The Meaning of Swap

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.

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.