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.

SDR Indemnification Removal: A Good Step Forward

An important yet largely unnoticed step in efforts to improve regulatory transparency came to pass last week. A bill to remove a provision within the Dodd-Frank Act that essentially compelled foreign regulators to indemnify US swap data repositories (SDRs) against litigation related to information provided by those SDRs became law.

The need for a technical fix to Dodd-Frank to remove this provision has long been recognised by US legislators and regulators. With foreign authorities unable or unwilling to provide indemnification, it meant global regulators were unable to get a complete picture of risk exposures, hindering transparency of derivatives markets.

While at the Commodity Futures Trading Commission (CFTC), several of my fellow commissioners and I heard first hand from overseas supervisors how big an issue this was. We called for the problem to be addressed – a position repeated by several of our successors at the CFTC since. That view was also shared by many US legislators, and earlier attempts to remove this provision garnered significant bipartisan support in both the House and Senate.

Five years on from the enactment of Dodd-Frank, the provision has finally been removed. This is extremely welcome, and marks a big step towards the sharing of derivatives transaction data across borders – in turn, enhancing transparency and enabling regulators to better monitor risk exposures and market activity.

More needs to be done, however. As it stands, a variety of data protection, client confidentiality and blocking statutes prevent counterparties from reporting key data, particularly when the repositories are domiciled in foreign jurisdictions. The CFTC has got round some of these legal barriers by temporarily allowing reporting parties to ‘mask’ the identity of their counterparties so as not to breach secrecy and data protection laws in foreign jurisdictions. But this needs to be tackled urgently to encompass all jurisdictions with privacy barriers, and to provide such protections to all parties with reporting obligations in a more permanent way in order for a global, transparent reporting regime to work properly.

The Financial Stability Board (FSB) has recognised this issue, and has set a deadline of June 2018 for FSB member jurisdictions to remove any barriers to reporting complete information, and to stop the masking of counterparty data by the end of 2018. FSB members are required to report the actions they plan to take by June 2016. Concurrent with this, the FSB member jurisdictions should prioritise the signing of memorandums of understanding (MOUs) between regulators to facilitate the sharing of data across borders. A couple of MOUs have already been signed, but use of this important tool is rare.

However, other, non-FSB members also need to tackle this issue – countries like Algeria, Bahrain, the Philippines and Taiwan, to name just a few. The masking of data cannot be eliminated entirely until legal barriers are addressed in those countries as well. Otherwise, firms face the unenviable choice of violating the reporting requirements in Dodd-Frank and similar legislation elsewhere, or breaching domestic secrecy laws.

Basel’s FRTB QIS: Why the Difference?

The Basel Committee on Banking Supervision’s impact studies are useful. They provide regulators with a crucial insight into the possible effect of new capital rules, before those rules are fully finalized. The public release of those studies is also a good thing. Banks, analysts and the media are able to get an early indication of the possible aggregate impact on capital levels, and scrutinize and debate those figures.

The recent release by the Basel Committee of an interim quantitative impact study (QIS) on the Fundamental Review of the Trading Book (FRTB) was therefore greeted with some anticipation. Inevitably, comparisons were made with a recent study published by ISDA, the Global Financial Markets Association and the Institute of International Finance, and run by Global Association of Risk Professionals. Equally inevitably, there was some puzzlement about differences in the numbers.

We thought it would be helpful to explain why. Most importantly, the two reports are looking at different things. The Basel Committee’s impact study uses December 2014 numbers, and is based not on the most recent QIS conducted by the Basel Committee based on June 2015 data (known as QIS 4), but the one before (QIS 3). The Basel Committee has made changes to the framework since QIS 3, including the addition of a residual risk add-on in the standardized approach. Securitization was also not included in the scope of QIS 3, but was added to QIS 4. That means these components, which were two big contributors to the capital numbers included in the industry report, are not incorporated in yesterday’s Basel Committee release.

In comparison, the industry study represents the aggregate results of actual QIS submissions from 28 banks, as part of Basel’s QIS 4 exercise. That QIS exercise was based on submissions that were made to the Basel Committee in early October 2015. QIS 4 was run after the residual risk add-on and the securitization requirements were added to the proposed framework via QIS instructions from the Basel Committee. According to the industry study, the residual risk add-on accounts for 47% of total market risk capital under the standardized approach. The results also show a 2.2 times increase in capital requirements for securitization.

These differences (QIS 3 versus QIS 4; December 2014 data versus June 2015 data) clearly mean the two sets of results can’t be compared like for like.

In its study, the Basel Committee writes:

“Further analysis is being performed in the next trading book QIS (based on end-June 2015 data) to assess any need for further recalibration of the parameters.”

We look forward to a release on the most recent QIS exercise, and we remain committed to constructively work with the Basel Committee to finalize the FRTB framework.

An Elegant Solution

Earlier this month, buy- and sell-side market professionals participated in an ISDA conference in New York on the future of the single-name credit default swaps (CDS) market. (Don’t worry if you missed it – a similar program is being held in London on December 1.)

The session was lively and well attended. The audience heard executives from firms such as General Electric, Blackrock, BlueMountain and Citadel discuss how and why they use CDS to hedge, manage and take risk. They heard that, despite the benefits, single-name CDS trading volumes continue to decline, for a variety of reasons. And they heard about potential solutions that could reinvigorate the market.

What were the key takeaways?

In the words of one panelist, single-name CDS are “an elegant solution” that belong in the portfolio of credit risk management tools. They enable bond investors to hedge the risk that an issuer may default. They also enable investors to diversify their portfolios by taking exposure via single-name CDS to companies that may not issue bonds often, or where physical bonds are difficult to source. In other words, they deliver considerable value to market participants. But despite that value, trading volumes are declining. Some of that decline is due to misperceptions (such as a belief that the use of single-name CDS caused the crisis – it didn’t). Some is due to regulatory uncertainty, some is the result of a benign default risk environment, and some results from the overall decline in structured finance.

One important trend that holds significant potential for the market’s renewal is the move towards central clearing of single-name CDS transactions. Clearing will free up capital on bank balance sheets and could bring much-needed liquidity to the market.

Unlike CDS index trading, there is no mandate to clear single-name CDS contracts. So despite the fact that hundreds of single names are clearable, the uptake for clearing has been relatively slow to date. The onset of margin requirements for non-cleared derivatives in 2016 and beyond will likely change that and incentivize the evolution to clearing.

But in the meantime, firms are considering several different ideas to reinvigorate the market. Some think regulators should mandate clearing of the more liquid single names. Others believe a tiered pricing structure may evolve for cleared and non-cleared single names. The merits of greater electronic trading are also being debated.

One upcoming change expected to occur in December is the move from a quarterly to a semiannual roll date for single-name contracts, which should improve efficiency in the market. It’s a step in the right direction.

We will no doubt see and hear additional ideas at our December conference in London. We at ISDA believe there is a future for the single-name CDS market, and we’re working in a number of ways to make sure that future is safe and efficient for all market participants.

Well Said, Chairman Massad

On the face of it, the mandatory reporting of derivatives transaction data has seen most progress of all the market reform commitments made by the Group of 20 nations in Pittsburgh in 2009. As highlighted in a progress report published by the Financial Stability Board (FSB) last week, 19 out of the 24 FSB jurisdictions have trade reporting requirements in place, and a further three are expected to follow next year. That compares favorably with the 12 out of 24 that have clearing frameworks in place, and the eight that have made progress on electronic trading rules.

But while there has been plenty of progress, significant challenges remain. In particular, a lack of standardization and consistency in reporting requirements within and across jurisdictions has led to concerns about the quality of the data being reported. That’s not good for supervisory authorities, which may be hampered in their ability to fulfill their regulatory obligations. And it’s not good for market participants, who have to meet multiple, different reporting rules and formats, increasing complexity and costs and reducing efficiency. In this sense, progress has been slow, disappointing and frustrating.

We therefore welcome the comments made by Commodity Futures Trading Commission (CFTC) chairman Timothy Massad in a speech last week. He recognized the importance of common identifiers for entities, products and transactions to enable data to be aggregated, and highlighted the need to develop and expand their use. He pointed to an international effort by the Committee on Payments and Market Infrastructures (CPMI) and International Organization of Securities Commissions (IOSCO) to develop guidance on these identifiers – expected next year. In addition, he said the CFTC is looking at the legal issues that prevent the cross-border sharing of data – a point also picked up by the FSB in another report last week.

Importantly, he also stressed the need for standardization in what is reported in the various data fields. There are hundreds of different data fields that must be filled in by reporting institutions – the exact number differs across jurisdictions and regulatory regimes. Often, the format of this information differs from institution to institution and repository to repository. Chairman Massad noted that industry developed standardized terms had not emerged, so the CFTC would work to specify the “form, matter and the allowable values that each data element can have”. The agency plans to publish proposals on roughly 100 fields before the end of the year, he added.

This represents a big step forward, and tallies with principles published by ISDA earlier this year. One thing to stress, however: the industry has been working to develop standards, in terms of taxonomies, transaction identifiers and, most recently, an industry project to develop common product identifiers. One of the big challenges has been the differences in regulatory requirements across jurisdictions. In short, regulators in different countries have asked for different things, in different ways.

In this sense, we welcome the work being conducted by CPMI-IOSCO to develop harmonized principles for key derivatives data elements, as well as unique transaction and product identifiers. Chairman Massad stressed that the CFTC’s in-house standardization efforts would be coordinated with those of CPMI-IOSCO. That is welcome, and important. CPMI-IOSCO is still working on its data harmonization efforts and plans to publish two additional consultations on key derivatives data elements early next year – the second of which will take industry feedback from the proceeding consultations into account. It’s important the CFTC’s work is aligned with this global initiative. Global consistency in rules and requirements is paramount. From that point, industry participants can escalate their ongoing efforts to develop best practices and common standards.

FRTB: Time Running Out

At the end of this year, the Basel Committee on Banking Supervision plans to finalize its Fundamental Review of the Trading Book (FRTB). And the impact – based on recent analysis led by ISDA, GFMA and IIF – looks like it will be significant, with banks having to hold multiples more capital than they do today.

According to an analysis of data submitted by 28 banks, and based on current calibrations, the standardized approach will result in 4.2 times the total market risk capital that firms hold under the existing methodology. That’s a big increase. And it matters for a number of reasons.

For one thing, trading book capital requirement increased substantially in the immediate aftermath of the crisis through Basel 2.5. Raising capital levels further was not a stated objective of the review. Instead, the FRTB was intended to overhaul trading book capital rules, replacing the mix of measures introduced through Basel 2.5 with a more coherent set of requirements. The changes are primarily targeted at addressing structural shortcomings in the market risk framework by including a risk-sensitive standardized approach, as well as reducing the variability in capital levels between banks.

The results suggest these objectives aren’t being met. For example, 47% of the total market risk figure comes from a new notional-based add-on to capture residual risks under the standardized approach. As a notional-based measure, it’s not risk sensitive: it depends on the size of positions, rather than the risk they pose. The analysis also shows large differences between capital numbers generated under the internal model and standardized approaches. This is important, because the Basel Committee intends the standardized approach to act as a credible fallback to internal models, making it easier for regulators to withdraw internal model approval. However, the analysis suggests a change from internal models to the standardized approach would require between 2.1 and 4.6 times more capital, depending on the risk-factor class.

The 4.2 times increase in market risk capital under the standardized approach isn’t just an issue for smaller, less sophisticated banks or those that lose regulatory approval to use internal models. Last December, the Basel Committee proposed introducing capital floors as a backstop to internal models. Any floor would likely be set at a percentage of the standardized model output – so, the higher the capital requirements under the standardized approach, the higher the floor.

Engagement between the regulators and the industry on the FRTB has been extremely constructive so far – illustrated by the Basel Committee’s decision in June to run an additional QIS. That came in response to concerns expressed by the industry about the quality of the data submitted for the first two firm-wide studies.

These results, however, pose some fundamental issues. An increase in capital of this magnitude could result in certain markets and businesses becoming uneconomic. This includes the securitization market, where the results show a 2.2 increase in capital requirements, as well as credit to the SME sector and small-cap equities. This reduces the availability of financing for borrowers at a time when some jurisdictions are increasingly focused on initiatives to generate and sustain economic growth. Additional increases in capital could also further reduce dealer capacity and affect market liquidity.

ISDA is pleased to be able to contribute to this important discussion to help quantify the impact of this capital rule. We hope the Basel Committee will continue with its constructive engagement and consider modifications suggested by market participants that will meet the objectives of the trading book reforms, while keeping capital at a level that is proportionate to the risk.

Client Margin Protections Should Be Recognized

As a former commissioner of the Commodity Futures Trading Commission (CFTC), I can attest to the importance that has been placed by regulators on the protection of client cash collateral. At the CFTC, we worked to strengthen that protection, and issued strict rules to ensure the integrity of customer accounts and restrict their access by futures commission merchants (FCMs), except when needed to further the customer’s own activities or to resolve a customer default.

These rules ensure client collateral is segregated and accounted separately from the FCM’s other assets, and cannot be used to fund the FCM’s own operations. There are also restrictions in place to ensure the margin can only be held in cash or highly conservative and liquid instruments, such as US Treasury bonds.

Many other jurisdictions have comparable requirements in place. For instance, the UK Financial Conduct Authority’s Client Asset Sourcebook sets out requirements relating to holding client assets and client money, and provides similar protection.

As pointed out in a letter published in the Financial Times today and signed by a group of exchanges, clearing houses and industry associations including ISDA, the Basel Committee on Banking Supervision’s leverage ratio doesn’t take these client margin protections into account when determining the exposures that banks face as a result of their client clearing businesses.

This treatment has been defendedas well as criticised – by some in the regulatory community. However, this is a major flaw in the application of the leverage ratio. In its rules, the Basel Committee stresses the importance of introducing a simple measure that captures the on- and off-balance-sheet sources of leverage faced by a bank. But properly segregated client cash collateral is not a source of leverage and risk exposure. In fact, it does the opposite: it acts to reduce the exposure related to a bank’s clearing business by covering any losses that may be left by a defaulting client. This exposure-reducing effect is not recognized by the leverage ratio.

Big strides have been taken in increasing the share of derivatives cleared through central counterparties in recent years, meeting one of the key objectives set by the Group of 20 (G-20) nations in 2009. Today, roughly 75% of the interest rate derivatives market is cleared, according to US swap repository data compiled by ISDA. But the leverage ratio in its current form could threaten continued progress.

Failure to recognize the exposure-reducing effect of client cash collateral would substantially increase a clearing firm’s total leverage exposure, leading to a rise in the amount of capital required to support client clearing activities. Many firms may decide the economics simply don’t stack up – and several banks have already taken that decision and retreated from client clearing. The end result will be a reduction in capacity to clear for clients, increased concentration in a smaller number of FCMs or clearing members, and higher costs for those end users that are able to find clearing members to clear on their behalf.

That seems very much counter to the G-20 objective to incentivize greater levels of derivatives clearing. We believe further data analysis on this topic is necessary to fully understand the impact. We would therefore encourage the Basel Committee to re-open its leverage ratio rules and reconsider this issue.

Bipartisan Consensus Emerges on Inter-Affiliate Trades

The term — inter-affiliate trade — is hardly a household phrase.  But it is at the heart of an important risk management issue, and consensus is growing that the issue needs to be addressed by policymakers.

Simply put, inter-affiliate trades are transactions that enable firms to centralize their risk management activities.  A European firm, for example, might prefer to enter into a swap with a local, European-based subsidiary of an American financial institution.  That institution, however, might choose to consolidate its exposure in a centralized, global risk management function.   So its subsidiary would, in turn, enter into an off-setting transaction with the financial institution’s centralized risk management function.  That internal, offsetting transaction is what is known as an inter-affiliate or internal risk management transaction.

Proposed rules in the US (Margin and Capital Requirements for Covered Swap Entities; Proposed Rule, Federal Register / Vol. 79, No. 185 / September 24, 2014) could require subsidiaries of American firms to exchange initial margin on these trades.  This could, in turn, be inconsistent with the regulatory approaches being taken in other key jurisdictions, and put firms operating in the US at a competitive disadvantage internationally.

For these and other reasons, US legislators came together in bipartisan fashion to ask American supervisors to consider exempting internal risk management transactions from the initial margin requirements.  As Congressmen Michael Conaway and Collin Peterson, who are, respectively, the chairman and the ranking member of the US House of Representatives Committee on Agriculture recently wrote to regulators, such transactions:

“enable financial institutions to provide customers with a single, client-facing entity for transactions, simplifying regulatory compliance for bank customers…Internal risk management transactions are necessary for global financial institutions to manage their risk profile and enable banks to provide cost-effective services to their clients.  Requiring affiliates to post initial margin on these transactions will disincentivize the use of this important tool and push higher transactions costs onto end-users.”

Not everyone in Washington agrees with this approach.  Perhaps the biggest concern is that such an exemption might mean that US banks would effectively take on the risks of affiliates that may operate in jurisdictions with lower capital and regulatory requirements.

However, there are a number of existing US regulations (such as the qualitative limits and quantitative requirements on inter-affiliate transactions in the Federal Reserve Act) that are designed to prevent US banks from taking on excessive risks from their affiliates.  In addition, major jurisdictions around the world are imposing rigorous capital, margin, reporting and other requirements to ensure that derivatives risks are transparent, understood and appropriately managed and properly mitigated.  Such rules will apply to the affiliates of US banks based in these jurisdictions.

Finally, imposing obstacles for firms that wish to centrally manage their exposures does not decrease risk.  It actually reduces operational efficiency, increases costs and works to increase risk with no countervailing benefit.  Ultimately, it may hamper the ability of banks to provide products in certain markets that can only be accessed through an affiliate, as the cost of posting inter-affiliate margin would make these products uneconomic.  The result would be a further fragmentation of markets and reduction in liquidity.

Dodd-Frank: The Five-Year Appraisal

This week marks the fifth anniversary of Dodd-Frank Act being signed into law by President Barack Obama. This incredibly ambitious, 848-page piece of legislation covered everything from derivatives clearing, reporting and trading, to bank resolution, consumer protection and financial market supervision.

Five years on, significant progress has been made in implementing the key elements of Dodd-Frank, particularly those covering reform of the derivatives market. Today, roughly three quarters of the interest rate derivatives average daily notional volume reported to US swap data repositories (SDRs) is cleared, according to data compiled by ISDA[1]. More than half of reported interest rate derivatives transactions are traded on a swap execution facility (SEF) each day. All swaps are now required to be reported to an SDR, providing more transparency in derivatives markets than ever before. US margin rules for non-cleared derivatives are close to finalization, and capital rules are being phased in.

All this was done in a very short time frame. Dodd-Frank was enacted less than a year after the Group-of-20 (G-20) nations agreed on a common set of objectives to overhaul derivatives markets. And the first detailed Dodd-Frank rule-makings from the Commodity Futures Trading Commission (CFTC) emerged shortly after that.

As a CFTC commissioner at the time, I remember all too well the work that went into developing these rules. The fact that so much was done so quickly speaks volumes about the dedication of the CFTC staff and the commitment of its former chairman, Gary Gensler. But I also remember that in the rush to complete the rules, there was an assumption there would be time to correct mistakes and review badly crafted rules.

I think the fifth anniversary of Dodd-Frank is a good opportunity to look at where problems exist and consider how best to resolve them, with the aim of making Dodd-Frank even more effective.

Cross-border harmonization is a prime example. In its 2009 communique, the G-20 leaders pledged to implement global standards consistently in a way that “ensures a level playing field and avoids fragmentation of markets, protectionism, and regulatory arbitrage”. That, unfortunately, hasn’t happened. The first-mover status of Dodd-Frank and lack of coordination with overseas regulators on the substance of the rules mean significant differences now exist in global rule sets. Rather than be subject to multiple, duplicative and potentially inconsistent rules, derivatives users are opting to trade with counterparties in their own jurisdictions where possible, leading to a fragmentation of liquidity.

This needs to be resolved so end users can continue to tap into global liquidity pools and avoid the higher costs that arise from a fragmentation of markets. Reconciling the rules on trading and clearing with those in other jurisdictions is a crucial step. US and European regulators have been engaged in long-running negotiations over whether US clearing house rules are equivalent to those in Europe, but discussions have stalled over technical differences in margin methodologies. A similar outcome may emerge for trading unless more is done to resolve differences in the trade execution rules. ISDA has contributed to this debate, and has proposed a set of targeted changes to US SEF rules that will encourage more trading on these venues and facilitate cross-border trading.

Cross-border issues also crop up in trade reporting. While regulators now have access to a huge amount of transaction data in their own jurisdictions, they are unable to gain a clear picture of global risk exposures and possible concentrations because of differences in reporting obligations within and across borders. Again, ISDA has proposed a series of specific fixes to improve regulatory transparency of derivatives reporting, which includes harmonization of regulatory requirements and the development and adoption of common reporting standards. A key recommendation is the repeal of the Dodd-Frank SDR indemnification requirement, which has restricted the ability of regulators to share data.

As well as greater harmonization in global rule sets, it’s important that equivalence or substituted compliance decisions are based on broad outcomes, rather than granular rule-by-rule comparisons. US regulators need to clearly articulate how substituted compliance decisions will be made in order to shed light on this process.

Other issues should also be reviewed. For example, Dodd-Frank made clear that commercial end users should be exempt from clearing requirements, but many firms opt to hedge through centralized treasury units (CTUs) in order to net and consolidate their hedging activities. Many of these CTUs classify as financial entities under Dodd-Frank, subjecting them to clearing requirements. While the CFTC has issued no-action relief, legislation clarifying that end users employing these efficient structures are exempt would provide greater certainty.

Consistency is also needed in margin requirements for non-cleared derivatives. Current proposals from US prudential regulators would subject transactions between affiliates of the same financial group to margin requirements, putting financial institutions that operate in the US at a competitive disadvantage internationally.

An objective review of these and other issues would make Dodd-Frank more effective, and would ensure end users can continue to hedge in a cost-effective and efficient way. A five-year anniversary is a good opportunity to reflect honestly on the successes and failures.

Read ISDA’s briefing notes on the Dodd-Frank Act.

Listen to an audio webinar discussion on Dodd-Frank progress.

[1] ISDA compiles data reported to the DTCC and Bloomberg SDRs