End-user angst in Munich

Munich angstIn the years since the financial crisis, an important point about derivatives has often been overlooked: they serve a genuine need by helping real companies to hedge very real risks. This point came across loud and clear in a recent survey of end-users conducted by ISDA: 86% of respondents said over-the-counter (OTC) derivatives were either very important or important to their risk management strategies. This was also a recurring theme at ISDA’s annual general meeting (AGM) in Munich earlier this month, where a succession of end-users and academics stressed the economic benefits of derivatives and their value to the real economy.

These end-users generally feel the financial system is on a sounder footing today than before the financial crisis, largely as a result of regulatory changes. But enthusiasm for specific regulations varies significantly. For instance, trade execution rules got a thumbs down from investors, despite the fact these rules were meant to help those users, primarily by ensuring greater transparency. In that aim at least, regulators appear to have succeeded: 74% of respondents thought electronic trade execution would have a positive affect on transparency. But more than half felt it would have a negative impact on ease of use, while 39% and 36% thought it would have a detrimental affect on price and liquidity, respectively. That’s a higher proportion than those who thought the impact would be positive.

Another key area of end-user concern is a lack of regulatory harmonisation and the resulting fragmentation of markets. Nearly half of survey respondents thought the market was splintering along geographic lines – a finding backed up by other ISDA research. This point was also picked up by end-user speakers at the AGM, who talked of their efforts to minimise cross-border problems by reorganising their operations to ensure non-US entities avoid trading with US dealers. The result, they argued, was less liquidity and higher costs for certain products – something reflected in the end-user survey, which found 83% of those who had witnessed some level of fragmentation believe it had led to higher costs.

For the most part, though, many end-users – and corporates in particular – have been sheltered from the direct costs resulting from new regulation. Corporates are largely exempt from mandatory clearing requirements and from forthcoming uncleared margin rules, excusing them from having to stump up initial and variation margin on their hedges – money they believe would be better spent on investment and research and development.

But there are other indirect costs: dealers are subject to higher capital charges for uncollateralised trades via new credit valuation adjustment (CVA) rules. While European banks are exempt from having to apply this CVA charge for trades with corporate customers, other banks aren’t – and those capital charges are likely to be passed on. Dealers will also look to hedge any client transaction, and these offsetting trades will almost certainly require margin to be posted against them. The dealer would need to fund that margin, creating a cost that may well be handed down to the client.

End-user speakers at the AGM claimed not to have seen any marked increase in price so far, suggesting dealers are largely absorbing these costs at the moment. They did, however, say they had seen some banks pulling back from certain markets and products. In other panels, dealer representatives acknowledged banks now have to pick and choose, with higher capital and leverage costs forcing them to concentrate on those areas where they have an advantage or where they can meet return-on-equity hurdles.

That’s already having an impact, with liquidity diminishing significantly in certain markets, affecting the ability of end-users to manage their risks efficiently. One buy-side speaker said some customised products were either no longer available or were trading “by appointment” only. That’s a big problem, as tailor-made, bespoke contracts fulfil a real need by allowing firms to closely offset their risk. Any reduction in the availability or increase in costs for these products could encourage some companies to hedge less, some speakers warned – a result that would lead to increased earnings volatility, less certainty in cashflows and – ultimately – less investment, less job creation and lower economic growth. That fear was voiced forcefully by a number of AGM end-user speakers.

That scenario thankfully doesn’t appear to have played out yet. The end-user survey found that 79% of respondents plan to increase their use of OTC derivatives or keep their hedges at the same level during the second quarter of 2014. But higher costs, fragmented markets and less liquidity could eventually take its toll, depriving end-users of an important risk management tool.

That’s an unintended consequence no-one wants to see. Could we end up with less safe, less efficient markets? That’s the concern that was voiced over and over again in Munich.

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.

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.