Tag Archives: Dodd-Frank

Why Limit Customer Choice on SEFs?

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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.

Be Pro-Active with One Month to Clearing

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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.

The Meaning of Swap

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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.
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* The CFTC defined the term “swap” and related terms; the SEC defined the term “security-based swap” and related terms.

Collateral Damage

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Of all the regulatory changes that have been proposed or implemented, the biggest potential game changer for the OTC derivatives markets are the collateral requirements that will now be imposed on all derivatives transactions.

Collateralization is, to be sure, common practice and an integral risk management tool in the OTC derivatives market today. The growing number of cleared OTC derivatives trades (more than 50% of the IRS market, for example) are subject to both initial (IM) and variation (VM) margins. The terms of collateralization are governed by the Credit Support Annex (CSA) to the ISDA Master Agreement.

To put this in context, collateralization of OTC derivative trades was something that was left to negotiation between two parties who would, based on their assessment of each other, customize and set terms accordingly. Those terms could (or not) include an initial margin (in most cases not), a requirement to post collateral if the mark-to-market exceeded certain levels (threshold amounts), and the type of collateral, frequency of collateral calls, and others.

However, in a broad swipe, new regulations across geographies make collateralization mandatory. More OTC derivatives will be required to be cleared, meaning that counterparties will now need to post IM and VM for them. Similar rules are soon to be unveiled by a group of global regulators, led by the US Federal Reserve Board, for transactions that are not suitable for clearing. By all indications, such collateralization requirements are likely to be more severe than those cleared, if nothing else to induce further use of clearing, and also because such transactions are likely to be less liquid and/or less frequently traded, requiring more collateral.

The effective result of these regulatory developments is a mandatory and massive “risk-off” move. Going forward, all participants in the derivatives markets “will not be allowed” to take the credit risk of their counterparties – be they CCPs or bilateral. The default choice will be no credit assessment, a presumption that the counterparty is not creditworthy, and thus a requirement for full collateralization.

We have written in this column before about the massive increase in new collateral that this regulatory initiative leads to (estimates range anywhere from $0.5 trillion to $2.7 trillion). Whatever the estimate, it is likely to be large (we are talking trillions, with a “t”), and comparable in size to the “quantitative easing” (QE) programs undertaken by major central banks recently. This QE-sized requirement, however, works in the opposite direction of the actual QE, and is likely to have adverse effects on the real economy. That’s because it requires that top quality assets and/or cash be “parked” and remain unutilized, as opposed to being plowed in the real economy (by banks), invested elsewhere (by asset managers) or used for productive purposes (by corporations). In this respect, it is interesting to note that at a time when the markets are likely to face increased demands for quality collateral, the central banks, through their QE programs, have been removing from the market such “quality” collateral (in the form of government, mortgage and other high quality bonds).

In addition, the market faces a lot of practical issues in implementing mandatory collateralization practices on this scale. These issues are likely to further exacerbate the shortage of collateral. In the aftermath of MF Global, confused and worried market participants demand (justifiably so) extra security for the collateral they post. There are demands for full segregation, custodian arrangements with third parties, even demands for no re-hypothecation (should we start marking the banknotes that we deposit as collateral?). CCPs, responding to these concerns, have started offering a variety of “segregated” solutions but the devil is in the details and much attention needs to be paid in understanding what these offerings entail. Further complicating matters is the lack or harmonized practices around the world when it comes to solvency law, as well as the fragmentation in the securities depository systems, particularly in Europe.

So, while a lot of attention is being paid to the question as to whether the market will comply with clearing and other requirements by 2012 year-end, the real elephant in the room is whether the marketplace will come up with the all the collateral that is required, and if it does, what the liquidity implications for the real economy will be. And these events will be coming at a time when other similar “risk-reducing” regulatory initiatives are in the making in the form of increased capital requirements (Basel III) with implications for the capacity of the banks to provide liquidity to the secondary markets, or simply lend money to the real economy.

We may get what some wish for: a completely “de-risked” economy. But at what cost?

A Debut in D.C.

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There was a premiere in Washington on October 14, though you might not have read about it in the arts and entertainment pages. Connie made his first appearance on the Congressional hearing stage, representing ISDA and its members before the Capital Markets and Government Sponsored Enterprises Subcommittee of the House Committee on Financial Services.

The script for the Subcommittee hearing was taken from a series of bills that have been introduced in the House of Representatives to address several troubling aspects of the Dodd-Frank Act (DFA) and the subsequent rulemaking. Among the bills discussed in the hearing were ones addressing swap execution facilities, inter-affiliate trades, pension plans’ usage of swaps and the so-called push-out provision of Section 716. Subcommittee chairman Scott Garrett should be commended for providing the stage to debate these important issues.

Our theme was the timeless one of delivering safe, efficient markets. We reiterated our support for the G20’s efforts to reduce systemic risk by focusing on improving counterparty credit risk management and transparency in the OTC derivatives markets. ISDA lent its backing to each of the bills under consideration, as did other individuals and organizations testifying. Our written testimony is available on the ISDA website.

As with any production in Congress, however, not everyone is reading from the same script. From the line of questioning of some members of the subcommittee, it is clear that financial regulatory reform is a play with two acts. Act One, AIG. Act Two, DFA.

This is misguided. Much of DFA has nothing to do with preventing another AIG.  The part that does – improved regulatory transparency – is already in place as a result of the CDS Trade Information Warehouse. It is hard to conceive that AIG-type trades could achieve a level of standardization that would lend themselves to clearing or SEF execution.

In addition, it is not clear to us that there is sufficient appreciation for the range of swaps that are used day in and day out to manage risk. Representatives from pension funds and end-users, in particular, spoke at the hearing of the need to make sure that we are not throwing the baby out with the bathwater. The swap world is one of many characters and scenes.

We will continue to play our part in debates like these, providing information that helps inform decision making. A perfect example of this was Connie’s response to a question regarding transaction costs for users of derivatives trades. One witness asserted that such costs total $50 billion annually. We await the study that demonstrates those costs, but in the meantime, Connie walked through some quick analysis based on straightforward assumptions that made the assertion seem unlikely. We like plots that are based on true stories.