic trading platforms – are avoiding trading mandated products with US firms where possible, as this would require them to trade on US-registered SEFs.

The introduction of Europe’s own trade execution rules in 2017 via the revised Markets in Financial Instruments Directive may eventually go some way to easing the problem. But there are significant differences between the existing SEF framework and the rules proposed by European regulators. In other words, an equivalence/substituted compliance determination between the two sets of rules is by no means a given, potentially exacerbating fragmentation.

ISDA believes regulators should abide by some high-level principles when developing and implementing their trade execution rules to maximise the likelihood of an equivalence/substituted compliance decision. In our Path Forward for Centralized Execution of Swaps paper, we set out three main factors. Importantly, regulators should only mandate certain products to trade on centralized trading venues based on objective criteria backed by data. Centralized trading may be appropriate for highly liquid products; it is not appropriate for illiquid instruments, and may discourage dealers from participating in these markets, depriving end users of important hedging tools.

Second, derivatives instruments subject to a trade execution mandate should be able to trade on different types of trading venues. Being overly restrictive will simply prevent derivatives users from accessing overseas pools of liquidity. Finally, trading venues must offer flexible execution mechanisms, rather than taking a limited, one-size-fits-all approach.

Based on these principles, ISDA believes targeted amendments to the US SEF rules are necessary. This would include changing the process for making mandatory trade execution determinations to ensure it is based on objective criteria and supported by data, rather than allowing SEFs to determine what is ‘made available to trade’. It would also mean granting greater flexibility in swap execution mechanisms rather than stipulating use of an order book or request-for-quote system that requires at least three market participants to submit prices.

ISDA believes that centralized trading venues provide a useful addition to derivatives market infrastructure and can help provide greater transparency on liquid products that are suitable for this type of execution mechanism. But the rules have to be consistent globally – and flaws need to be fixed as they emerge. The US SEF rules, in particular, can be improved, and regulators and market participants should not miss the opportunity to discuss where improvements can be made. ISDA’s buy- and sell-side members stand ready to contribute to this discussion. The ISDA principles are a first step, and adherence to them will encourage increased participation on centralized trading venues and will ensure these markets continue to work efficiently.

Data consistency failures must be addressed

ISDA recently issued a paper: Improving Regulatory Transparency of Global Derivatives Markets:  Key Principles. Those of you who know me from my days at the Commodity Futures Trading Commission won’t be surprised: derivatives data and reporting issues have been a topic of special interest to me for some time. Trade reporting is the key to improving regulatory transparency, which is one of the key Group-of-20 commitments. If we had the reporting back in 2007 that we have now, then it’s fair to say that a lot of uncertainty and fear that permeated the financial system during the crisis could have been avoided.

Trade reporting is also, of course, of special interest to ISDA and our members. Over the years, ISDA has played an important role in this area. Some examples include: helping to establish trade repositories for different asset classes; developing taxonomies for standardizing trade data; compiling sources of reference data; and codifying reference data in FpML. In addition, ISDA’s work in standardizing transaction terms and processes facilitates regulatory reporting and transparency.

Clearly, there has been progress in improving regulatory transparency over the past few years. But just as clearly, progress has stalled. Data requirements differ across jurisdictions. Some data requirements are not clearly defined. Standardized reporting formats have been not adopted quickly or broadly enough. The list of issues goes on and on.

In sum, the current trade reporting process is costly, inefficient and unproductive – and it makes meaningful data monitoring, analysis and aggregation on a global and a national basis more difficult than it should be. The end result is that regulators continue to lack a true picture of risk in individual jurisdictions because of incomplete and inconsistent trade data, and face impossible challenges on a global basis. Market participants, meanwhile, face costly, duplicative and conflicting trade reporting rules, and trade repositories have the unenviable task of collecting and standardizing data from multiple sources for multiple jurisdictions.

Solutions are at hand for each of these problems. We’ve outlined those we believe are most effective in the ISDA paper. It’s time to implement them, and we’re committing to doing our fair share.

Gearing up for non-cleared margin

In a recent ISDA survey of derivatives users, the introduction of margin requirements for non-cleared derivatives was highlighted as a key area of concern, with nearly two thirds of respondents who knew they would be subject to the rules saying they were worried about their ability to meet the requirements. That’s little wonder. Once implemented, the majority of derivatives market participants will need to post initial and variation margin on their non-cleared over-the-counter (OTC) trades. For many entities, it will be the first time they’ve had to post collateral on non-cleared transactions, and it comes with a whole host of infrastructure and documentation challenges.

ISDA is playing a leading role in helping the industry prepare for these changes – as a new webinar on WGMR implementation highlights.

These initiatives can be broadly split into three key areas, each aimed at safely and effectively implementing the global margin rules. First, the rules will require existing legal documentation between counterparties to be changed, and ISDA is leading the re-writing of these contracts. Second, third-party segregated accounts will need to be set up, along with systems and processes to oversee the exchange and settlement of collateral. Third, ISDA is working with its member firms to develop a standard initial margin methodology to establish a single, regulator-approved model that all market participants can use to exchange collateral in a manner that is consistent with the rules.

The development of this standard initial margin model (SIMM) has its roots in the 2013 WGMR requirements, which gave market participants the choice of using a standard table set by regulators or an internal model to calculate initial margin. The former is likely to lead to punitive margin requirements, but the latter creates the risk that each firm will develop its own margin model, leading to a situation where no two counterparties are able to agree on the initial margin amounts that need to be exchanged.

The SIMM will create a framework that all counterparties can use to calculate initial margin, reducing the potential for disputes. A proposed methodology was developed at the end of last year based on a standardised capital calculation described by the Basel Committee on Banking Supervision in its fundamental review of the trading book. Regulators have seen this methodology and are continuing to review it.

But there’s a lot that still needs to be done, and a short amount of time to do it in. Under the original framework published in September 2013 by the Working Group on Margining Requirements (WGMR), a body jointly run by the Basel Committee on Banking Supervision and International Organization of Securities Commissions, initial margin requirements will be phased in from December 2015, starting with the largest derivatives users. Variation margin rules, however, are scheduled to come into force for all covered entities from the end of this year.

The implementation time frame is made harder by the fact that final rules have not yet been published by the various national authorities. European regulators published their proposals in April, followed by Japan in July, US prudential regulators in early September and the Commodity Futures Trading Commission later that month.

Those proposals also contain a number of regional discrepancies, including issues as basic as the scope of coverage and the threshold for margin requirements to kick in. It’s uncertain whether these differences will remain in the final versions of the national rules, or whether the most problematic issues will be ironed out. Either way, it has added to the preparation challenges for firms.

That’s why ISDA has requested additional time to prepare from the point the final rules are published. ISDA sent a letter to the WGMR last August asking for a longer implementation period in light of the scale of the work needed to prepare for the rules, and there are indications that regulators are considering this.

Equally importantly, though, is the need for harmonisation of the various rules. OTC derivatives markets are global – counterparties often trade across borders. If one party calculates margin using the rules applied in its jurisdiction and a foreign counterparty ends up with a different number based on its national requirements, cross-border trading will become much more difficult. The result? Less choice and the fragmentation of liquidity.

Listen to a new ISDA webinar on the non-cleared margin rules and ISDA’s WGMR implementation initiative.

Frontloading certainty paves way for EU clearing mandate

The first clearing obligations are already in place in the US and Japan, and the European Union is now set to follow with its first mandates next year. One of the sticking points has been the fine-tuning of the frontloading requirement – a rule unique to Europe that essentially requires certain trades conducted before the clearing obligation comes into effect to be subsequently cleared.

The concept may sound simple enough, but it’s a requirement that is packed with complexity – and it has been an issue that ISDA and its members have continually flagged since the rules were first published. Recent modifications by the European Commission (EC), however, help eliminate many of the uncertainties, and pave the way for the introduction of Europe’s first clearing mandate for interest rate swaps.

The preceding iteration of the rules appeared in final draft regulatory technical standards (RTS), submitted by the European Securities and Markets Authority (ESMA) to the EC for endorsement on October 1. This version established four categories of derivatives users (an increase from the previous three) and also introduced a new threshold calculation – based on derivatives notional outstanding – to determine whether financial institutions that are not clearing members had to apply the frontloading requirements.

But the way the rules were constructed created significant legal uncertainty. For instance, non-clearing-member financial institutions would have had to determine what category they fall into based on derivatives notional outstanding figures in the three months prior to the official publication of the final rules, meaning the assessment would have been based on criteria not yet finalised, published or in force. What is more, the start and end points for the three months of data depended on an unknown date of publication of the final rules – at which point, the frontloading requirement would also have started.

Taken together, the rules would not have given any time for derivatives users to communicate their status to counterparties, meaning trading partners could have faced real uncertainty as to whether any trade conducted after the publication of final rules would be subject to frontloading.

The EC adjustments tackle these issues. Crucially, the assessment period for non-clearing-member financial institutions will now run in the three months after the RTS come into force, creating greater legal certainty for these entities. Those categories of firms subject to frontloading will also have two months to get the necessary systems, controls and procedures in place and to inform counterparties of their status. The phase-in dates for the start of the clearing obligation remain unchanged, however.

Another important change relates to treatment of cross-border intragroup trades – in other words, transactions between a European institution and a counterparty from the same corporate group based in a third country. These trades are exempted from the clearing obligation under the European Market Infrastructure Regulation (EMIR), but the exemption would only have applied if the intragroup counterparty is based in a jurisdiction with equivalent rules. Given the absence of equivalence decisions, these transactions could inadvertently have been caught by the frontloading requirement once the final RTS are published, as well as by the clearing obligation after the phase-in period. The EC modifications include a three-year exemption for these trades.

ISDA and its members have played a key role in highlighting these concerns, and have worked with regulators to develop practical responses. The end result will ensure the clearing obligation can be introduced in a safe and efficient way, and in a manner that is more consistent across jurisdictions.

Ensuring CCPs are not TBTF

Last month, ISDA issued Principles on CCP Recovery, a short paper that crystallizes and makes recommendations on the adequacy and structure of central counterparty (CCP) loss-absorbing resources and on CCP recovery and resolution.

These are, needless to say, very important issues in the global derivatives markets, particularly given the rapid increase in the volume of centrally cleared trades. The larger CCPs have become critical components of the financial markets infrastructure and are emerging as major hubs concentrating the vast majority of global OTC derivatives transaction flows and risk positions. Great care needs to be taken to ensure that CCPs are not the new ‘too big to fail’ institutions requiring public money to prevent their failure.

There are a number of important points in the paper. Chief among them: there needs to be more transparency with regards to the risk management standards and methodologies used to size CCP loss-absorbing resources. In particular, industry participants would like to see more disclosure on initial margin methodologies and the process for computing default-fund contributions (for instance, margin periods, stress scenarios used and assumptions made), and more detail on the risks faced by the CCP (for instance, the largest concentrations and exposures to clearing members). Without greater disclosure, it’s very difficult for market participants to accurately assess risks.

In addition, we believe standardised, mandatory stress tests should be introduced – again, to allow market participants to assess their risks and also to make like-for-like comparisons between CCPs. Regulatory input and action would be needed on this.

ISDA also makes an important recommendation on so-called CCP ‘skin-in-the-game’ (SITG). We believe CCP SITG plays a significant role in aligning the CCP’s behaviour with that of its clearing members by encouraging the CCP to maintain robust risk management practices. As such, ISDA recommends that SITG should be split into two tranches – one junior (to encourage good initial margin practices) and one senior to mutualised default resources (to encourage robust default fund sizing methodologies). Furthermore, for SITG to be effective, it should be material. Further quantitative analysis should be conducted to determine its optimal amount and structure within CCP loss-absorbing resources.

Crucially, there also needs to be a plan in place to address what would happen if CCP loss-absorbing resources prove to be insufficient. Regulators have suggested a variety of recovery tools, and in this respect, ISDA strongly recommends that recovery plans for each CCP are transparent and clearly defined. ISDA also strongly supports viable CCP recovery plans – a view that is consistent with regulatory objectives. Central to these plans is the notion that CCP recovery and continuity is likely to be less disruptive and less costly to the financial system than closure.

Another important ISDA recommendation is that recovery initiatives should only proceed so long as the default management process is effective. If it’s deemed to be no longer viable for any reason – for instance, the failure of an auction – then the CCP may have to consider closing the clearing service. Of course, it’s likely that resolution authorities would be evaluating which would be the most effective course of action in this situation.

ISDA’s paper joins several others that firms have written on an important topic that is of increasing interest and concern to policy-makers and market participants. It will be followed shortly by a longer, more technical paper that focuses specifically on CCP default management and recovery.

CCPs play a key role in the global derivatives markets and in the Group of 20 commitments to reform these markets. As a result, the adequacy of CCP loss-absorbing resources and the strength of CCP recovery and resolutions plans are important issues to consider and address. We hope our work in this area is a constructive step in the on-going process to build safe, efficient markets.