A new post on initial margin and the recent speech by the Federal Reserve Board’s Vice Chairman has been posted on our sister blog, media.comment.
A new post on initial margin and the recent speech by the Federal Reserve Board’s Vice Chairman has been posted on our sister blog, media.comment.
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.
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.
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).
Cross border guidance, extraterritoriality, and third country issues. Mutual recognition and substituted compliance.
In the OTC derivatives world, these terms have replaced old favorites like day count fractions, credit events and calculation periods as topics for discussion and debate.
Comments flooded into the CFTC from industry and regulator alike on the long-awaited CFTC guidance on the cross border application of its rules (as the Commission refers to them) or to third country issues related to extraterroriality (as Europe refers to them). Regulators are struggling over the mutual recognition of another country’s regulatory regime, or a system of substituted compliance, where one country’s rules can take the place of another’s in order to achieve compliance.
All this back-and-forth is driven by the 2012 year-end deadline to comply with the G20 commitment on clearing, execution, reporting and capital for OTC derivatives. Where do the US and Europe stand in achieving those goals? What are the differences between approaches? And how significant are those differences?
To assist our membership in understanding both the similarities and the differences, we have worked with the Clifford Chance law firm to produce a comparison of rulemaking on critical issues in both the United States and Europe. This is version 2.0, as we produced an earlier version almost two years ago. And with the regulations still evolving, don’t be surprised if there is a version 3.0.
What the comparison shows is that there is significant commonality in the approaches to issues in the United States and Europe.
But there are also some important differences. Treatment of end-users, the notion of major swap participant in the United States and the so-called “push out” rule are among those differences.
There are also differences in the timing of certain rules, driven largely by the fact that trade execution and pre- and post-trade transparency in Europe are part of the revisions to the Markets in Financial Instruments Directive (MiFiD), which is still working its way through the European process. We are not likely to have clarity on those issues until late this year or some time into 2013.
The comparison has a helpful summary chart indicating which rules (clearing, reporting, margin, capital, registration) apply to which entities (dealers, other financial counterparties, non-financial counterparties). From there, a reader can drill down to all the details.
As with any language, there are several levels of comprehension. One can learn the words, then the grammar, but true understanding comes when you know the subtle nuances of a native speaker. Think of the comparison we have produced with Clifford Chance as your Rosetta Stone for being able to be bilingual in the new world of derivativese.
Former New York City Mayor Ed Koch was famous for asking New Yorkers “How am I doin’?” The response gave him a quick job rating from his constituents. Sometimes it was a cheer, sometimes a boo.
With the publication this week of a series of final rules from the CFTC, it might be timely to ask “How are we doin’?” This set of rules covers a range of issues, including confirmations, valuation, portfolio reconciliation, dispute resolution and compression. In short, it’s a laundry list of what ISDA and our members have been focusing on in recent years to deliver safe, efficient markets.
And we’re happy to report that, on balance, the final rules would seem to us to elicit more cheers than boos.
For example, one important issue involves an extension of the time period for compliance with a set of external business conduct rules. This extension was important for purely practical reasons as much remains to be done by market participants to amend their contracts to address these rules. The process of doing so began with the recent launch of the Dodd-Frank Protocol and ISDA Amend, a joint ISDA-Markit initiative that automates part of the required compliance. We already have over three dozen adhering parties and we expect that number to grow substantially over the next month or so. But even with the efficiencies provided by those processes, mid-October was looking like a stretch to get everyone—buy side, corporates, pension funds and others—on board. So the extension was much needed.
In other portions of the release, ISDA’s comment letters are cited as the basis for changes in the final rules. Our positions, of course, were not adopted across the board and some concerns remain, but many critical parts of the rules reflect a reasoned approach to achieving regulatory goals. For example, the CFTC decided not to apply the rules retrospectively, something we advocated. On disputes, the difference in valuations must exceed 10% before dispute mechanisms are triggered and reports of disputes to the regulators are required if the dispute exceeds $20,000,000. The time periods for resolving disputes have been extended although they are still shorter than we advocated or have been working toward in our ongoing collateral committee efforts.
Also, the release acknowledges the successful efforts undertaken with the OTC Derivatives Supervisors Group, led by the New York Fed, to address issues such as confirmation backlogs and portfolio reconciliation. In executing its legislative mandate, the CFTC must put its own stamp on these issues while building on the real progress made through ISDA’s and the industry’s efforts with the ODSG.
The CFTC also acknowledges in several instances the central role played by ISDA documentation, the global standard for documenting derivatives. That’s an important consideration, particularly as we proceed with many amendments to the documentation driven by the Dodd Frank Act. The CFTC does not explicitly endorse ISDA documentation because it points out parties can—and do—negotiate variations to those terms. We are, after all, dealing with privately negotiated bilateral contracts.
Finally, the rules indicate that the CFTC will not view failure to comply with documentation and confirmation requirements as a violation of the rules or the Dodd Frank Act so long as procedures are in place to comply and there is a good faith effort to follow those procedures. This is a practical approach, and it is encouraging that the CFTC is motivated to encourage compliance and appears not to be constructing traps for the unwary.
We and our members will continue to study these final rules to identify implementation challenges and concerns. We look forward to a constructive dialogue on these issues in order to foster safe and efficient markets.
And in the meantime, feel free to let us know how we’re doin’.
While it is summertime, the livin’ is not (always) easy. The EU regulatory process continues unabated and with the publication of a first complete Compromise Text on MiFID 2/MiFIR earlier this summer, the journey to trading obligations and platforms in the EU has well and truly begun. The process will take another step forward with the ECON Committee vote in the European Parliament, scheduled (after a postponement) for late September.
One of the big questions that remains unanswered in the MiFID/MiFIR debate – and that explicitly needs to be addressed before its resolution – relates to liquidity.
There are two aspects to this issue. One has to do with the use of liquidity as a benchmark or trigger for determining whether a rule applies to a particular obligation. The second has to do with the impact of the rules on the liquidity of traded financial instruments.
First things first: On the subject of a liquidity trigger, at what point should a financial instrument or market be considered liquid enough to support particular regulatory obligations? Such obligations might include those related to mandatory central clearing of OTC derivatives; mandatory trading of derivatives on regulated venues; or pre- and post-trade public transparency. That question is at least in focus in the MiFIR debate. Much less attention is being paid to an equally important question: when does an instrument or market stop being liquid enough to support those obligations; and how do you suspend them?
This is not just an academic discussion. Various provisions in the MiFID/MiFIR proposals reference liquidity as a trigger for particular obligations (notably the trading obligation and pre-trade transparency requirements).
Moving now to the second issue, the impact of the proposed rules on liquidity: To what extent could additional regulatory obligations increase or impair the existing liquidity of a particular financial instrument or a market as a whole? To be fair, some policymakers show awareness and sensitivity to this issue.
In the continuing dialogue over the proposed rules (particularly over the trigger issue), it is important that policymakers consider the potential for liquidity to vary over time. To put it bluntly, there is no market where permanent liquidity can be guaranteed (or, by the same token, mandated). This might reflect changes in market conditions in general, or simply the nature of the individual product.
Changes in liquidity levels could be inherent to the product in question, with liquidity falling in the period after the conclusion of the contract. For example, an ‘off-the-run’ credit index contract is likely to be significantly less liquid than the ‘on-the-run’ equivalent. And, even for an on-the-run index, the five-year maturity will be liquid where, say, the four-year is not. Changes in liquidity levels could also reflect external factors, such as weakening in the supply of credit. For this reason, it is important that the market infrastructure is sufficiently flexible to accommodate any change in liquidity.
In addition, given the potential for liquidity to change, liquidity triggers should also typically be two-way, i.e. the trigger should not only define when a particular regulatory provision applies, but should also define when the provision ceases to apply. Ideally, it should be possible to suspend particular obligations immediately, to ensure that markets continue to function (albeit with less turnover) during times when liquidity is stressed.
It has long been our view that legislative reform should support liquidity in the interest of systemic resilience, should protect the funding requirements of corporates and sovereigns and should advance the principle of strong risk management. And to that end, we support linking obligations to liquidity in appropriate circumstances. However, liquidity triggers:
• Must consider the various factors that collectively constitute liquidity;
• Must be forward-looking;
• Must be two-way so that obligations can be disapplied when necessary.
There are many welcome and positive developments in the Compromise Text. However, where the European Securities and Markets Authority (ESMA) is given the task of determining or applying a liquidity trigger, then its mandate should be such as to allow it to consider all relevant factors.
We launched derivatiViews just about a year ago, and one need only look at the topics we have covered to get a sense of the issues we and the OTC derivatives industry have been facing. Let’s take the opportunity to reflect on some of those issues and also consider what lies ahead.
Of course, regulation and its implications have been a steady focus of derivatiViews. We have tried to be constructive in our commentary, recognizing the challenges that regulators face as they create a new regulatory regime. For instance, we acknowledged the notion under CFTC rules of the “legally separated, operationally comingled” approach to cleared margin segregation as a serious effort to balance a range of different views. Similarly, although we are still studying the details of the product definition rules, we recently noted the hurdles that the CFTC and the SEC had to clear to get to a final rule. The issues facing other regulators, particularly those in Asia, have been a periodic theme of our posts.
One development we wouldn’t have anticipated a year ago was that we would be in litigation against a regulator, specifically the CFTC. As we explained in December, this was not a step we took lightly, but we, together with our co-plaintiff, the Securities Industry and Capital Markets Association, believed that the way position limits had been considered in the rulemaking process, particularly the lack of consideration of the costs and benefits, cried out for scrutiny by the courts. As of this writing we are still awaiting word from the judge on the case. Regardless of the outcome on the case, we will remain engaged in the US, Europe and around the world in achieving a regulatory structure that works for everyone affected by derivatives. Which is pretty much everyone.
The continuing financial crisis in Europe provided ample opportunity for us to comment. We used this platform to further understanding about the role of CDS, the need to understand the legal terms and the importance of collateral in helping to reduce risk in these trades. When, in the end, the EMEA Determinations Committee decided that the forced restructuring of Greek debt constituted a credit event, we reflected on the many lessons learned and highlighted steps that we would take in light of that experience.
Halfway through this year it is also an opportunity to reflect on progress on our resolutions for the new year. We have remained actively engaged in capitals around the world on the issues affecting our industry. We are also in contact with global bodies, such as the Basel Committee, the Financial Stability Board and IOSCO, which play an increasingly important role in regulatory for this global business. We commented on the recent progress report by the FSB on progress toward the G20 commitments, which acknowledged the progress that has been made, particularly on clearing, and the significant work that remains to be done. It also acknowledged that market liquidity should be a consideration as countries consider mandates for execution, which had been the subject of a derivatiViews post from late last year.
We also remain focused on the steps necessary to increase safety and efficiency of our markets, including the many aspects of clearing, from documentation to margin to capital. In just the past few months we have remarked on the demands on collateral given the reliance on it in cleared and uncleared trades, the connectivity between the cleared and the bilateral world and the challenges of achieving meaningful consistency in data and reporting. Each of these issues has serious implications for the safety and efficiency of our markets.
We will continue to pursue our stated goals for the remainder of this year and beyond. And we will be prepared to address new developments that will no doubt drive our agenda. Whatever develops, please continue to check back here at derivatiViews for our take.
Musings about “the meaning of life” cross philosophies, cultures and centuries. Among the philosophical strands cited by Wikipedia that have contemplated this most basic of questions are utilitarianism and pragmatism together with stoicism.
More recently, the derivatives world has been contemplating the meaning of swap, a question that is central to existence in the post Dodd-Frank world. The CFTC and the SEC have now produced their treatise on this question* and it is one that we will all be studying in great detail over the coming days and weeks to see what answers it holds. And as with the meaning of life, we might be well served by looking at this final rule in a utilitarian and pragmatic way, while remaining stoic as we contemplate its implications.
The most immediate impact of the publication of the definition of swap is that the clock starts ticking on many rules that, by their terms, were not slated to become effective until the definition of swap was final. Reporting requirements will commence 60 days after the rule becomes effective (the date of publication in the Federal Register). Various timetables relating to clearing, including mandates for the clearing of certain trades, will now commence. There will be many clocks ticking over the coming months.
Congress left the agencies with the task of filling out the definition of these terms and it has been a long process to get to these final definitions. There is a case to be made that this definitional rule should have been one of the first rules finalized, and not one of the last. And, if Dodd-Frank had allowed the agencies to proceed on a more logical timetable, they might have adopted that approach. But the fire hose of rulemaking required by the law made it difficult for the agencies to take that more logical approach.
The swap definition is also one where the CFTC and the SEC had to come to agreement given the divided oversight of the OTC derivatives business mandated by the law. The market will benefit from consistency of their approach to this issue, so the additional time it took to get to the final, joint approach to the definition will hopefully prove time well spent. Still, the translation of the jurisdictional divide between the securities and futures world into the OTC derivatives creates challenges. One need only consider the experience with single stock futures over the past decade to get a sense of the regulatory challenges that can be created by something like a “mixed swap.”
One issue that remains open is the treatment of guarantees of swaps. Both agencies take the view that the guarantee would be considered part of the swap and, therefore, subject to its jurisdiction. But for now we must await further guidance on how they will treat the guarantee. Given the central role of the definition, how they address the guarantee issue may have implications for other parts of the agencies’ rulemaking, such as reporting and even registration.
There are many details in the final rule that will require a close reading of the rule and the possible need to approach the agencies for interpretive guidance. ISDA will be working with our members, both to assist them in understanding the rule and, where necessary, seeking that guidance. The meaning of swap, like the meaning of life, is best contemplated together with others who share the journey.
* The CFTC defined the term “swap” and related terms; the SEC defined the term “security-based swap” and related terms.
In many parts of the world, schools have come to the end of their terms, which makes it a nervous time for students: they are waiting for the report card to arrive. We at ISDA empathize, as we too have been waiting for a report card. It came this past Friday, in the form of the Financial Stability Board’s Third Progress Report on Implementation of OTC Market Reforms. The report measures progress toward the G20 commitments to reform OTC derivatives markets, agreed upon at the 2009 meeting in Pittsburgh.
So how did the OTC derivatives markets do?
Pretty well. As the report states:
Since the FSB’s previous progress report in October 2011, encouraging progress has been made in setting international standards, the advancement of national legislation and regulation by a number of jurisdictions and practical implementation of reforms to market infrastructures and activities.
One part of the report – the FSB’s discussion of exchange and electronic platform trading and market transparency – was especially encouraging. It elaborates on a recommendation to consider costs and benefits from their October 2010 report by explicitly adding that, “Authorities need to take action to explore the benefits and costs of public price and volume transparency…. including the potential impacts on wider market efficiency, such as on concentration, competition and liquidity.” We can’t say that the FSB has read our cost-benefit analysis of the Dodd-Frank requirement for SEF execution, but that sounds very familiar to the cost concerns that we raised in that study.
The biggest takeaway is that much remains to be completed by the end-2012 deadline to achieve the G20 commitments. The FSB leaves no doubt that they will be closely watching and driving for progress in the months ahead. As it states:
For the next progress report, the FSB intends to put additional focus on the readiness of infrastructures to provide central clearing, platform trading and reporting of OTC derivatives, the practical ability of industry to meet the requirements and the remaining steps for industry to take.
The report acknowledges that the largest markets in OTC derivatives – the EU, Japan and the US – are the most advanced in their progress. It also recognizes that other jurisdictions are understandably waiting for those three regions to finalize their approaches before committing to a particular path of reform. It urges all jurisdictions “to aggressively push ahead to achieve full implementation of market changes by end-2012 to meet the G20 commitments in as many reform areas as possible.”
That’s the assignment for the public sector. But the FSB also has some assignments for the private sector, ones that we at ISDA are actively engaged in. Market participants are urged to address standardization, clearing, trading on organized platforms and reporting to trade repositories. Check, check, check and check – those are on ISDA’s agenda as well.
In short, the report card was delivered, but there will be no extended summer break for the OTC derivatives industry or all of us here at ISDA.