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.

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.

SOM signature


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.



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.

Three months left and counting down….

European derivatives users are keenly waiting to discover what derivatives products are likely to be subject to the first clearing mandates, with the European Securities and Markets Authority (ESMA) expected to release its first consultation paper on the topic within weeks.

The process picked up steam back in March, when Swedish clearer Nasdaq OMX was authorized as a central counterparty (CCP) under the European Market Infrastructure Regulation. From the moment ESMA was notified of the approval by the Swedish regulator on March 18, the clock started ticking on a six-month window for ESMA to conduct a public consultation and submit draft regulatory technical standards to the European Commission (EC) for each authorized class of derivatives product it recommends for a clearing mandate.

Since then, four other over-the-counter derivatives clearing houses have been authorized – most recently, LCH.Clearnet Ltd on June 12 – and the current thinking is that ESMA will group together the products it thinks may be suitable for the first clearing obligations, possibly into a single consultation to begin shortly. Furthermore, while the derivatives classes so far authorized for clearing across the five CCPs include interest rate, foreign exchange, equity, credit and commodity derivatives, it is anticipated that ESMA will prioritize the most liquid interest rate and index credit derivatives classes in the first instance.

That approach would seem to make sense, given the six-month window for ESMA to hand its rules to the EC for endorsement is rapidly disappearing. Already, the time set aside for the industry to respond to the consultation is likely to be limited – the first post-consultation draft regulatory technical standards are due to be handed to the EC in less than three months. Those rules will then be reviewed by the EC before being handed to the European Parliament and Council of the European Union for approval.

The good news is that the products likely to be proposed for mandatory clearing first are those where there is already a high level of voluntary clearing and where there is an existing clearing obligation in the US – in other words, the instruments the industry is most familiar with clearing. That may help smooth the consultation process.

But there is still uncertainty about the detail of how the first mandates will be implemented in Europe, meaning every second given to the short consultation process will count.

Frontloading is one such issue where much of the detail will only be spelt out in the consultation paper. ESMA proposed a possible approach in a letter to the EC on May 8, in which the frontloading obligation – the requirement to retrospectively clear existing trades once the clearing mandates begin – would only apply for transactions that occur from the time the regulatory technical standards come into force until the end of any phase-in.

This proposed methodology removes much of the uncertainty that had previously existed, but doesn’t completely eliminate the pricing complexities for end-users during the phase-in period. The switch from non-cleared to cleared would come with an array of potential fee, capital, funding and discount-rate implications, all of which would need to be considered and understood at the inception of any trade during the frontloading period. End-users would also need to find clearing members to commit to clearing at a certain point in the future, which some may be unwilling to do. The fact the date of the switch to clearing would be known in advance under the May 8 ESMA proposal makes that calculation slightly less complicated, but there are still a number of variables that would need to be considered.

Ultimately, the minimum remaining maturity – a level to be set by ESMA that will allow contracts with a time to maturity below this threshold to avoid the frontloading requirement – will be critical in determining the impact. But this will only be fleshed out in the regulatory technical standards. The hope is that market participants will have enough time to absorb, understand and comment on the implications.

This all makes for another busy summer for ISDA and its members.

An Outstanding Question

The semiannual over-the-counter (OTC) derivatives statistics published by the Bank for International Settlements (BIS) have long been closely scrutinised as a reliable barometer of the derivatives market. And the latest figures, released last month, have thrown up some headline numbers that have troubled some commentators.

The overall size of the OTC derivatives market climbed to $710 trillion in notional outstanding at the end of 2013, from $693 trillion six months earlier. This increase, coming on the back of a sharp rise in the first half of last year, has kindled warnings that regulators aren’t doing enough, or that they’ve taken their foot off the regulatory reform pedal.

Nothing could be further from the truth, and a closer analysis of the data explains why. First, though, let’s just recap on what notional outstanding actually represents. It simply measures the total face value of all trades that currently exist, regardless of whether certain trades can be offset or netted against each other. As such, it’s not an accurate reflection of the amount of risk being transferred, the payments that are exchanged between counterparties, or the maximum loss that would be incurred should every outstanding derivatives contract be closed out – a point regularly acknowledged by the BIS in its studies.

In contrast, gross credit exposure – which measures the gross market value of outstanding derivatives after legally enforceable netting is taken into account but not considering the impact of collateral – actually fell from $3.8 trillion in June 2013 to $3 trillion six months later. Including the collateral that counterparties have posted to each other would reduce that exposure even further.

But even recognising what notional outstanding represents, and the limitations of what it tells us about derivatives risk exposure, there are some technical issues that need to be kept in mind. Most significantly, the BIS figures count each cleared trade twice: one between counterparty A and the central counterparty; and one between counterparty B and the clearer. A single $10 million trade between two parties subsequently cleared therefore becomes $20 million in notional outstanding for the purposes of the BIS data.

To adjust for that, the outstanding notional volume of cleared trades (themselves adjusted for double counting) would need to be subtracted from total notional. Looking at interest rate derivatives alone, approximately $226 trillion in cleared notional at the end of 2013 would need to be subtracted from the $584 trillion in interest rate derivatives notional, leaving $358 trillion. That’s more or less unchanged from the adjusted interest rate derivatives figure six months earlier. In other words, new regulation, and in particular, the push for greater amounts of centrally cleared trades, is the driver behind much of the apparent increase in notionals.

Nonetheless, a lot of work is being done to reduce the size of these figures. Compression has already reduced the outstanding notional of cleared and uncleared derivatives by $453 trillion as of April 2014, according to figures from Stockholm-based TriOptima. Industry efforts are under way to build on that – in part to reduce the operational burden for dealers, but also encouraged by regulations like the leverage ratio under Basel III, which sets capital based on gross notional, rather than net risk, exposures.

Far from taking their foot off the pedal, then, regulators have introduced rules that are very much driving these numbers. With clearing leading to double counting of notional, and compression cutting back on gross exposures, it’s difficult to know which way the next BIS numbers will run. One thing’s for sure, though – the notional figures reported won’t be an accurate reflection of risk.





End-user angst in Munich

Munich angstIn the years since the financial crisis, an important point about derivatives has often been overlooked: they serve a genuine need by helping real companies to hedge very real risks. This point came across loud and clear in a recent survey of end-users conducted by ISDA: 86% of respondents said over-the-counter (OTC) derivatives were either very important or important to their risk management strategies. This was also a recurring theme at ISDA’s annual general meeting (AGM) in Munich earlier this month, where a succession of end-users and academics stressed the economic benefits of derivatives and their value to the real economy.

These end-users generally feel the financial system is on a sounder footing today than before the financial crisis, largely as a result of regulatory changes. But enthusiasm for specific regulations varies significantly. For instance, trade execution rules got a thumbs down from investors, despite the fact these rules were meant to help those users, primarily by ensuring greater transparency. In that aim at least, regulators appear to have succeeded: 74% of respondents thought electronic trade execution would have a positive affect on transparency. But more than half felt it would have a negative impact on ease of use, while 39% and 36% thought it would have a detrimental affect on price and liquidity, respectively. That’s a higher proportion than those who thought the impact would be positive.

Another key area of end-user concern is a lack of regulatory harmonisation and the resulting fragmentation of markets. Nearly half of survey respondents thought the market was splintering along geographic lines – a finding backed up by other ISDA research. This point was also picked up by end-user speakers at the AGM, who talked of their efforts to minimise cross-border problems by reorganising their operations to ensure non-US entities avoid trading with US dealers. The result, they argued, was less liquidity and higher costs for certain products – something reflected in the end-user survey, which found 83% of those who had witnessed some level of fragmentation believe it had led to higher costs.

For the most part, though, many end-users – and corporates in particular – have been sheltered from the direct costs resulting from new regulation. Corporates are largely exempt from mandatory clearing requirements and from forthcoming uncleared margin rules, excusing them from having to stump up initial and variation margin on their hedges – money they believe would be better spent on investment and research and development.

But there are other indirect costs: dealers are subject to higher capital charges for uncollateralised trades via new credit valuation adjustment (CVA) rules. While European banks are exempt from having to apply this CVA charge for trades with corporate customers, other banks aren’t – and those capital charges are likely to be passed on. Dealers will also look to hedge any client transaction, and these offsetting trades will almost certainly require margin to be posted against them. The dealer would need to fund that margin, creating a cost that may well be handed down to the client.

End-user speakers at the AGM claimed not to have seen any marked increase in price so far, suggesting dealers are largely absorbing these costs at the moment. They did, however, say they had seen some banks pulling back from certain markets and products. In other panels, dealer representatives acknowledged banks now have to pick and choose, with higher capital and leverage costs forcing them to concentrate on those areas where they have an advantage or where they can meet return-on-equity hurdles.

That’s already having an impact, with liquidity diminishing significantly in certain markets, affecting the ability of end-users to manage their risks efficiently. One buy-side speaker said some customised products were either no longer available or were trading “by appointment” only. That’s a big problem, as tailor-made, bespoke contracts fulfil a real need by allowing firms to closely offset their risk. Any reduction in the availability or increase in costs for these products could encourage some companies to hedge less, some speakers warned – a result that would lead to increased earnings volatility, less certainty in cashflows and – ultimately – less investment, less job creation and lower economic growth. That fear was voiced forcefully by a number of AGM end-user speakers.

That scenario thankfully doesn’t appear to have played out yet. The end-user survey found that 79% of respondents plan to increase their use of OTC derivatives or keep their hedges at the same level during the second quarter of 2014. But higher costs, fragmented markets and less liquidity could eventually take its toll, depriving end-users of an important risk management tool.

That’s an unintended consequence no-one wants to see. Could we end up with less safe, less efficient markets? That’s the concern that was voiced over and over again in Munich.