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 Methodology (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 which 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.

Change Leverage Ratio’s Tax on Risk Management

Brexit may have overshadowed events over the past month, but it doesn’t mean everything else has just stopped. A huge amount of work is ongoing, from preparations for forthcoming margining requirements to flagging new straight-through processing rules. The capital space has been particularly busy with nine consultation responses filed in a matter of weeks, covering topics from internal models to the net stable funding ratio.

Our response to the Basel Committee on Banking Supervision’s consultation on the leverage ratio was one of the most recent. In it, we reiterate our concern about the impact of the leverage ratio on client clearing. This is an important topic, not least because the Group-of-20 specifically wants to encourage more clearing.

At its heart, the issue is fairly simple: we believe segregated initial margin posted by clients is not a source of leverage for banks, as it cannot be used to fund their operations. Rather, it is meant to cover any losses by a defaulting client – in other words, client initial margin is intended to reduce the exposure related to a bank’s clearing business. Despite this, the leverage ratio doesn’t currently recognize this exposure-reducing effect, which means the capital required to support this business is unnecessarily high. This makes the economics of client clearing more challenging for clearing-member banks.

Importantly, the Basel Committee said when launching its consultation in April that it would collect data to study the impact on client clearing – a step we welcome. ISDA has already pulled together some preliminary information, which indicates that not recognizing client initial margin has a significant effect on the leverage ratio exposure of client cleared transactions. This data will be further developed and submitted to the Basel Committee.

But it’s not just cleared transactions that are affected by this. A similar argument applies to bilateral non-cleared trades: segregated initial margin posted by customers should mitigate exposure, as it is intended to cover the losses racked up by a defaulting counterparty.

ISDA supplied data on this segment too, in response to a request from the Basel Committee for information on bilateral derivatives with counterparties. This issue will become increasingly important – and will have an increasingly large impact on capital requirements – as margining rules for non-cleared derivatives are rolled out.

Under those rules, initial margin has to be segregated and – like collateral posted for cleared transactions – cannot be used by a bank as a source of leverage. Exact requirements differ from jurisdiction to jurisdiction, but they all strengthen the protection given to initial margin, and ensure it is segregated from the margin collector’s proprietary assets. For example, under final margin rules published by the US Commodity Futures Trading Commission, initial margin must be held by a third-party custodian to ensure it is available to the non-defaulting entity in the event of a counterparty default. The custodian – which cannot be affiliated to either counterparty – cannot rehypothecate the margin.

Given this margin cannot be used as a source of leverage, and is intended to mitigate exposure, we believe initial margin received should be recognized as exposure-reducing in the leverage ratio calculation.

We very much welcome the fact the Basel Committee has reopened the leverage ratio for consultation – that kind of flexibility is important when regulators are implementing new rules virtually from scratch. We hope the points we raise will be considered and that the leverage ratio is made stronger as a result.

Read our response to the leverage ratio consultation by clicking here.

Brexit – Two Weeks On

Like many people, I woke up on Friday June 24 expecting to hear the UK had voted to remain in the European Union (EU). The final polls had suggested the Remain campaign was ahead, and sterling had begun to rally the day before. A prominent member of the Leave campaign had all but conceded late on the Thursday night. As I went to bed, early results from Gibraltar and Newcastle were in favor of remaining. Like many people, regardless of how they voted, I was therefore caught by surprise when I switched on morning news.

The vote by the UK to leave the European Union (EU) is a momentous event, and will have significant ramifications on the political, economic and financial landscape in both the UK and the EU. In the immediate aftermath, financial markets have been volatile, and the political fallout severe. Two weeks after the vote, there is considerable uncertainty about the ultimate form of any negotiated exit.

But there are some things we already know for sure. For one thing, the UK continues to be part of the EU, and will remain a member for some time yet. Once the UK government serves formal notice of its intention to withdraw via Article 50 of the Treaty on the Functioning of the European Union, it will have at least two years to negotiate a settlement. During that time, existing European regulations and treaties will continue to apply – as this statement from the UK Financial Conduct Authority makes clear.

We also know that the referendum vote to leave the EU will not, by itself, have any immediate consequences on the legal certainty of derivatives contracts, nor will it require any contractual change. Nothing will fundamentally change in the immediate term. That’s not to say derivatives users shouldn’t begin to consider future implications. To help with this process, ISDA has published analysis that highlights potential issues that counterparties will need to consider, including the impact on the choice of English law as the governing law for an ISDA Master Agreement.

Now the UK has voted to leave, ISDA will convene applicable working groups and hold a series of industry calls to ensure market participants are prepared for future developments. The first of those calls took place last week, in partnership with law firm Linklaters. This webinar briefing set out issues touching on passporting rights, the impact on clearing, trade reporting and margining, and legal and documentation. Close to 4,000 people listened in.

The overriding message was that little will fundamentally change in the near term: those UK firms subject to the European Market Infrastructure Regulation (EMIR) and the forthcoming revised Markets in Financial Instruments Directive and regulation will continue to have to comply at the moment. However, the implications post-Brexit will depend on the exit model that is agreed between UK and EU authorities at the end of the two-year negotiation period. That will determine whether, for example, passporting arrangements will continue to apply, and whether EU entities subject to the clearing obligation under EMIR will be able to clear through UK central counterparties.

ISDA’s top priority is to work with UK and EU authorities – as well as other affected jurisdictions – to resolve any cross-border differences and harmonize rule sets. Our goal is to ensure that we have consistent regulation to support deep pools of liquidity and risk management for our membership.

It is clear there is a lot of work to do in the months and years ahead. There is a lot of uncertainty. It’s vitally important we have a deliberate and organized process to provide financial, legal and operational certainty going forward.

For more information:

ISDA webinar on Brexit

ISDA analysis on implications of Brexit

ISDA statement on referendum vote

Unity Needed on Margin Timetable

Harmonization and coordination are easy enough to identity as objectives, but harder to achieve. Regulators can take a lot of credit, then, for their efforts to develop a coordinated global margining framework for non-cleared derivatives. As part of that, each national regulator agreed to adopt the same implementation schedule, setting a start date of September 1 for the biggest banks.

That carefully orchestrated timetable is now splintering. Earlier this month, a European Commission (EC) spokesperson confirmed that European rules would not be finalized in time for the September launch. European authorities will instead aim to deliver final standards by the end of the year, pushing the start date in Europe to the middle of 2017. As it stands, no other jurisdiction has followed suit – in fact, press reports suggest other regulators are holding firm.

We believe it’s positive that European regulators spend the necessary time to ensure their rules are appropriate. But the split in timing poses some important questions. Under the globally agreed timetable, implementation would be phased, starting with the biggest banks exchanging initial and variation margin from September 1 – known as phase one. The next major deadline is March 1, 2017, when the variation margin ‘big bang’ becomes effective for all covered entities – not just banks, but other financial institutions, including the buy side.

It is understood that European phase-one banks will now not be required to comply with margining requirements until the middle of next year – unless they are trading with phase-one banks still subject to margin rules in other countries. Presumably, that means the March 2017 variation margin big bang deadline will also be pushed back in Europe. That will have a far wider, and far more profound impact on cross-border trading.

Clarity on this point is important from a readiness and operations standpoint – as is clarity on how other regulators will approach the March 2017 deadline.

The implications of a fractured timetable are complex enough for the big phase-one banks. On the face of it, the delay creates an unlevel playing field – but the precise impact will depend on the status of each entity and the identity of their counterparties.

The complexity will increase exponentially once variation margin rules come into effect in March, when more derivatives users will be subject to collateral posting requirements. It will also lead to greater fragmentation and disruption of cross-border trading. If other regulators retain the March 2017 deadline and Europe does not, then it might encourage European market participants to trade with European dealers where possible.

Given the impact from March 2017 on the broader market, not just the largest banks, it’s important this issue is considered carefully. There is an easy answer: realign the global implementation deadline. We would urge regulators to do that in the interests of ensuring the market can continue to function efficiently.

Measure Twice, Cut Once

Last week, I was fortunate enough to be invited once again to testify before the House Committee on Agriculture’s Subcommittee on Commodity Exchanges, Energy, and Credit on the impact of new capital and margin rules. This came at an extremely opportune time. Margining requirements for non-cleared derivatives will be rolled out for the largest banks from September, while core elements of the Basel reforms are still evolving.

The problem is that no one has a clear idea of how these various rules will interact and what the ultimate impact will be.

As I said in my testimony, the old tailor’s saying holds true – measure twice, cut once. At the moment, we’re cutting our cloth in the dark.

What we do know for sure is that policy-makers such as the Group of 20 and the Financial Stability Board think further refinements to Basel III should be made without significantly increasing capital across the banking sector. Major improvements have already been made to ensure the financial system is more robust. As I pointed out last week, common equity capital at the largest eight US banks has more than doubled since 2008, while their stock of high-quality liquid assets has increased by approximately two thirds.

Unfortunately, recent studies by ISDA on those parts of the capital framework that have not been fully implemented show further increases in capital or funding requirements for banks, on top of current levels. This will increase costs for banks, and may negatively impact the liquidity of derivatives markets and the ability of banks to lend and provide crucial hedging products to corporate end users, pension funds and asset managers.

Given this, ISDA believes regulators should undertake a comprehensive impact assessment covering capital, liquidity and margin rules. Given continuing concerns about economic growth and job creation, legislators, supervisors and market participants need to understand the cumulative effect of the regulatory changes before they are fully implemented.

The margin rules are equally important – and we’re rapidly approaching the September effective date for the large, phase-one banks. ISDA has worked hard to prepare for implementation, by drawing up revised margin documentation that is compliant with collateral and segregation rules and developing a standard initial margin model called the ISDA SIMM.

But despite these efforts, challenges remain. For one thing, regulators need to send a clear signal that the ISDA SIMM is appropriate, giving banks the confidence to implement the model ahead of the start date.

For another, the Commodity Futures Trading Commission needs to finalise cross-border margin rules to ensure substituted compliance determinations can be made for overseas rules that achieve similar outcomes. These determinations need to be made quickly. Another three-year wait, as happened with the US/EU central counterparty equivalency standoff, will hobble cross-border trading and further contribute to the fragmentation of global derivatives markets.

I would just like to take this opportunity to thank the House Committee on Agriculture for its interest in these topics, and for holding this important hearing.

FRTB: One Piece of the Capital Puzzle

With any jigsaw puzzle, it takes time before the full picture starts to become visible. Look at any single piece in isolation, and the picture is unrecognizable. Slot several of the pieces into place, and the image slowly starts to take shape.

A comparison of sorts can be made with the package of capital, leverage and liquidity reforms being introduced by the Basel Committee on Banking Supervision. The Group of 20 (G-20) has set out the picture it wants to end up with: a Basel III framework with an increase in the level and quality of capital banks must hold compared with the pre-crisis Basel II.

But the G-20 has also decreed that any work to refine and calibrate elements of the Basel III rules prior to their finalization and implementation should be made without further significantly increasing overall capital requirements across the banking sector. This is where it’s hard to see how the pieces come together.

The latest segment of the capital jigsaw to be slotted into place is the Fundamental Review of the Trading Book (FRTB), an initiative to overhaul market risk requirements. In its January publication of the final FRTB framework, the Basel Committee estimated the revised standard would result in a weighted mean increase of approximately 40% in total market risk capital requirements. That estimate, though, was based on a recalibration of quantitative-impact-study data from an earlier version of the rules.

As a result, ISDA decided to lead an additional industry study based on data from 21 banks to determine the impact of the final requirements – and the results were unveiled at ISDA’s 31st annual general meeting in Tokyo last week.

The study shows an overall increase in market risk capital of between 1.5 and 2.4 times compared to current market risk capital. The lowest estimate of 1.5 times assumes all banks will receive internal model approval for all desks. If all banks fail the internal model tests for all trading desks, market risk capital would increase by 2.4 times. ISDA believes the end result will be somewhere in between, but this will depend on two key variables: interpretation of rules on a so-called P&L attribution test and whether the calibration of capital floors applies to market risk.

The former is particularly important – and currently problematic. Under the FRTB, banks have to apply for regulatory approval to use internal models for each trading desk, with approval dependent on passing a P&L attribution test (essentially comparing internal capital systems with front-office models). But there is currently a lack of clarity over how this test will work in practice, while banks have not had time to develop the infrastructure that would enable them to produce the data required for the test.

Without more certainty on the methodology, and without knowing whether or at what level capital floors will be set, it is difficult to accurately estimate the ultimate impact. But it is unlikely all banks will receive internal model approval for all desks, meaning the end result may be closer to 2.4 times than 1.5 times.

Crucially, the study shows the final FRTB framework hasn’t eliminated a cliff effect between standardized and internal models. If a particular desk loses model approval, capital requirements could immediately increase by multiple times. This had been something the Basel Committee had wanted to eliminate.

The FX and equity markets are most affected. Losing internal model approval under the new rules would result in a 6.2 times increase in capital for FX desks and a 4.1 times increase for equity desks[1].

These are big increases, and come on top of the jump in capital requirements already envisaged in Basel III. The question is whether this single piece of the jigsaw suggests the final picture will be out of line with what the G-20 expects. To put it more simply, will this piece, when combined with other changes in the capital framework, ultimately result in further significant increases in capital across the banking sector? The honest answer is that no one knows.

We do, however, know that large increases in capital could mean certain business lines end up becoming uneconomic. This could severely affect the ability of banks to provide risk management services and reduce the availability of financing for borrowers. At a time when some jurisdictions are increasingly focused on initiatives to generate and sustain economic growth, that’s a concern.

[1] These numbers exclude the so-called residual risk add-on, non-modellable risk factors and diversification across risk classes under internal models

Leverage Ratio: Time for a Spring Clean

For most of us in the northern hemisphere, April denotes the real start of spring, and with it, the opportunity for a little spring cleaning. The Basel Committee on Banking Supervision has marked the season with some spring cleaning of its own, reopening its leverage ratio for consultation this month.

ISDA welcomes this development – and it’s something we’ve been calling on for some time. The leverage ratio has been a cause for concern for derivatives market participants since its finalization in early 2014, in large part because of how it would affect client clearing. That’s because the leverage ratio, as currently formulated, doesn’t recognize that properly segregated client collateral reduces exposure for firms that provide clearing services. This means the amount of capital required to support client clearing services is not appropriately calibrated with the risks of that business. The end result: the economics of client clearing becomes extremely difficult for clearing members that provide this service, which runs counter to the objective set by the Group-of-20 nations to encourage central clearing.

The latest paper proposes a number of changes to the leverage-ratio calculation. It suggests replacing the current exposure method (CEM) with the standardized approach for counterparty credit risk (SA-CCR). On the face of it, this is a helpful change: the CEM is a fairly blunt methodology that doesn’t differentiate between margined and non-margin trades, and doesn’t recognize netting in any meaningful way. In comparison, SA-CCR is more risk-sensitive.

It’s disappointing, though, that the Basel Committee chose not include the issue of whether to recognize collateral posted by counterparties within the spring clean. The consultation offered a good opportunity to obtain evidence and consider the impact of recognizing segregated client margin as an offset to potential future exposure (PFE, one of the key components of the leverage-ratio calculation) under SA-CCR. ISDA maintains that properly segregated initial margin posted by a counterparty is not a source of leverage and risk exposure for a bank. On the contrary, it reduces exposure by covering losses that may be left by a defaulting counterparty.

The good news is that the Basel Committee has said it will specifically look at this issue with regards to client clearing. Over the coming months, it will collect data via an additional quantitative impact study to help determine the impact of the leverage ratio on client clearing. Depending on the result, it may consider allowing a clearing member’s PFE to be offset by initial margin posted by a client for cleared trades.

Among the other notable features of the proposal is a decision to maintain the margin period of risk (MPOR) in line with the SA-CCR, where the level depends on whether the transaction is cleared and collateralised, among other things. Under this approach, a cleared transaction subject to daily margining would attract an MPOR of five days – a reduction in the time horizon that should decrease clearing-member PFE compared to the CEM.

It’s too early to provide detailed feedback at this stage, but ISDA welcomes the opportunity to respond on this, and we will work with our members over the weeks and months to provide facts on the cost of not recognizing the risk-reducing impact of margin.

Clearing has become an extremely important feature of the derivatives market. As such, it’s vitally important we get this measure right.

Far from the Modelling Crowd

It’s been clear for some time that the enthusiasm for internal bank capital models has been waning within certain parts of the regulatory community. The latest signal of that decline is a recent Basel Committee on Banking Supervision proposal to restrict the use of models for the calculation of credit risk-weighted assets. Within that proposal is a very clear decree: the use of the internal model approach (IMA) for the calculation of credit valuation adjustment (CVA) capital is no longer allowed.

The timing of that announcement came as a surprise. One reason given for the decision is that the Basel Committee has doubts CVA can be effectively captured by an internal model. However, only one quantitative impact study (QIS) has so far been completed on proposed revisions to the CVA capital framework, and that was hindered by lack of completeness, an absence of clarity (particularly over the treatment of portfolio hedges) and time constraints (the QIS was run in conjunction with a QIS on the Fundamental Review of the Trading Book (FRTB), but with less preparation time to make the necessary changes to bank systems).

As a result, the Basel Committee launched a second, comprehensive QIS earlier this year. But the decision to eliminate internal models for CVA has been taken while that second QIS is still in progress, before the Basel Committee has even seen the data submissions from banks.

Regulators further justified their decision to eliminate IMA-CVA by noting that CVA capital will be significantly reduced anyway due to greater use of central clearing and the introduction of margining rules for non-cleared derivatives. That’s true, but certain counterparties – non-financial corporates and sovereigns, for instance – are exempt from mandatory clearing and margining. As a result, trades with these end users will be subject to a CVA charge calculated using a standardized or basic approach. An overly conservative methodology will therefore particularly affect those counterparties.

The decision to eliminate the IMA-CVA follows other, similar developments elsewhere: a requirement for all banks to model market risk capital using a standardized approach, and for those outputs to potentially act as a floor for internal models; a proposal to introduce capital floors more broadly; the emergence of non-risk-based backstops such as the leverage ratio; and the ditching of the advanced measurement approach for operational risk.

Some regulators have highlighted complexity and variation in risk-weighted assets (RWAs) as a rationale for wanting to restrict the use of internal models. ISDA understands these concerns, but believes there are ways to address trepidation about RWA variability without eliminating internal models – through greater consistency of model inputs or through ongoing testing procedures, for instance. Opting instead for a broad restriction in the use of internal models, or disallowing their use entirely, has several important implications.

For one thing, internal models are much more sensitive to risk and better align with how banks actually manage their business. In comparison, standardized models are relatively blunt, meaning the required capital charge for holding a particular asset might not adequately reflect its risk. This can lead to poor decision-making: a bank might choose to pull back from low-risk assets, counterparties or businesses where capital costs are relatively high. Conversely, they might opt to invest in higher-risk assets that appear attractive from a capital standpoint. These issues were what prompted the Basel Committee to create incentives for the use of risk-sensitive internal models in the first place via Basel II.

We believe, as a general point, that capital levels should reflect risk as closely as possible. A less risk-sensitive capital framework leads to the possibility of a misallocation of capital and an increase in systemic risk. Making decisions in a business that is intrinsically about taking and managing risk, based on a capital framework that is being made purposely less risk sensitive, creates its own hazards – as described in this recent article from Risk.

Another likely impact of this shift away from models is an increase in capital. That’s because standardized approaches tend to be more conservative. For example, an industry study on a draft of the FRTB rules, conducted by ISDA and other trade associations last year, revealed a move from internal models to the standardized approach would result in a jump in capital of between 2.1 and 4.6 times, depending on the trading desk. The Basel Committee has since published its final FRTB framework, and ISDA is involved in another study to determine whether these cliff effects still exist.

The Group-of-20 nations and the Basel Committee have both stated that further refinements to the capital framework should not result in significant increases in overall capital levels. We believe that is the right approach given the significant increases in capital that have occurred already as a result of Basel III. The challenge is that each individual measure tends to be considered in isolation. So while a single refinement might not meaningfully increase overall capital levels by itself, it might, when combined with all the other little tweaks, end up leading to higher capital levels in total.

Only a comprehensive impact study to determine the overall effect of all the changes together, including the changes to models, will provide the answer to this. And that should occur sooner rather than later.

Starter’s Gun Fired in European Margin Race

The March 8 publication by European supervisory authorities (ESAs) of their final rules on the margining of non-cleared derivatives marks the start of a sprint to comply ahead of the global, pre-agreed start date. ISDA and its members have been ‘in training’ for this race for the past three years, but the final draft regulatory technical standards give all entities affected by European rules the information they need to make the necessary changes to documentation, processes and systems. Many will read the rules and be relieved that some of the hurdles have been removed. But, as in any race, some challenges lie ahead.

There is certainly some good news in the 95-page release, reflecting many of the concerns raised by ISDA during the consultation process. Most significantly, many of the problematic points of difference between earlier European proposals and final rules from US prudential regulators and the Commodity Futures Trading Commission (CFTC) have either been eliminated or moderated – a welcome development that should help facilitate equivalence decisions between the US and Europe.

For example, the ESAs opted not to require initial margin exchange on physically settled foreign exchange swaps and forwards, and on the principal in cross-currency swaps, bringing their rules more in line with the approach taken in the US, and in the proposals made by other national regulators. Recognising that US rules do not cover equity options, European regulators also chose to introduce a three-year phase-in before these instruments are subject to margin requirements – a decision taken to avoid regulatory arbitrage, the ESAs said.

Action was taken to tackle practical problems highlighted by ISDA as well. A six-month delay on intragroup initial margin was included to reflect concerns that applications for intragroup exemptions may not be approved by national authorities in time for the September effective date. And a three-year phase-in was introduced for intragroup trades with non-EU affiliates to give time for equivalence determinations to be completed.

These are all good, positive steps that should help cross-border trading – an issue on which ISDA has been vocal. But there were some more challenging elements in there too. That includes a decision to stick with a requirement for margin to be collected within one day of the trade date (T+1). That’s in line with US final rules, although it differs from the approach taken in some other national proposals. Market participants had argued T+1 presents practical challenges for trades with counterparties in other time zones, particularly in Asia, where markets close early in the European day. European buy-side groups had also argued that the T+1 deadline for variation margin collection would, at best, impose significant costs on smaller financial end users, such as pension funds, for little reduction in systemic risk.

ISDA had recommended allowing more time for the calling and collection of margin. Ultimately, the ESAs made some attempt to allow more time for smaller firms to exchange variation margin, but only under strict conditions that appear to essentially involve the pre-funding of margin. This implies prohibitive extra costs.

But, as with any race, the clock is the biggest challenge. And with little time left to implement, this race has become a sprint. In the space of just six months, all outstanding collateral documents will need to be revised, technology will need to be implemented or adapted and tested, and regulatory approvals will need to be obtained. New legal documents to address segregation and collateral exchange must also be drafted and signed. That’s hefty to-do list, and a challenging timetable.

ISDA has been in training for some time to prepare the ground for implementation. Central to this initiative is the development of a standard initial margin model, known as the ISDA SIMM, which will be available for firms to use to calculate how much initial margin needs to be exchanged. ISDA has been touring the globe in recent months, showing the methodology to regulatory authorities, alongside a transparent governance structure, in order to smooth to path to implementation. Significant time and resource has also been spent to prepare for the necessary revisions to the ISDA credit support annex in each jurisdiction, as well as to develop a protocol to ensure the changes can be made to outstanding agreements as efficiently as possible. Additional initiatives include the development of a dispute resolution mechanism.

But while plenty of preparation has been done by ISDA and the industry as a whole, the nuts and bolts of implementation could not begin until final rules were published. US prudential regulators published their final rules at the end of October, and the CFTC followed two months later. The March release from European regulators fires the starting gun on the sprint to be ready for implementation in Europe.

MIFID II: Wait for CPMI-IOSCO on Product Identifiers

Later this week, an industry workshop will convene in Washington, DC to discuss efforts to develop global, harmonised data standards for derivatives. This is an important – and welcome – initiative. Existing regulatory reporting regimes have been hampered by differences in reporting rules between jurisdictions, variations in reporting formats and a lack of global standards, making it tough to aggregate data across trade repositories and across borders.

The workshop, run by the Committee on Payments and Market Infrastructure (CPMI) and International Organization of Securities Commissions (IOSCO), will focus on three key topics, each covered by consultation papers issued last year: unique transaction identifiers, unique product identifiers and other data elements.

ISDA strongly supports this initiative. Agreement on common standards will be a major step on the path to harmonisation, and will improve the ability of supervisory authorities to aggregate data across trade repositories. It will also hopefully go some way towards reducing costs and complexity for reporting parties, particularly those that are subject to multiple reporting requirements.

ISDA has been contributing to this effort, and launched an industry wide Symbology project last year to develop a common product identifier for regulatory and reference data purposes. This initiative will incorporate the recommendations made by CPMI-IOSCO.

Despite this progress, the risk of fragmentation remains. In Europe, for example, the European Securities and Markets Authority (ESMA) has chosen ISINs as the sole identification standard under the revised Markets in Financial Instruments Directive and regulation (MIFID II/MIFIR). The final draft regulatory technical standards were published in September last year – after CPMI-IOSCO had begun its harmonisation initiative – and is currently being reviewed by the European Commission (EC).

The risk is that the MIFID II/MIFIR requirements may end up not reflecting the final global recommendations by CPMI-IOSCO. Certainly, there are a number of challenges associated with using ISINs in their current form for derivatives. ISINs work well for bonds, where an issuer can apply for an identifier in advance of issuance. In contrast, there isn’t an issuance process for derivatives: each contract is created through the act of trading and in response to client requests.

What’s more, each derivative can differ to suit the needs of the counterparties, with variability in everything from maturity to day-count convention. While a single bond with a single ISIN can be bought and sold by multiple participants, each derivative trade could theoretically require a unique ISIN to reflect the variability in terms. This means the number of ISINs required each day could run into the millions, way in excess of what is currently issued.

As it stands, ISINs can only be created by a network of national numbering agencies that are sole providers of the identifier in their local markets. Putting aside the lack of competition this creates, current turnaround times for new ISINs would need to be dramatically sped up in order to satisfy derivatives market practices.

ISDA is working with regulatory authorities, the International Organization for Standardization and the Association of National Numbering Agencies to consider how the ISIN could be modified to cater for derivatives.

Nonetheless, we believe it is important that European authorities allow the flexibility to incorporate the recommendations from CPMI-IOSCO within MIFID II/MIFIR, rather than tying themselves to ISINs now. (ISDA and the Global Financial Markets Association wrote a letter to the EC in December 2015, which outlined these issues.) Having different derivatives product identifiers for different purposes in different regions creates significant costs and complexity for users and market infrastructures, for little benefit. The optimal solution would be to use a product identifier solution that is global in application and consistent across jurisdictions.

Both regulators and market participants agree on the importance of global harmonisation. Real progress is being made by both CPMI-IOSCO in agreeing global standards for data, and by the industry through ISDA’s Symbology initiative. It would be a unfortunate if individual regulators go their own way now, when we’re so close to a common standard.