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

A big step in tackling too big to fail

Early next month, a group of 18 global banks will formally sign a new ISDA Protocol that will ensure the cross-border derivatives they trade with each other are captured by national resolution regimes. By knitting together these various statutory regimes, the ISDA Protocol is an important step in meeting a regulatory and industry objective to address the too-big-to-fail problem.

As I explained in a comment piece published by the Financial Times recently, a number of statutory resolution regimes either already exist or will shortly be introduced that suspend certain rights that allow derivatives counterparties to terminate outstanding transactions with a bank under resolution. The idea is that this ‘stay’ will give national authorities time to deal with the troubled bank in an orderly way and avoid the market instability that might occur should counterparties all close out their derivatives trades with it at once.

Those national special resolution regimes include Title II of the Dodd-Frank Act and the European Union Bank Recovery and Resolution Directive. Between them, they will ensure a large share of the derivatives market is covered by stays should a bank counterparty enter into resolution. The risk, however, is that cross-border trades might not be captured by any single regime. If a US bank enters into resolution, for example, there is doubt over whether the stay under Title II of Dodd-Frank would apply to any English law or other non-US law contracts it might have agreed with its counterparties.

Recognising this might hamper regulatory efforts to resolve the failing institution in an orderly way, 18 global banks last month agreed to adhere to ISDA’s Resolution Stay Protocol. The Protocol, which essentially changes the terms of derivatives agreements to opt adhering parties into certain foreign resolution regimes, will be signed by those firms early next month and will come into effect on January 1, 2015. The Protocol also includes a stay that could be used when a US financial holding company becomes subject to proceedings under the US Bankruptcy Code – although this will only become effective once relevant rules are issued by US regulators.

By adhering to the Protocol, the 18 banks will extend the coverage of stays to more than 90% of their notional derivatives outstanding, and this will increase as more institutions sign the Protocol.

Additional banks are expected to adhere during 2015, but not all firms will be able to sign up to this initiative voluntarily. Buy-side institutions, for instance, have fiduciary responsibilities to their clients that mean they cannot voluntarily give up contractual rights. Regulators have acknowledged these concerns, and declared they will implement new regulations on a country-by-country basis in 2015 to encourage broader adoption. In a report published in September, the Financial Stability Board outlined some potential regulatory options, covering both direct and indirect measures.

The first step, however, is get the 18 global banks on board. That in itself represents a big piece in the too-big-to-fail puzzle, and will help put financial markets on a sounder footing.

Cross-border Concerns Are an ISDA Priority

CEO Scott O’Malia reflects on his first weeks at ISDA

It’s now been some five weeks since I joined ISDA.  I have participated in two regional meeting and have had the opportunity to meet with or hear from a number of members in North America, Europe and Asia.

I have been very impressed with your level of commitment to ISDA and your depth of knowledge on key derivatives issues. I have often heard that ISDA’s ability to harness the collective expertise of its members sets it apart. I now see for myself just how true this is.

I am also seeing first-hand how vital ISDA’s work is for its members and for the derivatives markets. Whether it’s the development of a standard margin model for non-cleared swaps, the Basel III capital rules, new documentation definitions or issues around bank resolution, ISDA works to add value in a myriad of important ways.

I know there are a number of issues that you are concerned about and I assure you that the ISDA board and staff are focused on providing timely solutions.   In the near term, ISDA will focus on the completion of a new “resolution stay” protocol that will address the concerns of key regulators, who are intent on putting in place an alternative to the past practice of bailing out too-big-to-fail banks.  I am also pleased to report that ISDA has delivered a single, standard initial margin methodology to regulators worldwide for their input and approval. We will remain focused on achieving a workable timetable to implement the OTC margin rules and provide timely comments on the draft rules that have been recently released.  ISDA’s staff is also working to develop principles around clearing house resolution and recovery in order to be prepared to contribute to the debate that is beginning worldwide.  While our objective is to prevent the possible default of a clearing house, we must have a strong understanding of the recovery or resolution process in the event of failure.

Perhaps the biggest concern I have consistently heard over the past month or so is the importance of cross-border harmonization.  In the medium and longer term, ISDA will remain focused on providing solutions to global regulators to resolve their differences and create an outcomes-based regulatory regime that relies on substituted compliance.  ISDA will continue its advocacy for more consistent data reporting standards across jurisdictions; trading protocols and platforms that aggregate liquidity, rather than fracture it; and consistency in rules surrounding clearing mandates and OTC margining.

Regulators are very much aware of this issue. In fact, the Financial Stability Board in mid-September published a paper stressing the need for regulators to defer to other countries’ regulatory regimes.

But it’s important this recognition of the issue translates into action. Without it, markets will fragment, splitting liquidity pools along geographic lines and increasing costs for end-users. That’s clearly bad for firms, it’s bad for markets and it’s bad for customers.

Over the next month, I will continue to participate in the regional conferences in Asia and use the time to meet with ISDA members to listen to their priorities and engage with regulators to remind them of the important work ISDA performs on behalf of its large and diverse membership.

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