Parting Thoughts

ISDA CEO Bob Pickel reflects on his nearly 17 years in senior positions at ISDA

Swaps and ISDA have played a central role in my professional career ever since the mid-1980s when I was with the law firm Cravath, Swaine & Moore, ISDA’s original outside counsel. As I leave this incredible organization and consider other opportunities, I wanted to share a few reflections from my various roles at ISDA.

My belief in the essential power of these risk management tools known as swaps remains unshaken. From the early days of managing interest rate and FX risk, through equity, commodity, credit, weather, longevity and more, the logic of companies using these financial tools to adjust their exposure to risks of all sorts is irrefutable. However they are traded, however standardized they are, however the risk is managed, banks, companies, investors, governments and many others are more empowered to tailor their risk profile by virtue of the availability of these products.

ISDA has stood for safe, efficient markets for its nearly 30 years of existence. The way we have delivered on that promise at the macro level has been by focusing on so many of the details at the micro level. And I am proud to have been a part of delivering on that promise. The documentation architecture that we have built and the opinions that support that architecture are, perhaps, the most obvious examples of ISDA getting the details right so that, in the aggregate, markets are safer and more efficient.

As ISDA and the market grew, we focused on all aspects of the counterparty relationship. Growing derivatives markets created operational challenges, and our operations groups addressed those challenges through increasingly standardized processes and the use of technology, including FpML. Collateral use grew, not just to mitigate counterparty credit risk, but to facilitate trading, and we worked to provide solutions. Numerous iterations of the regulatory capital rules have changed the economics of products and trading strategies, and here we have served as both advocates for our membership and facilitators of implementation. Tax and accounting issues have been an undercurrent throughout, and we have always emphasized the need to provide the appropriate representation of these products and the risks they seek to manage.

It has been just as important to get the word out about the value of swaps and all that we have done to deliver on our promise of safe, efficient markets. We do that in many ways. Advocacy delivers that message to policy-makers. Our communications team reaches out to the media to get the word out more broadly. Our research efforts provide the analytical support for our messages. And our extensive, global conference program trains and informs people who need to understand how these products can be used in their businesses.

All that, and it has been great fun as well. That has been most true when we gather for our annual general meeting. Going to a different location every year puts a huge burden on our conference team, but the AGMs are what so many of our members remember fondly. From Rome in 1998 to Munich earlier this year, the AGMs have been an opportunity for me to get to know our members and to better understand their concerns.

ISDA’s three greatest strengths historically have been its global nature, the diversity of market participants represented in our membership and the range of products that we address. In the future, whether or not the products are cleared or electronically traded, I believe these will remain its strengths. ISDA’s scope and diversity – in terms of geography, asset classes, product types and members – creates financial and logistical challenges, and coming to consensus isn’t always easy. But the end result is stronger for having been forged in a process that encourages such broad input.

Organizations are ultimately only as strong as their people. I have been fortunate to have so many colleagues who are as committed to the organization as I am. This includes the many members of the ISDA Board, including six different chairmen, who I have worked with during my time at ISDA. It includes a committed, knowledgeable staff that has grown over three-fold during my time with ISDA, housed in seven offices instead of the two when I started. And it includes the many, many members who have contributed their time and expertise to ISDA. Since I became ISDA’s CEO in 2001, our global membership has doubled.

I am delighted that Scott O’Malia has agreed to take this organization forward as CEO, starting in just a few weeks. I will be working with our Chairman, Steve O’Connor, the ISDA Board and my many colleagues on the ISDA staff to help Scott with the transition to his new role. He can take great comfort in knowing that the broader ISDA membership will be working with all of us to maintain ISDA’s position as the global derivatives organization, working as always for safe, efficient markets.

All the best from a very grateful member of the ISDA team.

bob2

 

A MIFID brainteaser: define liquidity

What do we mean when we say a financial instrument is liquid? That it trades 100 times a day? Ten times a day? Less than that? It’s a question the European Securities and Markets Authority (ESMA) currently has the unenviable task of trying to answer for all non-equity instruments as part of its efforts to draw up detailed rules for the implementation of the revised Markets in Financial Instruments Directive (MIFID) in Europe. Unenviable because a lot is riding on getting the definition spot on – continued market liquidity at current levels for one.

The definition is crucial to much of what is in MIFID and the associated Markets in Financial Instruments Regulation (MIFIR). Liquid instruments will be subject to strict pre- and post-trade transparency requirements, as well as potentially having to comply with an obligation to trade on a regulated market, multilateral trading facility, organised trading facility or equivalent third-country venue.

Under ESMA’s May 22 proposals for post-trade transparency, for instance, information on price, volume and time of trade would have to be made public within five minutes of a transaction in a liquid instrument taking place (although deferrals exist for trades that meet yet-to-be-decided size-specific and large-in-scale thresholds). If an instrument is deemed to be illiquid, however, publication of the most sensitive information is deferred until the end of the following day.

ESMA does have some guidance on how to approach the liquidity definition within MIFIR. A liquid instrument is one where there are “ready and willing buyers and sellers on a continuous basis”. MIFIR also sets a variety of criteria that should be used to determine this: average frequency and size of transactions over a range of market conditions; the number and type of participants; and the average size of spreads, when available.

On a hunch, it seems likely the most standardised parts of the over-the-counter derivatives market may meet these liquid instrument parameters. A study conducted by analysts at the Federal Reserve Bank of New York, based on three months of interest rate derivatives transaction data from 14 large global dealers in 2010, found the most popular interest rate swaps traded up to 150 times each day – a frequency that would presumably meet the continuous buying and selling requirement under MIFIR. However, plenty of instruments barely traded: the New York Fed reported more than 10,500 combinations of product, currency, tenor and forward tenor over the three-month sample, but found approximately 4,300 combinations traded only once during that period.

ESMA’s proposals are meant to weed out these kinds of infrequently traded instruments from the post-trade transparency requirements, with regulators recognising that an overly broad regime could deter dealers from facilitating client trades in less liquid products, causing a further decline in liquidity. ESMA suggests looking at a minimum number of transactions and the number of trading days on which at least one transaction occurred within a certain time frame, alongside the other criteria on average transaction size, number of market participants and spread size.

The critical element in all of this is where the thresholds will be set. ESMA hasn’t yet started its analysis of derivatives data, but it took an initial stab at setting some possible numbers for bonds within its proposal, suggesting six possible combinations. For the minimum number of days on which at least one trade takes place over a year, it suggests a threshold of 120 or 240 days – in other words, the instrument must trade at least once every other day or once a day. That’s combined with a minimum-number-of-trades-per-year threshold of 240 or 480 in all but one of the six scenarios, equating to an average of just one or two trades a day.

It’s clear the choice and combination of thresholds can dramatically alter the proportion of trades classed as liquid. In two of the ESMA scenarios, where the minimum number of trades per year and average daily volume are fixed at 480 and €100,000, respectively, increasing the minimum number of trading days from 120 to 240 reduces the universe of bonds classed as liquid from 4.71% to 1.61% and lowers the percentage of volume captured from 86.67% to 62.90%.

This same kind of analysis will also be performed for OTC derivatives once ESMA has collected the relevant data – and ISDA is working to help pull that information together. In setting the thresholds, it’s likely ESMA has a figure in mind with regards to the percentage of traded volume in each instrument it wants to apply the liquidity requirements – in fact, it says as much in its proposal, noting that it will combine expert judgement with a coverage-ratio-type approach when setting thresholds. Given US regulators set a coverage ratio of 67% for the purposes of the Dodd-Frank rules, it’s not beyond the realms of possibility that ESMA will target a similar level.

The question then is whether the thresholds required to reach this percentage coverage level truly reflect continuous buying and selling activity, as per MIFIR’s requirement. The challenge for ESMA will be in balancing a desire to apply the new transparency rules to a large enough portion of trading volume in each market with thresholds that reflect real liquidity, based on an objective analysis of the data.

All told, a lot of work for both market participants and regulators – and a matter of months to do it in.