Surf’s Up!

Summer is here and the beaches are open in the US, Europe and elsewhere. How appropriate then that the second wave of mandatory clearing has now hit US shores.

This is an important development, and marks a big step forward in reducing counterparty credit risk through clearing, which is one of the two major strategic G20 initiatives to reduce systemic risk.  (The other – increased regulatory transparency – is being accomplished through trade reporting and the establishment of trade repositories.) At this point, the vast majority of interest rate and credit default swaps in the US must be cleared.

The first wave of mandatory clearing in March covered the (relatively) low hanging fruit, entities like dealers and active traders that were already clearing or well-prepared to do so.

The June wave of mandatory clearing covers a wider swath of the asset manager and fund communities. The focus has been on putting in place legal documents and operational arrangements that will enable these entities to clear the interest rate and credit default swaps for which clearing is now mandated. Dealers, clients and regulators will be closely observing this experience as many of these entities will be clearing trades for the first time.

ISDA has worked with its members to address the challenges of this new wave of mandatory clearing. The phased implementation adopted by the CFTC was an outgrowth of discussions between ISDA and the CFTC dating back to 2011. The documentation that firms are using is based on the FIA-ISDA Clearing Addendum published a year ago. And we announced on Monday that four dealer firms have announced their support for the Clearing Connectivity Standard (CCS) we are developing with Sapient to facilitate reporting of cleared swaps. We believe CCS provides a sound basis for reporting and communication, initially here in the US and, in due course, around the world.

And the clearing tide is rising in other parts of the world. ISDA is working with its members and regulators in other jurisdictions to anticipate those developments. This week we announced, together with the Futures and Options Association, the publication of a clearing addendum for use in the European context in clearing arrangements that use a principal-to-principal arrangement, instead of the agency model (FCM) required in the US. While driven by the upcoming clearing requirements under EMIR, the ISDA-FOA addendum can be used in any jurisdiction where the principal arrangement is used.

The final wave of mandatory clearing in the US arrives in September. The experience of the first two waves and the efforts of ISDA and its members to date will, we believe, position the swaps industry well as that next wave comes ashore.

And let’s not lose sight of the broader landscape of regulatory reform and the progress that has been made.

The September 2009 G20 commitments in Pittsburgh provide the contours of reform, with clearing and trade reporting foremost among them. Sure, there are issues firmly on the horizon yet to be fully resolved (SEF implementation, MiFIR, extraterritoriality, initial margin, to name a few). But the progress made on clearing and trade reporting is significant, something we’ll be reporting on soon in our semiannual market analysis.

So that’s the lay of the land – and the sea – of derivatives regulatory reform.

On the (broken) record…

Last Monday, ISDA submitted its response to the second BIS/IOSCO consultation on “Margin requirements for non-centrally cleared derivatives”. The second consultation asked market participants to comment on two specific areas: the treatment of physically-settled FX transactions, and the question of re-hypothecation. At the same time, it asked for comments on the newly proposed phase-in of initial margin (IM) requirements, and the accuracy and applicability of the results from the Quantitative Impact Study (QIS) conducted as part of the first consultation.

Here are some of the broad themes that emerge from the second consultation:

First, the regulators’ stance towards IM requirements remains unchanged. The IM proposals contained in the second consultation are in line with those of the first consultation, calling for imposing a universal two-way initial margin (IM) requirement on all covered entities (all OTC derivatives participants except for sovereigns, supranationals, central banks and non-systemically important corporates). However, the second consultation excludes entities with aggregate notional amounts of less than €8 billion notional outstanding during the last three months of the preceding year.

Second, while the regulators seem to acknowledge the potential impact of the IM requirements on liquidity, they attempt to mitigate these negative effects by:

  • Phasing in and gradually applying the requirements starting in 2015 with the largest entities (those with more than €3 trillion notional during the last three months of the preceding year), and gradually capturing all covered entities by 2018;
  • Allowing limited netting to be used in connection with the standardized table method;
  • Contemplating (and asking participants about) the possibility of some form of re-hypothecation.

Third, the published QIS results confirm ISDA’s estimates as to the quantum of the proposed IM requirements. If nothing else, the QIS results indicate even higher quantities of required collateral to meet the IM obligations (from $1.7 to roughly $2.2 trillion, if all covered entities use internal models – and from $0.8 to $0.9 trillion – and a potentially higher number, depending on how the €50 million threshold is applied1).

Indeed, reflecting the regulators’ anxiety as to the quantum of the IM proposals, there are some encouraging morsels in the stew, such as the effort to exempt a number of smaller entities. Unfortunately, even in this case, the metric used is notional amounts. Since that is not risk sensitive, it is inconsistent with the overall objective of reducing systemic risk. It would make more sense if the metric used was risk sensitive and, as we suggest in our response, took into account the hedging activities of the entity.

Most importantly, if one takes all of the above into account, the thrust of the consultation and the industry’s response remain more or less unchanged. If the proposed IM requirements go ahead as proposed, the sheer quantum of them is likely to cause irreparable damage to market liquidity and to the general economy. We have repeatedly listed these arguments before in various shapes and forms; in our March paper Non-Cleared OTC Derivatives: Their Importance to the Global Economy; in last November’s presentation Initial Margin For Non-Centrally Cleared Swaps: Understanding the Systemic Implications; and also in a shorter take in a media.comment post from January.

Moreover, as our research in the collateral space expands, so does our anxiety as to the potential effects of the IM proposals to the general economy. Collateral serves a fundamental function in the secured financing market and is a source of liquidity as it is a substitute for money/credit. Removing trillions from the collateral market, however phased-in such requirements are, undoubtedly will have a negative effect on the economy.

And if those adverse effects are not enough, there’s another factor to consider: the IM requirements are highly pro-cyclical, hitting participants at the worst possible time when everyone is on a quest for liquidity. In an effort to enhance systemic resiliency by reducing counterparty risk, we may be introducing other risks, such as liquidity and economic risk, that may make it harder to achieve a more resilient system.

So, for the record, that’s where ISDA stands on the IM issue. If the record sounds a little broken because we have been playing it a lot recently, that’s because we have. These are important issues and it’s clear that their impact needs to be fully assessed before they are finalized and implemented.

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1 The new consultation seeks to apply the €50 million threshold on a consolidated basis, potentially neutralizing the benefit this exemption, as the threshold gets divided by the number of entities belonging in the consolidated group.

All Quiet on the Clearing Front

A milestone week for OTC derivative clearing has come – and almost gone. Unless you are immersed in Dodd-Frank (like we are) you probably didn’t even notice.

And that’s a good thing.

Starting this past Monday, swap dealers and active funds* in the United States have been required to clear various interest rate swaps and CDX credit trades. No one would guarantee beforehand that things would go smoothly, but at this point we can say that everything went pretty much according to plan.

At the end of the first day of clearing we reached out to our members to hear about their experiences, particularly any significant issues they may have had. As the adage goes, silence is golden. No issues of any particular concern were raised and three more days of smooth sailing on the clearing front only reinforces that view.

Deadlines always help to focus attention and we know from our members – buy side, sell side and CCPs – that they were working hard through the past weekend to get systems and documentation up to snuff for Day 1 of Clearing. Perhaps a few even listened to our urgings from a month ago. All that hard work paid off.

One reason this first wave of clearing went smoothly is that much of the clearing to which the mandate applied was already underway. Dealer-to-dealer trades in the affected product types have been cleared for quite some time. At least some of the active traders had tested the waters on clearing. This reflects the industry’s commitment to the key tenets of regulatory reform that reduce systemic risk, including the reduction of counterparty credit risk through clearing.

With one deadline successfully met, market participants are looking ahead to several new ones. External Business Conduct Rules (EBCR) become effective on May 1. The next two waves of clearing occur on June 10 (for commodity pool operators, private funds and non-dealer financial entities) and on September 9 (for everyone else, other than commercial end-users).

For the May 1 deadline, we will be rolling out our next Dodd-Frank Act protocol shortly and will be holding an EBCR webinar on Thursday, March 21 (click here to register). For the next waves of clearing we will continue to work with our members and the broader market to assist them however we can to prepare for those important dates. Those next categories of market participants facing the clearing mandate are a bigger universe than the active funds, making the education process even more of a challenge.

Future efforts will be buoyed by the experience of the first day of clearing. When it comes to the many challenges of regulatory implementation, we firmly believe that success breeds success.


* The clearing mandate also applies to major swap participants, but at this point only two firms have registered as such and neither is engaged in new trading.

Why Limit Customer Choice on SEFs?

Last week we published the results of a survey of buy-side firms on proposals to mandate how many quotes must be requested when utilizing a swap execution facility (SEF). The CFTC proposal would require a minimum of five quotes and the entire industry has been waiting to see what the final rules will say on this point.

The survey, which we conducted with the Asset Manager Group of SIFMA with additional input from the Managed Funds Association, indicates overwhelmingly that the five quote minimum requirement will mean higher transaction costs, wider spreads, constrained liquidity, exposing of investment strategies, migration to different markets and use of alternative products that are not traded on SEFs.

Is this what regulatory reform was intended to achieve?

The fact is, the creation of SEFs was intended to provide a third way of trading derivatives, fitting along a spectrum that included the traditional means of OTC derivative trade execution on the one hand and the exchange traded world on the other. Sitting in the middle of that spectrum would allow SEFs to blend the best of both worlds. If SEFs are not sufficiently different from the former or too much like the latter, we would fall short of one of the goals of the G20 and the Dodd-Frank Act.

Dictating, and in the process limiting, customer choice does not seem to us to be a good way to achieve those goals. A minimum quote requirement takes the decision out of the hands of the users of the products with no clear demonstration that better pricing, lower costs or greater liquidity would result.

And who is more able to opine on such matters than the participating firms in the survey? Asset managers, hedge funds, insurance companies, pensions, foundations, endowments, corporates and others, together holding nearly $18 trillion in assets responded to the survey. Does someone other than those institutions know better than they what suits the needs of their accounts and investors?

SEFs can and should flourish, if we get the regulatory structure right. Many firms are eagerly awaiting the final rules from the CFTC so that they can begin final preparations to register as SEFs and launch their offerings. Rigid requirements with no demonstration of benefits, such as minimum quote requirements, will only weigh down these innovative offerings.

Let’s not burden SEFs and their many potential customers before they even get up and running.

The Ides of EMIR

We recently wrote about the first deadline for clearing in the United States, which applies to swap dealers, major swap participants and active funds. We now have official confirmation of the deadline for a number of requirements under the European Market Infrastructure Regulation (EMIR). With the publication this past Monday of the regulatory technical standards under EMIR, that date is now confirmed as March 15 ‒ less than two weeks away.

Under the CFTC rules in the US, non-financial end users will not be subject to the clearing mandate. That is not the case in Europe, where non-financial end users (called non-financial corporations, or NFCs), depending on their level of activity, may be required to clear transactions if their derivatives activity exceeds thresholds of €1-3 billion (after hedging), depending on asset class.

But the immediate focus under EMIR is not clearing, but several other requirements.

In order to assist end users in navigating the EMIR rules to determine which provisions they need to comply with, we held a webinar this week. Our public policy team was joined by end user representatives who have been at the forefront of derivatives regulatory developments (you can access the slides from the webinar here).

The webinar focused primarily on the compliance needs of European NFCs. Of particular interest were the challenges faced by smaller firms who may not have the resources to keep up with the rapidly changing regulatory landscape, nor with the new obligations EMIR creates for them. As such, a key objective of the webinar was to increase awareness of the obligations and promote compliance.

Equally important to convey was that even if NFCs do not face a clearing requirement from EMIR, they will face other requirements under this Regulation, some applying as soon as March 15. And of course, their counterparties ‒ the providers of OTC derivatives ‒ will be subject to all the new EMIR rules, which will affect the pricing and availability of OTC derivative products for everyone.

On March 15 the confirmations obligation kicks in for all entities in scope under EMIR (financial corporations (FCs) and NFCs alike), and EMIR requires that all such entities have procedures and arrangements in place to confirm transactions. For subgroups of FCs and for those NFCs that are likely to exceed the above-mentioned clearing threshold (sometimes referred to as NFC+s), there are additional obligations in the form of required daily mark-to-market and mark-to-model valuations.

That fast-approaching Friday, March 15, is also the date by which potential NFC+s are required to declare to their competent authority if they exceed the clearing threshold. Such thresholds are set by asset class (again, €1-3 billion exclusive of “hedging” transactions), and breaching a threshold in any asset class creates the obligation to clear all asset classes.

Later in the year (around Q3), all entities face obligations that address portfolio reconciliation, portfolio compression, and dispute resolutions. Reporting to trade repositories begins for interest rates and credit derivatives, effective 90 days after a trade repository has registered. Other asset class reporting will be phased in beginning in 2014. Finally, mandatory clearing will start some time in the summer of 2014, assuming all goes well with the CCP authorization process.

Clearly, a lot lies ahead. ISDA is committed to work closely with the regulatory community and will continue – through the Regulatory Implementation Committees (RICs) that have been set up for this purpose – to interpret the new obligations, and to assist members with compliance.

Be Pro-Active with One Month to Clearing

March brings the first day of spring and the first days of mandatory swap clearing in the United States and Europe. In this derivatiViews, we focus on the imminent deadline in the United States. Next time we will focus on the state of mandatory clearing in Europe in light of last week’s action in the European Parliament.

The first wave of mandatory clearing in the United States comes into effect on March 11, 2013. The CFTC has specified both the categories of entities that must begin clearing, and the types of transactions that must be cleared, commencing on that date.

Swap dealers, major swap participants and active funds must begin clearing several categories of interest rate swaps and four categories of CDX and iTraxx credit default swaps. This timetable has been fixed since last November, when the categories of swaps subject to mandatory clearing were finalized by the CFTC.

Even with the advance notice, we know that many market participants that will be affected by this development, particularly the active funds, face compliance hurdles. In order to assist our member firms, we have prepared a standard form letter that can be sent to active fund customers to alert them to the requirements. Whether you are a potential sender of the letter or a potential recipient, we urge you to take the time to read it.

Keep in mind that some funds may still be determining whether they hit the “active” threshold of 200 trades a month which determines if they must comply with this first-wave clearing mandate. And swap dealers face a challenge in determining which of their customers hit the threshold because that determination is not just a function of their trades with the fund, but all the trades that the fund does with any counterparty.

The ISDA August 2012 DF Protocol and our ISDA Amend process provide a convenient mechanism that funds can use to communicate with their dealer counterparties about whether they are an active fund and, therefore, subject to the clearing mandate on March 11.

Much of the DF Protocol relates to business conduct requirements that come into effect on May 1 (as extended pursuant to a no-action letter at the end of last year). However, for entities that face the March 11 clearing mandate, the deadline is now, for all intents and purposes. As we urged in our December derivatiViews linked above, proper planning for Dodd-Frank requirements is best done as early as possible. Don’t wait until the last minute.

As always, the ISDA staff is available to provide assistance as these deadlines loom. The ISDA website, in particular our Dodd-Frank Documentation Initiative page, is your best first stop to understanding what lies ahead in the United States.

We will march on to clearing in Europe next time.

No Action ≠ Do Nothing

As the year draws to a close, we are seeing a steady stream of no action and other determinations coming out of the CFTC. ISDA has been actively involved in seeking those decisions from the CFTC in response to members’ concerns and very practical considerations that made compliance in the timeframes required increasingly challenging as deadlines loomed. We and market participants are grateful for the responsiveness of the CFTC to the concerns that have been raised. We believe that the dialogue we have established in this process will serve the industry well as regulations come into effect in 2013.

We have just posted a presentation on our website that gives an update on the status of the various no-action requests. Where the request has been granted, links are included to the letter issued by the CFTC, which includes the terms and conditions on which the relief was granted.

An important lesson to take away from the no action process is that the industry’s efforts to achieve compliance with new regulations must proceed with an undiminished level of intensity even in the face of the actions taken by the CFTC. This is for a number of reasons.

First, certain requirements are not delayed. Most importantly, reporting for credit and interest rate swaps kicks in at the end of the year. And, while reporting for equity, FX and commodity trades has been delayed, it is only until Feb. 28, 2013. So January will be busy regardless.

Second, one of the reasons that the CFTC was receptive to providing these targeted delays in effectiveness of certain provisions was because they saw demonstrable efforts being made toward compliance. For example, the ISDA Dodd-Frank Protocol now has over 4,000 adhering parties, and that number is growing steadily. But the rate of uptake on questionnaire delivery via our ISDA Amend solution  lags behind. So ISDA and market participants must show that the additional time will be warranted to  achieve greater compliance rates with the use  of these effective tools.

Finally, more deadlines will loom next year as the requirements in Europe begin to take effect. We just heard that the timetable is jelling around reporting starting mid year, reconciliation and dispute resolution in late summer and frontloading of trades into clearing later in the year. Clearing mandates won’t likely apply until summer 2014, but many other steps will need to be taken in anticipation of those mandates. So the short delays achieved in the US through the no action process will only lead to a compression of compliance activity globally.

ISDA stands ready to assist its members in understanding and implementing these regulatory changes. We will also maintain an active dialogue with regulators to help them understand where the pressure points may be in the compliance process so that the changes are implemented in a way that achieves policy goals with the least disruption to market liquidity and the ability of companies to hedge risk.

So enjoy the holidays and be prepared to join with us as we continue to address the major changes underway.

IM getting serious

Click to open ISDA’s new Initial Margin For Non-Centrally Cleared Swaps Analysis

A key recommendation of the G20 2009 Pittsburgh Communique was to enhance systemic resiliency by reducing bilateral counterparty risk and mandating central clearing of “standardized” OTC derivatives. ISDA and market participants are fully supportive of the G20’s clearing initiatives. Today, more than half the market is cleared and more clearing is on the way.

However, most industry estimates expect that 20 percent or more of the notional value of OTC derivatives cannot be and will not be clearable. Such swaps play an important economic role for the global economy, ranging from housing to corporate financing. Policymakers are hoping to eliminate counterparty risk of these unclearable trades by proposing margin requirements – both initial (IM) and variation margin (VM) – for them.

We fully support mandatory exchange of VM among covered entities. Experience (good and bad) has demonstrated that the practice of frequently exchanging the unrealized mark-to-value fluctuations between two parties is beneficial in reducing counterparty risk. It avoids the build-up of large unrealized positions that could become destabilizing in periods of market stress. This is a widely adopted practice in the OTC derivatives marketplace. And, had this practice been followed – which was NOT the case with AIG and certain monolines in the US – counterparty risk would not be the issue it has become today for the OTC derivatives industry. So, the requirement for VM exchange alone would be more than enough to address counterparty risk concerns.

However, while we support the use of VM, the same can not be said for imposing mandatory IM on counterparties. A rudimentary risk/benefit exercise reveals that the approach is flawed. We see minimal benefits in terms of incremental risk reduction – above and in excess of what is already provided by capital requirements.

Instead, we see huge risks in the making. The outright quantum of margin required under these proposals, even in “normal” market conditions, is significant.

Take, for example, the data that is coming out of the QIS study that the BCBS/IOSCO is conducting. The numbers are revealing. Even if we take the most optimistic scenario (where ALL market participants use some form of internal model to maximize netting benefits), we still estimate incremental margin requirements of approximately $800 billion. This is an amount of incremental collateral which, even under normal circumstances, is challenging to raise.

What’s worse: we know that IM requirements in stressed conditions could go up by at least three times, raising potential requirements at a time when liquidity will be most needed. This is a clear recipe for disaster, only exacerbating systemic risk. And as to the proposed use of thresholds to alleviate the IM impact, at times of crisis, they just make the problem worse. It’s a message we plan to share with supervisors and regulators around the world. (ISDA’s recent analysis of data regarding IM estimates and their impact is here.)

In short, ISDA believes that mandatory, risk sensitive IM will not achieve its purported goals. We instead advocate a three pillar framework for ensuring systemic resiliency: a robust variation margin framework, mandatory clearing for liquid, standardized products and appropriate capital standards.

No Margin for Error

On Friday, ISDA submitted its response to the BCBS/IOSCO proposal on Margin Requirements for Non-Centrally Cleared Derivatives. This is one of the most important issues today in financial regulation. It is not hyperbole to suggest that the future of OTC markets depends on getting it right. Less apparent, but equally true, is that the resiliency of the financial system does too.

Broadly speaking, the BCBS/IOSCO proposal aims to reduce counterparty risk, a goal ISDA shares. But they seek to do it by imposing a universal two-way initial margin (IM) requirement on all covered entities. Covered entities are defined as all OTC derivatives participants except for non-systemically important corporates, sovereigns and central banks. The proposals also call for variation margin (VM) exchange by all covered entities. And if the above were not enough, the proposals call for collateral exchanged to remain segregated and not be re-hypothecated.

It is obvious that the BCBS/IOSCO proposal aims to replicate the mechanics found in the context of clearing. CCPs seek to completely insulate themselves through the imposition of VM (which settles unrealized gains/losses), and IM (meant to provide a cushion to absorb losses that may materialize in trying to cover its risk if a counterparty defaults). By doing so, CCPs effectively neutralize (to a 99% confidence interval) counterparty risk.

And there lies the rub.

In the context of a CCP, such a minimization of counterparty risk is appropriate and the utilization of VM and IM are tools (along with their default funds) used to accomplish this objective. CCPs are not supposed to take credit risk themselves, but to pass through the benefits associated with multi-lateral clearing. However, extending these concepts to the bilateral context is inappropriate, because the parties involved are typically creditworthy entities on their own, and back their creditworthiness with their own capital as well as the proper use of credit mitigants.

So, imposing mandatory margin requirements on bilateral trades would be tantamount to insuring for the same risk twice.

We can understand – and in fact, we fully agree with – the mandatory exchange of VM among covered entities. Experience (good and bad) has demonstrated that the practice of frequently exchanging the unrealized mark-to-value fluctuations between two parties is very beneficial in terms of reducing counterparty risk. It helps avoid the build-up of large unrealized positions that could become destabilizing in periods of market stress. This is a widely adopted practice among practitioners in the OTC derivatives markets. Had this practice been followed by AIG and certain monolines in the US, counterparty risk would probably not have become such a big issue.

While the requirement for VM exchange alone would be more than enough to address counterparty risk concerns, the BCBS/IOSCO proposal goes a step further. In order to further reduce counterparty risk in the eventuality that one of the parties in a bilateral trade defaults, they call for IM to establish a buffer. The buffer – the IM – is meant to absorb any losses realized during the time (10 days) when the non-defaulting party is closing out or replacing the risk it had with the defaulting party. This innocuous step has huge unintended consequences.

In addition to being unnecessary (as this exposure is typically covered by other risk mitigants that the two parties typically agree among them), this arrangement is inefficient. That’s because BOTH parties are required to post IM – but only one defaults. It would also require all covered entities to create new set ups to meet these requirements (be they in the form of new operational processes, cash and collateral and custodian management needs, new agreements etc.). All of this implies higher costs for derivatives users as they will bear the increased cost of doing business, irrespective of whether they are covered entities or not.

Unfortunately, the detrimental effects of this proposal do not stop here. While one cannot argue with the intentions of the regulators to reduce counterparty risk, it seems that the potential implications of this proposal have been grossly underestimated. The combination of requiring the posting of an across-the board two-way IM – which has to be segregated and cannot be re-hypothecated – leads to some very large collateral requirements.

ISDA has performed some preliminary analysis to gauge the potential demand for collateral that this proposal could generate. If this were to be implemented on the existing portfolio of non-cleared OTC derivatives outstanding, incremental collateral demand could run as high as $15.7 trillion.

Now $15.7 trillion may sound like a very large number. It is! But for all practical purpose, any number above a couple of trillion would make the cost of meeting such requirements prohibitive – even if it is feasible at all to locate so much collateral. Collateral demand in such amounts is likely to cause irreparable damage both to the OTC derivatives market, but also to the general economy.

So, once again we have come full circle. Risk does not disappear. It just changes form. Regulators have initiated margin proposals to enhance systemic resiliency by reducing counterparty risk. But in the process of doing so, they are about to decrease systemic resiliency by introducing healthy amounts of liquidity risk (caused by the shortage of collateral) and economic risk (caused either by the shortage of liquidity and/or by all the economic risks that are likely to remain unhedged).