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.

On the (broken) record…

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

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

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

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

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

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

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

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

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

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

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


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

No Margin for Error

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

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

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

And there lies the rub.

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

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

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

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

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

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

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

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

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

The Derivatives Information Age

We live in the information age, when the sources and volume of information are seemingly limitless. No longer do we need to rely on a few channels of information delivering an edited version of events. The Internet, social media and 24 hour news in today’s distributed information environment are a virtual fire hose of data, facts and events.

The deluge of material in this environment can be overwhelming at times. That’s why Internet search engines are so valuable. (Note: our interest in this paradigm stems in part from the fact that one of our close family members is a software engineer at Google.) It’s also why trusted brands that help users sort through the data are more important than ever.

OTC derivatives markets, like computing and information, are distributed as opposed to centralized business environments. There are many nodes in the global network of bilateral transactions that reflect, transmit and distribute important data – about the price of credit, counterparty credit risk and market trends – to others in the network.

While the value of distributed derivatives markets is clear, there’s also significant merit in centralized hubs of information that aggregate transaction and exposure data. That’s why ISDA and the industry are establishing trade repositories for OTC derivatives. Widely used for credit and rate derivatives, an equity repository has also been launched and others are under construction for commodity and FX derivatives. The information contained in these repositories will enable regulators to see where risks are building up and to connect the dots between counterparties.

This past week CPSS and IOSCO produced a consultative report regarding OTC derivatives data reporting and aggregation. ISDA will be commenting on the report, but at first glance we can say that it is a thorough discussion of the role of repositories and the challenges in making sure that the information provided is meaningful to those who may rely on it. Among the concerns highlighted, which we share, are:

• Transaction-based reporting may be necessary for some purposes, such as market manipulation. More important is to generate information that will help identify where risk is building up, which is more a function of counterparty level reporting.

• That’s why ISDA endorses the idea of a counterparty exposure repository that tracks and measures counterparty credit risk. Swap dealers in many jurisdictions routinely provide this information today to their prudential regulators. We believe this would be a much more efficient means of tracking counterparty risk than trying to obtain counterparty exposure from trade-level data.

• In fact, the CPSS/IOSCO report notes the difficulty of requiring that repositories collect valuation information for transactions on an ongoing basis as well as collateral and netting related to them. It urges further study, which makes sense as this would be an entirely new direction for repositories. The issues of counterparty credit risk, and the beneficial impacts of netting and collateral on that risk, also need to be analyzed further.

• Trading activity in the OTC markets is significantly different from trading in the exchange-traded equity and futures markets. The expectation for repositories should be tailored to reflect these differences. For example, given the far smaller number of trades done on any day the timing for delivery of the information and the level of detail may differ from exchange level reporting.

• Confidentiality of information provided to a repository remains a paramount concern for market participants, and the report acknowledges the importance of these concerns. Yet the recent disclosure by a US senator of information regarding trading activity provided to the CFTC on a confidential basis highlights the need to remain vigilant to ensure that proprietary information is not made public.

Our overarching concern about the derivatives information age reflects the experience of the broader information age. Will the ever increasing flow of data through the information fire hose make it more or less possible to identify the meaningful from the meaningless?