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.

The euro swaps surprise

As surprises come, it should have been a non-event. On March 18, Swedish clearing house Nasdaq OMX announced it had been authorised as a central counterparty (CCP) under the European Market Infrastructure Regulation (EMIR), the first in Europe to get the regulatory nod of approval. Clearers had to submit their applications by September 15 last year, and national authorities had a six-month limit to consider them once they were confirmed as complete, meaning the authorisation was well in line with the schedule outlined by the European Securities and Markets Authority (ESMA).

Nonetheless, the announcement caught the market completely unawares, and has led to a situation where European derivatives users are unsure how to price and risk-manage euro-denominated interest rate swaps, the largest segment of the interest rate derivatives market.

How did this happen?

It all boils down to the oddly named and much misunderstood frontloading requirement under EMIR. Frontloading is a bit of a misnomer – it actually refers to a requirement to backload certain derivatives transactions to a CCP, specifically those trades conducted between the point in time ESMA is told a clearing house has been authorised to clear certain derivatives classes and the start of a clearing obligation for those products.

The problem arises because it’s uncertain which trades will be captured by this requirement, and when. Once ESMA is notified of a CCP authorisation, it has six months to conduct a consultation and draw up regulatory technical standards for each class of products it thinks may be suitable for mandatory clearing. The European Commission (EC) then has up to three months to endorse the standards, before they pass to the European Parliament and Council of the European Union, which have up to two months to accept the rules if they haven’t been modified by the EC and up to six months if they have. The rules are then published in the official journal, and come into force 20 days later.

According to a time line published by ESMA last year, the earliest a clearing mandate will come into effect after a CCP is authorised is nine months; the latest is 16 months. But there could be phase-ins written into the rules that extend the start date beyond that.

This all matters because Nasdaq OMX doesn’t just clear the smaller Scandinavian currencies – it also clears euro interest rate swaps. That means the clock is now ticking, and any euro swap transacted by a European participant from March 18 onwards may need to be backloaded to a CCP at some unknown time in the future.

This creates some real risk management headaches for European derivatives users. Should individual trades now be treated as cleared, non-cleared, or a mixture of both? It’s virtually certain a clearing mandate will apply for euro interest rate swaps at some point, but it’s not clear when. The situation is even less clear for other, less liquid products – ESMA may decide after its consultation period that some instruments are not yet suitable for mandatory clearing, particularly if they are only cleared by a single CCP.

Market participants had hoped regulators would provide further clarity on frontloading before the first CCPs were authorised. Without this guidance, derivatives users can’t be sure whether any single trade will ultimately be subject to frontloading or not. That’s why the approval of Nasdaq OMX came as such a shock.

Further clarity will come at some point. But the sooner the better. Until it does, uncertainty will continue to hamper risk management in the euro swaps market, making it more difficult for end-users in Europe to implement the hedges they need.

Progress, of a sort

Eight months on from the much-heralded “path forward” agreement that set a roadmap for how US and European regulators would deal with cross-border regulatory issues, the fruits of the new cooperative approach have started to emerge. In February, the Commodity Futures Trading Commission (CFTC) issued conditional no-action relief allowing US entities to continue trading on European multilateral trading facilities that haven’t registered as swap execution facilities, so long as those platforms meet requirements that are identical to those applied in the US.

It may not have been exactly what some European venues were hoping for, but this represented notable progress. At one point last November, following two clarifications by the CFTC that seemed to extend US rules further than ever before, it looked like the path forward would become a road less traveled.

There’s still a huge number of cross-border issues that need to be tackled – among the most urgent, Europe’s equivalence determinations for US central counterparties (CCPs). Under the European Market Infrastructure Regulation (EMIR), European banks would not be allowed to act as clearing members of any CCP in a non-equivalent jurisdiction, while Europe’s Capital Requirements Regulation prevents them from applying the lowest possible 2% risk-weight for cleared exposures at those venues. Together, these rules could have a devastating impact on the business of any non-equivalent clearing houses.

A comparison between US and European clearing rules throws up a number of seemingly intractable inconsistencies – for instance, a one-day margin period for futures contracts under US rules less onerous than the two days required under EMIR. Nonetheless, some have speculated that the new-found spirit of cooperation between US and European regulators may allow a compromise to be reached.

That doesn’t answer what happens elsewhere, though. Trades conducted between US and European entities account for a large portion of the cross-border universe, but there are plenty of transactions involving counterparties from other jurisdictions too – Australia, Hong Kong, Japan, to name but three. Some regulators have set out broad parameters for equivalence or substitutability determinations, but these are imprecise and lacking in detail.

Generally, regulators agree that foreign rules should be deemed equivalent if they pursue the same outcome. But beyond a pretty clear global consensus on central clearing and reporting – both key Group of 20 (G-20) objectives and initiatives supported by ISDA and the derivatives market – the desired outcomes differ from jurisdiction to jurisdiction. Dodd-Frank, for instance, covers everything from trading, clearing, reporting and business conduct rules to broader bankruptcy and resolution proceedings. EMIR covers clearing and reporting, with trade execution covered by the revised Markets in Financial Instruments Directive, but many other countries with smaller derivatives markets have opted to tackle clearing and reporting only.

The risk is that some national regulators will approach each outcomes-based equivalence determination as a broad, like-for-like comparison of their own regulatory and legislative framework. That tactic would likely doom any equivalence process to failure. Rather, regulators need to focus on whether the core objectives set by the G-20 are being met, taking foreign legal regimes and local market practices into account.

The trouble is getting to this point, as well as having a mechanism in place to deal with any disputes. The International Organization of Securities Commissions has suggested it may be able to play a role here, drawing up a set of principles – perhaps similar to those published by ISDA last year – and intermediating in equivalence determinations. This could involve peer reviews, colleges of supervisors and regulatory visits, comparable to what the Basel Committee on Banking Supervision has in place for Basel III. It seems like a good idea, and could do much to resolve potential problems and ensure the global derivatives market continues to be just that: global.

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.

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.

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.

LSOC it to Me

The derivatives world is full of acronyms. CDS, IRS, CCP, CVA. The list goes on. ISDA itself is an acronym, and a relatively popular one at that.

Well, we can now add another acronym to the mix:  LSOC. If you haven’t heard it yet, you are likely to, in the cleared swap world of the future in the United States. LSOC stands for “legally segregated, operationally commingled.” Under rules adopted by the CFTC (acronym alert!) last week, it is the basis for the complete legal segregation model, which determines how margin for cleared swaps will be held for the benefit of customers of a futures commission merchant (or, to cite another acronym, an FCM).

ISDA has been supportive of the LSOC approach since the very early days of the CFTC’s deliberations on customer margin for cleared trades. It is an approach to margin that bears similarities to the way that collateral has traditionally been held in the OTC derivatives business. The legal rights to collateral in OTC trades are clear under the widely-used ISDA credit support annexes backed by the legal opinions obtained by ISDA. Operationally, collateral provided for OTC trades may be commingled or even in some cases rehypothecated, but the legal rights of the provider of credit support are protected by the terms of the documentation.

The process followed by the CFTC in reaching its final rule last week is an example of effective dialogue among the CFTC and various interested parties. Soon after the Dodd-Frank Act (we’ll spare you the acronym) was passed, several market participants raised concerns with the CFTC that they could potentially find themselves less protected in margin arrangements for cleared swaps than for non-cleared OTC swaps, where they had  negotiated third-party custodial arrangements. They wanted to take advantage of the risk reduction offered by clearing their trades, but they did not want to forego the degree of protection for margin that they had so carefully negotiated for the collateral in their OTC trades.

Through an advanced notice of proposed rule making, proposed rules, roundtables and an ongoing dialogue with ISDA and other market participants, the CFTC worked this issue extensively. Swap clearing is a pillar of national and international approaches to regulatory reform, and margin and its treatment is a linchpin of clearing. It was important to get this right so that customers would not have to be concerned about the protection of their margin as they moved to the cleared swap world.

LSOC seeks to strike a balance by recognizing that while full legal segregation of collateral can provide the highest degree of protection, it can also create operational challenges where a third-party custodian is involved. Complete segregation through a third-party custodian also comes at a cost and some customers may take the view that the extra protection is not justified by that cost. Clear, robust legal rights are essential. If those are in place, greater flexibility on the operational side is acceptable. Maintaining legal segregation while allowing for commingling of margin for operational reasons—the LSOC approach in a nutshell—was the best result.

The CFTC will continue to consider the approach to margin in both the cleared swaps and futures worlds as the market builds experience with LSOC and more details are discovered regarding what happened at MF Global. ISDA and the industry will also assess its experience with LSOC and the other rules adopted by the CFTC last week. The dialogue that has been established through the CFTC’s consideration of LSOC will serve the CFTC and the industry well for the future.

The long and short of it is that LSOC is a good step in the right direction.

Is There a Better Way?

ISDA has published studies recently that give us a better understanding of the functioning of the OTC derivatives market leading up to and during the financial crisis. A recent paper on the US banking system found relatively modest losses arising out of counterparty defaults of plain vanilla derivatives.

The paper also found that mandatory clearing called for by the Dodd-Frank Act would increase variation margin by $30 to $50 billion among US banks, again a relatively small sum in a $14 trillion economy. Clearing, of course, requires payment of initial margin as well. The Office of the Comptroller of the Currency (OCC) estimated in a paper that initial margin requirements could total over $2 trillion globally under certain circumstances, a truly staggering sum. Other estimates of initial margin start at the hundreds of billions of dollars of new collateral needed. What this means is that the new regulations may require over a trillion dollars in initial margining to protect against incremental exposures whose current mark-to-market value is perhaps $50 billion. We have not seen any cost benefit analysis of clearing and initial margins that justifies this approach.

How did we get here? During the financial crisis, global regulators were unsure how the market would handle defaults of major participants. OTC derivatives contracts amounted to hundreds of trillions of dollars of notional amounts with thousands of participants. It was not clear how many were subject to collateral requirements nor was there uniformity in collateral practices. Some had initial margin and daily margining. Others only had variation margin after a threshold exposure was reached. Furthermore, regulators did not know if another mortgage problem existed through a single entity such as AIG FP or through widespread risk-taking by many participants. Out of this grew the requirement for mandatory clearing and trade reporting.

The requirement is leading to a host of clearinghouses around the world. As they are created and used, they reduce the benefits of bilateral netting (which we discussed in a previous derivatiViews). In some cases, the benefits of risk reduction from clearing will be exceeded by the additional risk created by losing netting benefits. That’s even before considering the costs of clearing.

As noted, the clearing requirement was not subject to analysis nor were other alternatives. ISDA would like comments from readers on the following approach:

  • First, we do agree that interdealer contracts for standardized products should be cleared. For very active participants, initial margining is quite efficient.
  • Second, all financial entities (subject to de minimis exceptions) should have two-way collateral arrangements for variation margin. This would include AIG and all the monolines that wrote CDS on mortgage CDOs. These arrangements should be completely standardized – no exposure thresholds and margin posted daily. The collateral process could be overseen by an independent third party.
  • Third, the parties can decide for themselves the amount and extent of initial margin required.
  • Finally, trade and counterparty reporting should be put in place to reveal risks taken both by individual counterparties as well as by many participants together.

Our proposal will not eliminate losses due to the absence of initial margin. But it will reduce the excess costs of initial margins for creditworthy counterparties. And it will also give regulators the transparency they need. With initial margin running anywhere from the hundreds of billions to the OCC’s estimate of $2 trillion or more, perhaps the benefits of our proposal exceed the alternative “one size fits all” approach that we are unfortunately moving toward.