Cross-border Overreach

Those of you who have come to an ISDA conference, read our comment letters or, indeed, read this blog over the past several years know that cross-border harmonization matters a lot to us and our members. The derivatives markets are global, and end users have been able to benefit from tapping into a single, global liquidity pool when putting on their hedges. Split that single pool into multiple liquidity puddles, each distinct from the other, and end users face less choice, higher costs, and a lower chance of executing large-sized trades, particularly in stressed markets.

Unfortunately, the global liquidity pool for certain instruments has shown clear signs of fragmenting over the past two years, caused by variations in the timing and substance of the derivatives regulations implemented in each jurisdiction. But a recent proposal from the US Commodity Futures Trading Commission (CFTC) threatens to drive a wedge into that fracture and force it even wider.

The proposed rule, published in October, expands the CFTC’s extraterritorial reach way beyond what was outlined in previous 2013 cross-border guidance, which set out which rules should apply when counterparties trade across borders. To be more specific, the proposed rule requires non-US affiliates that aren’t guaranteed by a US parent but are consolidated on its balance sheet for accounting purposes – so-called foreign consolidated subsidiaries (FCSs) – to meet CFTC threshold registration and external business conduct requirements when trading with non-US entities. The proposal also requires those non-US counterparties to count their trades with FCSs for the purposes of CFTC registration.

This is a change from what went before – the CFTC’s cross-border guidance specifically stated that Dodd-Frank requirements would not apply if a non-US, non-guaranteed affiliate of a US person trades with a non-US entity. There were good reasons for this. The US parent is not obliged to cover any losses that may be incurred by the affiliate – the result of the absence of a guarantee – and the non-US affiliate and non-US entity would be subject to overseas regulation anyway.

Without fully explaining the rationale for the change, the CFTC has decided that US requirements should apply after all, at a stroke exposing a whole new universe of non-US trades to duplicative and potentially inconsistent requirements. Absent a substituted compliance decision, trades conducted between an FCS and a non-US entity would need to comply with both US obligations and the requirements of the host regulator simultaneously.

So far, the proposed extension of extraterritorial reach only applies to a couple of Dodd-Frank requirements, but the CFTC says it will consider how other requirements, including trading, clearing and reporting mandates, should apply to FCSs in future.

The implications are severe. Non-US corporate end users that are classed as FCSs will find it difficult to trade with dealers based in the host country, as potential overseas counterparties will look to avoid being subject to multiple sets of rules, as well as potentially breaching a notional threshold of trades with US persons that would require them to register with the CFTC as swap dealers. US dealers will find their non-guaranteed, non-US FCSs are unable to compete overseas, for the same reason. Liquidity will suffer as a result, leading to increased transaction costs.

We feel this goes beyond the CFTC’s statutory remit. Congress was very specific in stating that the Dodd-Frank regulation should only apply to activities that have a “direct and significant effect” on commerce of the US. We don’t think a trade between a non-US, non-guaranteed FCS and a non-US entity meets that criterion. At any rate, the non-US affiliate would be regulated by local foreign-country regulators, and either is or soon will be subject to similar regularly requirements to Dodd-Frank, as per commitments made by the Group of 20 in 2009.

In short, we think this proposal to expand the CFTC’s extraterritorial reach should be shelved. It will impose significant additional compliance costs on FCSs and non-US entities. It will put FCSs at a massive disadvantage in overseas markets. And it will further fragment liquidity.

The fact is, the rules are converging. In the trade execution space, Europe is finalizing its rules for implementation in January 2018, and Japan already has a trade execution mandate in place. Rather than extend the reach of its rules even further, now is the time for the CFTC to work with overseas regulators to prepare the ground for substituted compliance determinations. Once that’s achieved, the CFTC can be sure that those activities that genuinely have a significant and direct connection to the US are covered by similar requirements, whether in the US, Europe, Japan or elsewhere. Those activities that have a remote connection to the US should not be under CFTC jurisdiction in the first place.

Just a quick PS: we’ll be discussing cross-border issues later this week at our first trade execution conference in London. Hope you can join us.

Screwdriver, Not Sledgehammer

Build a car engine from scratch, and it’s a fair bet that it won’t be purring the first time it’s switched on. That doesn’t mean the engineer has failed, and it doesn’t mean the whole thing needs to be smashed up. It’s just likely to need fine-tuning and refinement before the engine is really performing as it should.

A similar thing can be said of financial regulation. Draw up a whole new framework for derivatives clearing and reporting when nothing like that has existed before, and it stands to reason that not everything will work out quite as it’s meant to. The easy thing to do would be to say that the legislation is set in stone and to move on. The more difficult approach is to take the time to tinker under the bonnet and make it as good as it can be.

That’s why Europe deserves credit for taking a cold, hard look at existing European regulation to see what’s working well and what’s not, and thinking about how it can be made better. This requirement for a review was baked into the European Market Infrastructure Regulation (EMIR) legislation, and the European Commission last week published an initial report, incorporating feedback received as part of the EMIR review and so-called ‘call for evidence’ on European financial regulation.

The report highlights a number of areas that require further review, including an assessment of whether the rules have a disproportionate impact on non-financial corporates and small financial entities. Such a review makes sense, as these firms may not pose systemic risk, yet they face significant compliance costs in meeting the rules, which could limit their ability to invest and/or lend.

For instance, European rules currently require both parties to a transaction to report each new derivatives trade. This is out of line with the approach taken by many other regulators, which typically take an entity based approach, where sole responsibility for the accuracy of reported data is assigned to one counterparty – usually the dealer for a bilateral transaction. The dual-sided mechanism within European rules creates cost and complexity for little apparent gain.

According to research conducted by ISDA, the aggregate cost for end users in meeting Europe’s dual-sided reporting requirements is estimated to be in excess of €2 billion. Despite this, data quality is poor. A lack of clarity around what needs to be reported and how, and differences in reporting requirements between repositories, means pairing rates are low – around 60%. We think moving to an entity based approach would not only reduce cost for end users, but would actually improve data quality and consistency.

There were also positive noises on clearing. Notably, the EC highlights the importance of a mechanism to promptly suspend the clearing mandate. As it stands, this can only be achieved following the approval of regulatory technical standards, but this takes time. A market shock that impacts liquidity or the failure of a clearing house would require a much faster response – which is acknowledged in the report.

The highly controversial frontloading requirement is also flagged for review. ISDA has long raised concerns about the operational complexity of this rule – which is unique to Europe – and the European Securities and Markets Authority has already made several adjustments to it. We think the challenges caused by this requirement far outweigh any possible benefits, and removing it would not reduce the effectiveness of the incentives to clear within EMIR.

Access to client clearing for small financial institutions with limited derivatives activity is another area highlighted by the EC (an issue examined by ISDA in a recent research report). This has been largely attributed to the impact of the Basel Committee on Banking Supervision’s leverage ratio, which does not allow clearing-member banks to recognize client collateral as risk reducing in the leverage ratio exposure calculation. The EC has proposed changes to this approach in its revised Capital Regulations Regulation and directive proposals, which is intended to reduce the cost of offering client clearing services.

So, what’s the next step? The EC has recommended a legislative review of EMIR next year, as well as a look at the relevant technical standards linked to the legislation. We welcome that approach, and think other jurisdictions should consider doing something similar. The chances of getting everything 100% right first time on such a far-reaching piece of legislation are small. Regulators and legislators should not back away from reviewing what they’ve done to ensure everything is working as they intended.

Getting Smart

Complying with new financial regulation has led to the layering of new processes and systems onto existing infrastructure. With a number of new links in the chain – electronic trading, clearing, reporting, margining – derivatives operations have become increasingly complex and unwieldy. No wonder, then, that distributed ledger and smart contracts have excited so much interest. These technologies offer the tantalizing prospect of revolutionizing the way derivatives are booked and managed, automating and streamlining a complex, overburdened system and cutting operational costs.

That’s the vision, anyway. Getting there will be difficult. The term ‘smart contract’ is fairly broad, but is generally taken to mean converting the terms of a trading relationship into shared executable code to automate certain actions or obligations. The intention is to increase efficiency and reduce costs through mutualized processes. Establishing the extent to which such coding should be used – whether it should be adopted for all aspects of a trading relationship or just in some specific areas – is going to be a major debate.

Any transition to smart contracts won’t be easy, either. The industry can’t just smash up the old infrastructure and switch to a new one overnight. To allow trading to continue without hindrance, there will have to be a slow, step-by-step process of change and improvement.

ISDA will play an active part in this evolution. Smart contracts will require standards, and this is an area where ISDA has a long track record, dating back to the publication of the ISDA Master Agreement. We’ve been looking into this issue for some time, and we held our first industry roundtable on the topic earlier this month. At that meeting, we considered how Financial products Mark-up Language (FpML) might be used as a basis for derivatives smart contracts.

FpML is an open source messaging standard for derivatives based on the ISDA taxonomy, and is already widely used in the industry. Using existing standards like FpML as a starting point may be a crucial shortcut to the rollout of industry standard, platform-agnostic smart contracts.

The roundtable was attended by technology experts, law firms and industry participants, and close cooperation between each of these groups will be crucial if smart contracts are to get off the ground. During the meeting, ISDA showcased a proof-of-concept smart interest rate swap contract based on FpML, and much of the discussion focused on how to connect all the various moving parts of a typical derivatives trading relationship together. Should a smart contract be placed on a distributed ledger platform? How does this technology operate within existing legal frameworks, nationally and internationally? Should the legal language of the various ISDA product definitions or legal documentation be folded into the design? How will increased automation affect termination rights and the management of counterparty defaults?

We need to develop answers to these knotty questions, and ISDA will be pushing ahead with more industry discussion in the New Year and beyond – so watch this space. We will be drawing on the breadth and depth of our membership, including sell-side, buy-side and law firms, as well as infrastructure and technology service providers to validate different concepts and technology solutions. The key is to gather the right experts with appropriate domain knowledge to contribute to the design. While others will take on the purely technological challenges, such as scalability and security, ISDA will host the discussion around legal standards and application, and contribute to the development of data standards and code. We are perfectly placed to hold this project together.

This project is part of a wholesale review of derivatives market infrastructure. In September, ISDA released a whitepaper that called for greater standardization in documentation, data and processes.

It won’t be quick and it won’t be easy. But the need for change is obvious, and it’s incumbent upon the industry to work together to make improvements in the most efficient and consistent way.

VM Rules: Take Action Now

It might only be November, but people already seem to be turning their minds to what’s in store for 2017. There’s likely to be a lot on the agenda, but one date looms large for the derivatives market: the March 1 implementation of variation margin requirements for non-cleared derivatives. That’s not surprising: the scale of the task is massive, and firms need to take action now in order to stand a chance of being ready in time.

Many market participants already post collateral to cover price changes on their derivatives trades, so you’d be forgiven for asking what all the fuss is about. The answer is that the rules make variation margin posting compulsory on all non-cleared trades, and set strict requirements on the type of collateral that can be posted, the frequency of the margin calls, and the required timing for settlement, among other things.

Crucially, these regulatory changes mean derivatives users will have to modify their existing collateral support agreements. And seeing as the March 1 deadline captures a broad swath of financial institutions – asset managers, pension funds, insurance companies, hedge funds – it will mean thousands of counterparties will need to change or set up thousands of agreements in a very short space of time. This will represent a repapering exercise on a scale and under a timetable never before attempted.

So, what do firms have to do to get ready? An important first step is to understand whether and when each trading relationship will be subject to margin requirements, and what rules will apply. To help with that process, ISDA has developed a self-disclosure letter that enables market participants to exchange the necessary information, covering the US, European Union, Canada, Japan and Switzerland. In order to speed up the exchange of information, this was incorporated into ISDA Amend – an online tool developed by ISDA and IHS Markit – on October 28. This is something each firm could – and should – get started on now.

The next step is to start revising and/or setting up new documentation. ISDA has now published a variety of revised credit support documents under various legal regimes, but the real challenge is how to make those changes without the grueling task of having to bilaterally negotiate with every single counterparty.

In response, ISDA has developed a variation margin protocol that will enable firms to quickly and efficiently amend existing contracts or set up new agreements that comply with variation margin requirements. The protocol was published for the US, Japan and Canada in August, and we expect to publish European Union provisions soon following publication of final European rules on October 4.

The protocol for those jurisdictions will be available on ISDA Amend later this month, which will eliminate much of the manual work of notifying counterparties and reconciling the various elections made. Once that is up and running, market participants will have a little more than three months to onboard all their counterparties.

The timeline is even more challenging for those jurisdictions that have yet to publish final rules. In an article published in Risk recently, I estimated it would take four and half months to develop a protocol and build it into ISDA Amend from the point the rules are finalized. If regulatory timelines don’t allow for the building of an automated industry solution, then firms will have to bilaterally negotiate changes with each counterparty – a hugely time-consuming and resource-intensive task.

Even with the protocol available, the variation margin deadline will pose a massive challenge for the industry. Over the past two months, we’ve held a series of conferences across the globe focusing on the margin rules. The comments from those who attended made clear that many firms are seriously worried about their capacity to agree the necessary changes with every one of their counterparties.

The message is very clear: start to prepare for March 1 now. Understand what the rules will mean for you; look at your outstanding contracts; and start getting in touch with your counterparties. Any firm that leaves it much longer may find it is unable to trade from March 1.

We’re Ready to Help

The initiative to develop a globally consistent standard for a derivatives product identifier has been rumbling on for a while now. This is something in which both the regulatory community and the industry have a big stake. Regulators want to be able to aggregate data in order to fulfill their mandate to monitor and assess risk – a uniform product identifier makes that a lot easier. The industry wants consistency in order to avoid a situation where multiple identifiers emerge for different purposes – a nightmare scenario where complexity would go through the roof and costs would rise.

So, everyone is agreed this is a good idea. The question is what standard should be used. The European Securities and Markets Authority (ESMA) has thrown its weight behind the ISIN, and has mandated its use for certain reporting obligations under the revised Markets in Financial Instruments Directive. Other regulators haven’t yet shown their hand. That’s because the Committee on Payments and Market Infrastructures (CPMI) and International Organization of Securities Commissions (IOSCO) are working to finalize technical guidance on a common product identifier, which is expected before the end of the year.

That would appear to leave regulators with a stark choice: either CPMI-IOSCO recommends an ISIN-based identifier; or ESMA changes its approach to match the standards published by CPMI-IOSCO; or we’re left with a fragmented system of multiple identifiers.

There’s been a lot of discussion about whether and how ISINs can be used as a derivatives product identifier, and ISDA has played a full part in that. We’ve worked extensively with the International Organization for Standardization (ISO) and the Association of National Numbering Agencies (ANNA) to develop a multi-tiered ISIN framework for regulatory and business purposes, and have offered to provide the intellectual property associated with ISDA terminology and definitions free of charge to make this work.

We believe it’s possible for regulators and the industry to work together to agree a consensus approach that uses the ISIN. For that to succeed, however, it’s imperative that the identifier framework meets some key principles – and ISDA published a paper outlining those principles in May.

Among the most important is the need for open governance. Specifically, we think it’s crucial that derivatives market participants play an active part in development of the standard and its ongoing governance.

As it stands, ISINs can only be allocated by infrastructures approved by ANNA, and each one is the exclusive provider of ISINs in its local market. Given the absence of competition in selecting and designing the infrastructure, it’s important the governance framework reflects the views of market participants – the actual users of the ISIN – and not just those with a commercial interest in the infrastructure. Open governance is the only way to ensure the identifier works across jurisdictions and supports both regulatory and business purposes.

We would urge regulators to take advantage of the expertise and experience of the derivatives industry to ensure we have a single derivatives product identifier that suits regulators and the industry alike. It’s in all of our interests to make this work.

Beware the Code Freeze

Europe has picked up the pace of its approval process for rules on the margining of non-cleared derivatives. The latest thinking is that the European Parliament will wrap up its non-objection this month, prompting the market to reassess the likely date the rules will come into force. Depending on what the Council of the European Union (EU) does, it’s possible the largest EU phase-one banks could be posting initial and variation margin from early January.

We welcome the push to harmonize implementation schedules with those in the US, Japan and Canada. The margin requirements were originally intended to be rolled out according to a globally consistent timetable – a plan we supported. That fell by the wayside when the European Commission announced in June it would delay its rules until 2017 – a move that was later followed by Australia, Hong Kong, Singapore and India. So, we think realigning Europe with the US and others as soon as possible is a good thing.

There is a fly in in ointment, though. Many banks enforce an end-of-year code freeze that prevents them from making any changes to systems and models. Introducing far-reaching margin rules during this freeze could pose risks. Worryingly, it could hamper the ability of banks to make fixes to newly installed collateral systems and processes if something goes wrong.

We think a mid-January implementation for the EU would be safer from an industry perspective. Those few extra weeks would mean the code freeze would be finished and any emergency IT fixes that need to be made can be made.

Go too far beyond mid-January, however, and we start approaching another hurdle: the March 1, 2017 rollout of variation margin requirements. This deadline will affect a much wider universe of firms, and will involve thousands of counterparties having to make changes to thousands of outstanding collateral agreements at once. This on its own will pose major resource issues for the industry. If combined with the delayed European phase-one requirements, it could stretch capacity to breaking point.

So, we’re probably looking at a window of between mid-January and early February for the European rules to come into force. That gives enough time to get past the code freeze, but means there’s a tiny bit of breathing space before the variation margin requirements are introduced. We think this gives the best chance for the margin rules to be implemented in Europe without disruption.

No End to ISDA SIMM Work

No sooner had the first deadline for the posting of margin on non-cleared derivatives passed than attention had begun to switch to the next set of hurdles. There are some big challenges ahead – not least, the March 1 deadline for variation margin, which will capture a much wider universe of derivatives users. But meeting the implementation timetable isn’t the only thing the industry has to think about. Keeping the ISDA SIMM in line with regulatory requirements and ensuring it continues to reflect market conditions is another major preoccupation.

The ISDA SIMM – a common methodology for calculating initial margin – has been widely adopted by the largest, so-called phase-one derivatives users since the margin rules were rolled out in the US, Japan and Canada on September 1. But that doesn’t mean the job is done. Firms had to obtain approval from US regulators prior to using the ISDA SIMM on September 1. The approval letters began to arrive in August, but asked for phased updates to the methodology during 2017 as a condition for using the ISDA for certain product types.

That work is already under way, and the first round of modifications is due at the start of next year. In fact, many of the required enhancements had actually been earmarked by the industry for action once the initial September 1 deadline was out the way – for instance, further development of the treatment of cross-currency swaps. After all, the ISDA SIMM was never intended to be a static model, built once and then left for users to get on with it. It was always recognized that regular updates and recalibrations would need to be made.

The ISDA SIMM itself is relatively simple, designed to be used by the widest possible audience. Users need to determine their own sensitivity inputs for specified risk factors, but other parameters – risk weights, correlation and risk buckets – are centrally defined to help ensure consistency. Along with dealing with regulatory requests, these parameters need to be regularly reviewed and recalibrated.

As promised at the inception of the ISDA SIMM, this will all be done through a transparent governance framework, comprising an ISDA SIMM Governance Forum, which is open to all ISDA members that are subject to the initial margin requirements, and an ISDA SIMM Governance Executive Committee, which takes the decisions over alterations. These two entities are supported by ISDA staff and are overseen by the ISDA Board of Directors.

This governance committee will oversee an annual recalibration of these parameters and will conduct a yearly methodology review will ensure the model continues to perform as it should. A key part of this process will be feedback from users. By reporting difficulties with reconciliation or significant margin shortfalls, market participants will give the governance committee the right information to judge the performance of the model and make changes as necessary. Persistent or material shortfalls that are common to ISDA SIMM users could trigger an update outside the annual recalibration process.

The really important thing is making sure everyone continues to use the same version of the model. So, once vetted by regulators, any methodology changes will be published, and an appropriate time will be given to make the updates. The last thing anyone wants is to get to a situation where everyone is using different versions of the same model.

This all means the ISDA SIMM will continue to be a heavy lift. With the first regulatory enhancements and the first annual recalibration due next year, and with new users adopting the methodology in September 2017, there’s no time to sit back and relax. But the governance framework ISDA has put in place will ensure the necessary changes are as transparent and painless as possible.

Margin Rules: Lessons Learned

It’ll probably come as no surprise that one of the major preoccupations for ISDA and many of its members over the past week has been the implementation of non-cleared margin requirements. On September 1, 20 or so of the largest derivatives users began exchanging initial and variation margin on their non-cleared trades under rules that took effect in the US, Japan and Canada. Barring some teething problems, the rollout went relatively smoothly given the scale of the change and the time given to the industry prepare for it. However, we won’t be stopping here – we know there is plenty more work to be done.

September 1 preparations went to the wire, with many firms working to sign the relevant documentation with their counterparties right up to the start date. Some were unable to set up custody accounts for all of their counterparty relationships for September 1. Banks were also waiting until the end of August for clarity on whether they had approval to use the ISDA SIMM.

This largely boils down to time. Final rules from domestic regulators were needed for the industry to finish drafting new credit support annex (CSA) agreements, and to implement, test and seek regulatory approval for initial margin models. The magnitude of the changes meant market participants didn’t have much time to get it all done. Final rules from US prudential regulators were the first to emerge a little more than 10 months ago, with Japanese regulators publishing theirs at the end of March.

Preparations were further complicated by news that European regulators wouldn’t have their rules ready in time for a September launch – with Australia, Hong Kong, India and Singapore subsequently following its lead to defer the start date until next year. The split in what had been a globally coordinated implementation timetable created new cross-border and compliance headaches.

Adding to this complexity was the absence of a substituted compliance determination between US and Japanese rules (the Commodity Futures Treading Commission is set to vote on whether Japanese rules are equivalent today – a week after the rules went live).

Given this, what ISDA and its members have achieved is nothing short of staggering. For the first time, the industry has developed and agreed to a common, transparent model to calculate initial margin on non-cleared derivatives – the ISDA SIMM. A new set of industry standard documents has also been drafted and published in record time, setting out the process for exchanging variation margin and initial margin under various legal regimes. (A summary of ISDA’s various initiatives is available here.)

There are, of course, lessons to be learned from the September 1 implementation. The most obvious is that it takes time to put these changes into effect. Adapting or agreeing new collateral agreements and setting up custody accounts for every in-scope counterparty relationship cannot be completed in a matter of weeks. While only 20 or so entities were caught by the first-phase implementation in the US, Japan and Canada, it required negotiation or revision of hundreds, if not thousands of documents for their various subsidiaries.

This is particularly relevant as European and other regulators look to finalize their rules and set a new time frame for implementation.

We are mindful of the challenges in implementing the rules, and we will work with regulators and market participants to make them aware of how these deferred phase-one rollouts will impact the ‘big bang’ launch of variation margin requirements, which apply to all entities under the scope of the rules from March 1, 2017. The near-simultaneous rollout of deferred phase-one and variation margin requirements could seriously test implementation capacity.

We’d like to see certainty in the timeline for all jurisdictions, alongside a realistic implementation window for deferred rollouts. Equally important is the need to ensure market participants fully appreciate the scale of the task ahead of them in preparing for implementation. ISDA will continue to play a central role in informing members about these requirements and providing the tools to help firms comply. We’ll also continue to monitor the ISDA SIMM via a transparent governance framework to ensure it meets industry and regulatory requirements.

ISDA will be focusing on this issue at our regional events in the coming months. Our New York conference is next week, so we hope to see you there. Click here for more information.

Resolution on CCP Resolution?

The Financial Stability Board (FSB) and its chairman, Mark Carney, last month reiterated their intention to prioritize central counterparty (CCP) resilience, recovery and resolution for the remainder of 2016. They are absolutely right to focus on this issue. Several clearing houses have become systemically important as a result of global clearing mandates, and it’s vital this infrastructure is as secure as possible – which means establishing a credible and robust recovery and resolution framework.

This isn’t a new topic, of course. Considerable thought has gone into this at both the regulatory and industry level over the past few years – and ISDA has published several papers on the issue (here’s our most recent). But the thinking is continually evolving, particularly on the issue of resolution. An important recent consideration has been when and how recovery becomes resolution – in other words, at what point should resolution authorities step in, and what tools will be available to them?

It’s a crucially important issue. At ISDA, we recognize there may be situations where a resolution authority has to intervene before CCP-led recovery efforts have fully run their course. That might include circumstances where it is felt the recovery measures set out in the CCP rule book would further increase systemic risk or lead to contagion. But, if resolution authorities elect to enter a CCP into resolution, we believe it is important to abide by certain conditions to maximize certainty and predictability and maintain market confidence.

In particular, we recommend that resolution authorities, should they intervene, follow the rules and the tools defined in the CCP rule book. ISDA has already set out a proposed recovery framework, which includes a variety of loss-allocation and position-allocation tools and the sequence of their use, aimed at providing maximum predictability of outcomes. We recommend this framework be adopted in CCP rule books, approved by regulators and followed by resolution authorities. By following this transparent rule book, a resolution authority would provide comfort to market participants and minimize market disruption, as well as ensure the concept of ‘no credit worse off’ – a central element of the ISDA recovery framework – is applied.

Careful thought should also be given to the point of entry. ISDA believes recovery should be CCP-led as far as possible, but if that is not possible, the indicators for a resolution authority intervention should be defined upfront. Clarity over the entry point would, again, help provide certainty about the process.

It’s important, though, that these triggers aren’t automatically applied. For instance, it’s possible one of the conditions for intervention might be failure by the CCP to achieve a matched book. However, it’s also possible the problem is limited to a small subset of illiquid products. In that case, it might be preferable for the CCP to implement position-allocation tools for that subset, such as partial tear-up, rather than trigger resolution of the entire CCP.

There’s another important element to all of this. Whether through recovery or resolution, clearing participants should be compensated for any losses incurred through loss-allocation or position-allocation tools, over and above the CCP’s funded and unfunded default resources. This emulates the outcome that would be achieved if clearing participants were to go through an insolvency process.

All of this comes back to CCP resiliency. Ensuring CCPs are strong to begin with minimizes the prospect of a recovery or resolution action. That’s why the measures outlined in our paper on CCP resilience – transparency, stress testing, appropriate skin in the game, monitoring of concentration risk and scrutiny of suitability of products for clearing – are vital.

In making these proposals, ISDA is continuing in its long-standing role of ensuring legal and contractual certainty for industry participants, and in helping to build reliable and transparent procedures to deal with periods of market stress. Both the FSB and European regulatory authorities are due to publish further proposals on CCP soundness in the coming months, and ISDA will continue to engage with its membership, the wider industry and all relevant regulatory institutions to ensure the best solution on this issue.

Infrastructure Investment

Speak to anyone who knows a thing or two about the infrastructure that the modern world is built on – roads, rail, power generation and supply, etc – and they will tell you that often the biggest obstacle to its improvement is the ‘legacy’ issue. Once a system is in place, built at great cost and effort, transitioning to improved technology can be challenging.

This is a headache that the derivatives market now faces. Much of the infrastructure used in the handling of data, the processing of documentation, the execution and confirmation of trades and the exchange and management of collateral, is over-complex, needlessly duplicative and inconsistent.

Let’s face it – old systems were developed for old problems. With the financial reforms at various stages of implementation, our members are looking for new solutions to automate and streamline the massive reporting, trading and clearing requirements and new collateral management requirements in the derivatives space. To support our members and address the operational challenges and complexity head on, ISDA itself has reorganized its working groups to focus on developing solutions for critical infrastructures that are now embedded in the fabric of the derivatives market. For instance, we see tremendous potential to move collateral management from faxes, email and Excel spreadsheets to a more automated and streamlined process.

ISDA is in an ideal place to help guide this change. At our core, we are a standards body. We have brought the market together to establish the ISDA Master Agreement and the ubiquitous Credit Support Annex (CSA). Today, we are leading the market to bring a standardized approach to non-cleared margin rules with the ISDA Standard Initial Margin Model (SIMM). We are developing new CSAs to comply with the updated segregation requirements, and we are putting together a globally-applied resolution stay protocol to harmonize resolution regimes. Looking ahead, there is an opportunity to future-proof the legal documentation process through smart contracts, and to develop industry operational standards to facilitate the processing of trades throughout the trade lifecycle. Additionally, so much more can be done to modernize and upgrade the process by which we exchange collateral by driving standardization and automated efficiency.

ISDA has canvassed its members on these issues, and turned their proposals into a whitepaper that will lay out some proposed steps toward reform. We have been engaging with members and fintech / regtech firms to identify problems and recommend solutions. To give you a preview, our paper will focus on three specific areas.

  • Data: Agreement on formats and identifiers would significantly benefit market participants and regulators. In particular, a robust, granular, multi-use product identifier with strong governance on an open-source infrastructure would remove many systemic inefficiencies and further promote transparency.
  • Documentation: Despite a plethora of standard documents published for industry use, it is an unfortunate fact that many documents are still customized between transacting parties. The benefits of this customization are now being questioned, and there are opportunities for further standardization to drive more efficient processing, both within firms and across the market. We are committed to future-proofing the essential ISDA documentation through ‘smart contracts’ that will facilitate the automation strategies being developed by distributed ledger and block chain firms. ISDA has a lot to offer to speed the adoption in this space.
  • Duplication: There is a huge opportunity to cut down on the complexity and multiplicity of business processes required to support the same functions within or across asset classes. Standard processing models can facilitate the extension of Financial products Markup Language (FpML) in order to remove cost and inefficiency and provide a solid base for further evolution.

This isn’t about levelling existing infrastructure and starting from scratch. It is about finding a more efficient, less costly way of operating vital processes, and making sure that new, beneficial technology can be brought to bear without adding further burdens to an already over-stressed system.

ISDA will continue to encourage and facilitate discussion on these issues among traditional and new operators in the derivatives market. Our membership is exceptionally broad, and our door is always open to new firms and new ideas. This is a challenge that will be overcome, above all, by cooperation and collaboration, and ISDA will always provide a platform for this to take place.