Getting Smart

Complying with new financial regulation has led to the layering of new processes and systems onto existing infrastructure. With a number of new links in the chain – electronic trading, clearing, reporting, margining – derivatives operations have become increasingly complex and unwieldy. No wonder, then, that distributed ledger and smart contracts have excited so much interest. These technologies offer the tantalizing prospect of revolutionizing the way derivatives are booked and managed, automating and streamlining a complex, overburdened system and cutting operational costs.

That’s the vision, anyway. Getting there will be difficult. The term ‘smart contract’ is fairly broad, but is generally taken to mean converting the terms of a trading relationship into shared executable code to automate certain actions or obligations. The intention is to increase efficiency and reduce costs through mutualized processes. Establishing the extent to which such coding should be used – whether it should be adopted for all aspects of a trading relationship or just in some specific areas – is going to be a major debate.

Any transition to smart contracts won’t be easy, either. The industry can’t just smash up the old infrastructure and switch to a new one overnight. To allow trading to continue without hindrance, there will have to be a slow, step-by-step process of change and improvement.

ISDA will play an active part in this evolution. Smart contracts will require standards, and this is an area where ISDA has a long track record, dating back to the publication of the ISDA Master Agreement. We’ve been looking into this issue for some time, and we held our first industry roundtable on the topic earlier this month. At that meeting, we considered how Financial products Mark-up Language (FpML) might be used as a basis for derivatives smart contracts.

FpML is an open source messaging standard for derivatives based on the ISDA taxonomy, and is already widely used in the industry. Using existing standards like FpML as a starting point may be a crucial shortcut to the rollout of industry standard, platform-agnostic smart contracts.

The roundtable was attended by technology experts, law firms and industry participants, and close cooperation between each of these groups will be crucial if smart contracts are to get off the ground. During the meeting, ISDA showcased a proof-of-concept smart interest rate swap contract based on FpML, and much of the discussion focused on how to connect all the various moving parts of a typical derivatives trading relationship together. Should a smart contract be placed on a distributed ledger platform? How does this technology operate within existing legal frameworks, nationally and internationally? Should the legal language of the various ISDA product definitions or legal documentation be folded into the design? How will increased automation affect termination rights and the management of counterparty defaults?

We need to develop answers to these knotty questions, and ISDA will be pushing ahead with more industry discussion in the New Year and beyond – so watch this space. We will be drawing on the breadth and depth of our membership, including sell-side, buy-side and law firms, as well as infrastructure and technology service providers to validate different concepts and technology solutions. The key is to gather the right experts with appropriate domain knowledge to contribute to the design. While others will take on the purely technological challenges, such as scalability and security, ISDA will host the discussion around legal standards and application, and contribute to the development of data standards and code. We are perfectly placed to hold this project together.

This project is part of a wholesale review of derivatives market infrastructure. In September, ISDA released a whitepaper that called for greater standardization in documentation, data and processes.

It won’t be quick and it won’t be easy. But the need for change is obvious, and it’s incumbent upon the industry to work together to make improvements in the most efficient and consistent way.

VM Rules: Take Action Now

It might only be November, but people already seem to be turning their minds to what’s in store for 2017. There’s likely to be a lot on the agenda, but one date looms large for the derivatives market: the March 1 implementation of variation margin requirements for non-cleared derivatives. That’s not surprising: the scale of the task is massive, and firms need to take action now in order to stand a chance of being ready in time.

Many market participants already post collateral to cover price changes on their derivatives trades, so you’d be forgiven for asking what all the fuss is about. The answer is that the rules make variation margin posting compulsory on all non-cleared trades, and set strict requirements on the type of collateral that can be posted, the frequency of the margin calls, and the required timing for settlement, among other things.

Crucially, these regulatory changes mean derivatives users will have to modify their existing collateral support agreements. And seeing as the March 1 deadline captures a broad swath of financial institutions – asset managers, pension funds, insurance companies, hedge funds – it will mean thousands of counterparties will need to change or set up thousands of agreements in a very short space of time. This will represent a repapering exercise on a scale and under a timetable never before attempted.

So, what do firms have to do to get ready? An important first step is to understand whether and when each trading relationship will be subject to margin requirements, and what rules will apply. To help with that process, ISDA has developed a self-disclosure letter that enables market participants to exchange the necessary information, covering the US, European Union, Canada, Japan and Switzerland. In order to speed up the exchange of information, this was incorporated into ISDA Amend – an online tool developed by ISDA and IHS Markit – on October 28. This is something each firm could – and should – get started on now.

The next step is to start revising and/or setting up new documentation. ISDA has now published a variety of revised credit support documents under various legal regimes, but the real challenge is how to make those changes without the grueling task of having to bilaterally negotiate with every single counterparty.

In response, ISDA has developed a variation margin protocol that will enable firms to quickly and efficiently amend existing contracts or set up new agreements that comply with variation margin requirements. The protocol was published for the US, Japan and Canada in August, and we expect to publish European Union provisions soon following publication of final European rules on October 4.

The protocol for those jurisdictions will be available on ISDA Amend later this month, which will eliminate much of the manual work of notifying counterparties and reconciling the various elections made. Once that is up and running, market participants will have a little more than three months to onboard all their counterparties.

The timeline is even more challenging for those jurisdictions that have yet to publish final rules. In an article published in Risk recently, I estimated it would take four and half months to develop a protocol and build it into ISDA Amend from the point the rules are finalized. If regulatory timelines don’t allow for the building of an automated industry solution, then firms will have to bilaterally negotiate changes with each counterparty – a hugely time-consuming and resource-intensive task.

Even with the protocol available, the variation margin deadline will pose a massive challenge for the industry. Over the past two months, we’ve held a series of conferences across the globe focusing on the margin rules. The comments from those who attended made clear that many firms are seriously worried about their capacity to agree the necessary changes with every one of their counterparties.

The message is very clear: start to prepare for March 1 now. Understand what the rules will mean for you; look at your outstanding contracts; and start getting in touch with your counterparties. Any firm that leaves it much longer may find it is unable to trade from March 1.

We’re Ready to Help

The initiative to develop a globally consistent standard for a derivatives product identifier has been rumbling on for a while now. This is something in which both the regulatory community and the industry have a big stake. Regulators want to be able to aggregate data in order to fulfill their mandate to monitor and assess risk – a uniform product identifier makes that a lot easier. The industry wants consistency in order to avoid a situation where multiple identifiers emerge for different purposes – a nightmare scenario where complexity would go through the roof and costs would rise.

So, everyone is agreed this is a good idea. The question is what standard should be used. The European Securities and Markets Authority (ESMA) has thrown its weight behind the ISIN, and has mandated its use for certain reporting obligations under the revised Markets in Financial Instruments Directive. Other regulators haven’t yet shown their hand. That’s because the Committee on Payments and Market Infrastructures (CPMI) and International Organization of Securities Commissions (IOSCO) are working to finalize technical guidance on a common product identifier, which is expected before the end of the year.

That would appear to leave regulators with a stark choice: either CPMI-IOSCO recommends an ISIN-based identifier; or ESMA changes its approach to match the standards published by CPMI-IOSCO; or we’re left with a fragmented system of multiple identifiers.

There’s been a lot of discussion about whether and how ISINs can be used as a derivatives product identifier, and ISDA has played a full part in that. We’ve worked extensively with the International Organization for Standardization (ISO) and the Association of National Numbering Agencies (ANNA) to develop a multi-tiered ISIN framework for regulatory and business purposes, and have offered to provide the intellectual property associated with ISDA terminology and definitions free of charge to make this work.

We believe it’s possible for regulators and the industry to work together to agree a consensus approach that uses the ISIN. For that to succeed, however, it’s imperative that the identifier framework meets some key principles – and ISDA published a paper outlining those principles in May.

Among the most important is the need for open governance. Specifically, we think it’s crucial that derivatives market participants play an active part in development of the standard and its ongoing governance.

As it stands, ISINs can only be allocated by infrastructures approved by ANNA, and each one is the exclusive provider of ISINs in its local market. Given the absence of competition in selecting and designing the infrastructure, it’s important the governance framework reflects the views of market participants – the actual users of the ISIN – and not just those with a commercial interest in the infrastructure. Open governance is the only way to ensure the identifier works across jurisdictions and supports both regulatory and business purposes.

We would urge regulators to take advantage of the expertise and experience of the derivatives industry to ensure we have a single derivatives product identifier that suits regulators and the industry alike. It’s in all of our interests to make this work.

Beware the Code Freeze

Europe has picked up the pace of its approval process for rules on the margining of non-cleared derivatives. The latest thinking is that the European Parliament will wrap up its non-objection this month, prompting the market to reassess the likely date the rules will come into force. Depending on what the Council of the European Union (EU) does, it’s possible the largest EU phase-one banks could be posting initial and variation margin from early January.

We welcome the push to harmonize implementation schedules with those in the US, Japan and Canada. The margin requirements were originally intended to be rolled out according to a globally consistent timetable – a plan we supported. That fell by the wayside when the European Commission announced in June it would delay its rules until 2017 – a move that was later followed by Australia, Hong Kong, Singapore and India. So, we think realigning Europe with the US and others as soon as possible is a good thing.

There is a fly in in ointment, though. Many banks enforce an end-of-year code freeze that prevents them from making any changes to systems and models. Introducing far-reaching margin rules during this freeze could pose risks. Worryingly, it could hamper the ability of banks to make fixes to newly installed collateral systems and processes if something goes wrong.

We think a mid-January implementation for the EU would be safer from an industry perspective. Those few extra weeks would mean the code freeze would be finished and any emergency IT fixes that need to be made can be made.

Go too far beyond mid-January, however, and we start approaching another hurdle: the March 1, 2017 rollout of variation margin requirements. This deadline will affect a much wider universe of firms, and will involve thousands of counterparties having to make changes to thousands of outstanding collateral agreements at once. This on its own will pose major resource issues for the industry. If combined with the delayed European phase-one requirements, it could stretch capacity to breaking point.

So, we’re probably looking at a window of between mid-January and early February for the European rules to come into force. That gives enough time to get past the code freeze, but means there’s a tiny bit of breathing space before the variation margin requirements are introduced. We think this gives the best chance for the margin rules to be implemented in Europe without disruption.