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.

Honey, I Shrunk the Market

The OTC derivatives market knows that 2012 will be a transformational year for the industry. By year-end, the industry has to meet the challenging objective, laid out by the G-20, of trading all “standardized” derivatives transactions on electronic platforms, where appropriate, and clearing them through central counterparties (CCPs).

Increasingly, this task is looking extremely ambitious. ISDA made its views known in a letter to the European rule-making bodies. Market participants and regulators need time to think through the issues and prepare solutions to the challenges posed. Rushing through them can only lead to increased risks and unintended consequences. 

We have written before on some of these issues. Many of them emanate from the fact the supervisors are attempting to regulate a global marketplace with a series of “national” or “jurisdictional” regulatory initiatives – Dodd-Frank in the US, EMIR and MiFID in Europe, as well as other initiatives elsewhere (Japan, Canada, Hong Kong, Korea, Australia and others).

The OTC derivatives market, however, is perhaps the clearest example of a global market that has emerged over the past three decades. Unlike most of the underlying “cash markets” – which have grown locally and have been in existence for decades if not for centuries – the youth of the OTC derivatives market has enabled it to build its international foundations from the beginning. The ISDA Master Agreement is used by almost all participants to document transactions ubiquitously, and is perhaps one of the few – if not the only – document with global acceptance and application. Most OTC derivative trading books are global, feeding on demand and supply of client flows from all over the world. The integrated technology they use allows them to “see” and manage the same book as it passes through time zones and locations. Most banks that deal in OTC derivatives typically have a single global back-office where all the transactions, occurring around the world, are processed. The industry has built single data repositories where virtually all worldwide OTC derivatives transactions are captured by product.

Attempting to shrink this global industry and make it fit “national” or “jurisdictional” definitions presents a monumental task and an equally monumental risk. It gives rise to a myriad of risk management, operational, legal and technological issues that the industry and the regulators are only beginning to come to grips with.

An example from the US dollar interest rate swaps (IRS) market helps illustrate some of the issues that arise. It is well known that Fannie Mae and Freddie Mac are massive receivers of fixed rate IRS to compensate for the prepayment risk that exists in the large mortgage portfolios that they hold. This risk, to a large extent, is offset by European or Japanese corporate hedgers (in addition to the US), which are typically fixed rate payers. Attempting to clear such transactions can potentially lead to massively unbalanced positions in the respective CCPs, resulting in (and creating) a bifurcation of risk (in an otherwise risk-neutral position) and the need to post potentially different (and incremental) amounts of initial margins. Similar examples can be drawn from the CDS, commodities and equities OTC derivatives markets.

Worse, these “national” or “jurisdictional” regulatory initiatives are incompatible both in content and in the timeframe in which they are being rolled out. The CFTC in the US has a head start, having issued a number of rulings, but even that Commission is behind its own stated schedule. The SEC is further behind in its rulemaking, although it is supposed to work jointly in some cases with the CFTC. The situation is even more challenging in Europe where EMIR (the European equivalent of Dodd-Frank regarding clearing) is just now being finalized. ESMA – which is supposed to follow with its own rules – has not started the process either. And this is on clearing alone. The introduction of electronic trading platforms is likely to be another transforming event for the industry’s structure, the effects of which are only beginning to be discussed.

And while all this is happening, the end-2012 deadline is casting its shadow. There is increasing realization that there is simply not enough time to deal with all these issues. And if things are rushed so that deadlines are met, the likelihood increases substantially that mistakes will be made, risks will be overlooked, or simply that ill-conceived rules will be put in place with unintended consequences.