Tag Archives: regulation

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.

Honey, I Shrunk the Market

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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.