Steps on the Way to China Netting

Anyone who knows ISDA knows we care passionately about close-out netting. It’s one of the bedrocks of good risk management, and results in drastically lower credit exposures between counterparties. Being able to squash the positive and negative values of multiple trades between a pair of counterparties into a single net payment from one to the other means a default is likely to be less disruptive to the financial system.

We’ve long campaigned for netting certainty, and we’ve worked with authorities across the globe to help them draft legislation on the enforceability of close-out netting. Off the back of that work, we’ve so far commissioned netting opinions in more than 60 countries, with others in the pipeline.

That work continues, and we’re making progress in a number of areas – including in China, where we recently published a netting opinion for certain Chinese sovereign entities and an update to our China netting memorandum.

The netting opinion states that certain agencies that act on behalf of the government – the People’s Bank of China, the Ministry of Finance and the State Administration of Foreign Exchange – are not subject to any bankruptcy regime in China. That means the legal issues relating to bankruptcy stays, an administrator’s ‘cherry-picking’ right and statutory set-off under China’s Enterprise Bankruptcy Law are not applicable. They would therefore not affect the enforceability of contractual early termination and netting provisions in the ISDA Master Agreements held by these entities.

The updated netting memo, meanwhile, builds on an earlier release in 2014, and provides more detail on bankruptcy proceedings for China’s commercial banks, securities companies and insurance firms. It also includes an updated discussion on changes that should be made to the ISDA Master Agreement when ’automatic early termination’ is specified as applying to a Chinese counterparty, so all outstanding transactions under the agreement are terminated automatically if there’s a bankruptcy petition relating to that counterparty. Alongside a collateral memo we published in 2016, it goes a long way to helping firms build a picture about the state of play and the issues they need to consider when trading with Chinese entities that are subject to the Enterprise Bankruptcy Law.

These are all important steps to the ultimate goal: to have legislation in China that recognizes the enforceability of close-out netting. To that end, we’ll be taking the next step in June, when we host a seminar in Beijing on the benefits of close-out netting.

We believe the development of close-out netting legislation in China would create more certainty for financial institutions, and encourage more participation. Once these elements are introduced, the conditions will be in place for China’s derivatives markets to further develop and flourish, providing end users with a means of managing their interest rate and foreign currency exposures.

The Past and the Future

There’s a lot we take for granted in the derivatives space. The fact there’s a common language, for example – an agreed set of definitions and standard terms everyone can agree on. This means there’s a common foundation for negotiating trades, whatever the product and whatever the jurisdiction. But it wasn’t always like this, and it certainly wasn’t inevitable we’d get to this point.

Look back to the early 1980s, and the derivatives market was very different. Then in its infancy, each deal involved weeks and weeks of tortuous negotiations to agree terms. This was because each bank had developed its own contract, each with its own unique terms and definitions – something frustrated lawyers referred to as multiple agreement disorder, or MAD.

ISDA was established in response to this mess, and the result was the ISDA Master Agreement, a standard document that essentially removed the shackles from the derivatives market and set it on its path of growth. That was 30 years ago this month – an anniversary we celebrated with those who helped create the Master Agreement at Middle Temple Hall in London last night. Thirty years on, the Master Agreement is still as important as it was in 1987, and it stands as a perfect example of the industry cooperating to create something flexible, comprehensive and durable.

Jump to 2017, and the industry faces a new set of challenges that are equally as significant. Market participants now face a complex web of execution and post-trade management processes, largely as a result of regulatory change. Managing a trade through its lifecycle has become resource-intensive and costly as a result.

New technology – smart contracts and distributed ledger systems, in particular – offers the chance to mitigate these inefficiencies. The potential is enormous, but, as with the derivatives markets 30 years ago, the foundations need to be right. That means coming up with standard definitions and processes, and building the structure on a strong legal framework.

Just as with the development of the Master Agreement, ISDA is the perfect place for this to happen. We’ve already started work on this, and published a white paper last year on the future direction of derivatives processing and market infrastructure.

There is plenty of work to be done on smart contracts. We need to bring technology partners and members together to create the appropriate balance of automatable and enforceable agreements. Some of the most fundamental challenges include how to represent contractual obligations in a standard code using well-defined processes and definitions, and anticipating and developing the means to redress extraordinary events of a discretionary nature during the lifecycle of a trade. The territory between automated processes and those requiring human intervention will need to be clearly defined.

We’ve been restructuring our working groups to start discussing these issues. The work on smart contracts, process automation and a consistent data taxonomy is in the early stages. But it’s an incredibly exciting place to be. And, just with the publication of the Master Agreement 30 years ago, it could be transformational for the derivatives market.

Keeping the Foot on the Pedal

Over the past week, regulators across the globe have responded to looming market disruption by providing flexibility to derivatives users in their attempts to meet a March 1 deadline for posting variation margin on their non-cleared derivatives trades. This flexibility was critical. With firms struggling to amend their collateral documents in time, there was a very real risk that derivatives users would have been unable to trade from tomorrow, as ISDA and others warned in a letter earlier this month.

Thanks to well-coordinated action taken by global regulators to provide forbearance, that danger has now receded. The exact nature of the relief differs jurisdiction to jurisdiction, but regulators have generally provided derivatives users with additional time to finish making the changes to their credit support annex (CSA) agreements.

Given most derivatives counterparties already exchange variation margin on their non-cleared trades, this additional flexibility will not lead to an increase in systemic risk. It will, however, ensure counterparties have more time to negotiate the complex changes to their outstanding CSAs to ensure these documents reflect new regulatory edicts on eligible collateral, settlement timing and haircuts.

That process of negotiation has been complicated and time-consuming, and the scale of the task has been overwhelming. The March 1 ‘big bang’ implementation date captures banks, asset managers, insurance companies and hedge funds, and involves updating more than 150,000 CSAs. The time scale in which to make those changes has also been impossibly short. Market participants had to wait for final rules from national authorities to know exactly what changes were needed and how to phrase the amendments to create legal certainty, but those rules were published a matter of months ago in some cases.

According to the most recent survey numbers from ISDA, only 15.31% of active and new CSAs had been executed by February 17. That represents a doubling from the week before, but indicated that a large proportion of the market wouldn’t have been ready by March 1.

The flexibility afforded by regulators gives the industry more time to get that work done, and will minimize market disruption and maintain market access for a variety of derivatives users. But that does not mean market participants will sit on their hands. The industry remains committed to completing the necessary work as quickly as possible, and ISDA will continue to monitor and report progress in the weeks ahead.

Summary of regulatory action:

IOSCO statement

Commodity Futures Trading Commission

US prudential regulators

European Supervisory Authorities

Financial Conduct Authority

Central Bank of Ireland

Australian Prudential Regulation Authority

Monetary Authority of Singapore

Hong Kong Monetary Authority

Office of the Superintendent of Financial Institutions

CFTC Action Welcome, But More Needed

For some time now, we’ve been warning that many derivatives users wouldn’t meet a March 1 deadline to amend their credit support annex agreements (CSA) in order to comply with new variation margin requirements. Yesterday’s announcement of a six-month transition by the Commodity Futures Trading Commission (CFTC) is therefore very welcome. It leaves the March 1 start date intact, but allows firms to continue trading while they finish the substantial work needed to amend their documents.

As our letter to regulators last week pointed out, sticking with March 1 without such transitional relief would have caused unnecessary market disruption. Most firms already post variation margin on their non-cleared derivatives trades, but face being shut out of derivatives markets unless they manage to amend their outstanding collateral documents. The scale of the task is huge – we estimate approximately 160,000 CSAs need to be updated. Despite a determined industry effort, CSA negotiations have proved to be hugely complex and time consuming. Last week, we disclosed our latest industry survey data, which showed only 4.43% of CSAs had been amended.

The CFTC has taken a practical approach to this issue. Its relief letter provides market participants with a six-month transition that enables firms to continue to access derivatives markets. During that six-month period, counterparties must show they are working hard to complete the necessary CSA amendments, and all swaps entered into from March 1 must be compliant by September 1, 2017.

This is similar to relief provided late last year by Australian regulators. Hong Kong and Singapore have also provided six-month transitions.

But while welcome, this relief needs to be complemented by similar action from other regulators. Unless a globally coordinated transition is agreed, there is a risk of market fragmentation, with counterparties shifting trading relationships to those entities or regions that have secured relief. Given the fact many counterparties have existing variation margin arrangements, this would cause significant disruption for no purpose.

We think all derivatives users should be able to access derivatives markets from March 1. As such, we urge global regulators to work together to provide consistency across jurisdictions.

Time Running Out

First, the good news. The number of credit support annexes (CSAs) that had been amended to meet new regulatory variation margin requirements more than doubled during the past week. The bad news is the overall proportion is still very low, at just 4.43%. With less than three weeks before deadline, it’s difficult to see how every one of the thousands of firms affected will be ready and able to continue accessing derivatives markets from March 1.

The market disruption this would cause is the reason why ISDA and a group of other trade associations, representing both buy and sell side, wrote to regulators earlier this week asking for a transition period. Under one possible scenario, the requirements would come into force as planned on March 1, but market participants would be able to continue trading while they finish their documentation updates. As with the forbearance provided by Australia in December, regulators could ask for trades conducted during that transition to be backloaded to the effective date, therefore keeping pressure on the market to amend their documents.

Seeing as most counterparties already post variation margin, this transitional period won’t lead to an increase in systemic risk. But denying a vast swath of market participants access to derivatives markets because they haven’t updated their documentation would create significant problems, with smaller end users likely the most affected. We think it’s important that all users of derivatives are able to continue to access derivatives markets to hedge from March 1 – hence the request for forbearance.

The obvious question is why progress has been so limited. The simple answer is that the legal and operational challenges of amending, replacing or executing roughly 160,000 CSAs is huge. The terms of those CSAs already in place with clients tend to be highly variable, which has required bilateral negotiations between each counterparty pair to agree the necessary changes. Despite determined efforts to get this done by the industry, supported by ISDA, the bespoke nature of many of these agreements has meant these negotiations have been complex and time consuming.

Once amended, these documents then have to be loaded into reference data systems and activated for trading. Operations staff are working hard to get this done, but the numbers are overwhelming. So far, just 12.29% of those CSAs that have been amended have been loaded up.

So, progress has been made, and derivatives users will continue to push as hard as they can. But March 1 looks extremely optimistic. As it stands, we think there is a material risk that a large proportion of firms won’t be ready. That could result in fragmentation, market disruption, higher prices and the inability for end users to put on hedges.

A Global Framework Should Still be the Goal

This week, ISDA hosted a symposium on the future of bank capital in Europe. It was a good time to convene a conference to discuss the latest European Commission (EC) proposals for revisions to the capital requirements directive and regulation. This event didn’t disappoint in terms of insights provided. Our speakers – including senior legislators, regulators and market participants in Europe – spent a lot of time discussing the current negotiations at the Basel Committee on Banking Supervision and the proposals in Europe.

At the start of the year, the Basel Committee announced it needed more time to finalize its latest raft of measures, amid a widely reported disagreement over the level of a proposed output floor. From a policy perspective, European regulators are uncomfortable with an output floor and the reduction of risk sensitivity it would cause – and this uneasiness came across loud and clear from our speakers, along with their support for internal models. There’s also currently uncertainty about the path the new US Administration will take, with media reports suggesting further negotiations at the Basel level may be put on hold until the changing of the guard is complete.

But what struck me was the genuine eagerness for a global agreement, and the hope that a compromise can be found by the Basel Committee that will work for everyone. It serves no one’s interest to have a Basel agreement that lacks global consistency and adherence, or – worse – creates a regulatory imbalance. This would undermine the Basel Committee’s leadership role.

In many respects, it seems to me that both Europe and the US want the same thing. It was clear from our speakers that European policy-makers want a common agreement that strikes a balance between financial stability and economic growth. In other words, the final rules should be risk sensitive to avoid a detrimental impact on market liquidity, and to ensure banks are able to continue to lend to the real economy and provide crucial hedging products to end users.

The EC has proposed revisions to its capital requirements directive and regulation that try to achieve that balance. The proposals contain targeted amendments to the Basel measures that will encourage clearing, ease the capital burden on market-making activities, and reduce the pricing impact on end-user hedging. These types of changes are necessary, as banks will play a crucial role in helping the European Union foster deeper and more liquid capital markets – a key objective of the capital markets union.

These high-level aims – financing the real economy, fostering economic growth, creating jobs and establishing an agreement that offers a consistent a level playing field – are in line with the objectives of the new Trump Administration.

Our speakers at the conference all talked about their desire to have a single global agreement. We agree that is important. A single capital framework means a level playing field, less complexity and lower costs. We would encourage the Basel Committee to consider its final rules with a focus on ensuring economic growth. We also encourage US regulators to consider the European revisions to the Basel measures as their starting point to ensure a more consistent and risk appropriate framework.

All Eyes on March 1

From March 1, thousands of financial institutions will find themselves subject to new rules that will require them to exchange variation margin on their non-cleared derivatives trades. Four weeks out, the task of meeting that deadline looks as daunting as ever. In fact, it looks a probable that many firms won’t make it, raising the prospect they’ll be temporarily unable to access derivatives markets

This might come as a surprise to some. After all, the exchange of variation margin on derivatives trades is relatively common; many counterparties already do it. The complication is that the new rules set strict requirements on everything from eligible collateral to settlement timing, and these specifications need to be reflected in counterparties’ credit support documentation

This means modifying all existing agreements or setting up new ones – a monumental task made all the more difficult by the late publication of final national rules in some cases. And it can’t be done unilaterally: changes to each credit support annex (CSA) agreement need to be agreed by the other party

That takes time. There are a couple of ways firms might make those changes, but the preferred option for many at the moment is to bilaterally negotiate the necessary changes to existing CSAs and then to use those for both legacy and new trades. Given the variability in terms within existing CSAs, and the potential pricing impact a change in terms might have on a legacy portfolio, this approach is requiring manual intervention, analysis and discussion with each counterparty. And, for the larger dealers, those discussions will have to take place thousands of times, reflecting the size of their client base and the number of CSAs they have outstanding

The good news is that the industry, supported by ISDA, has mobilized its resources to meet the March 1 requirement. ISDA has provided solutions to help compliance, including a suite of margin-rule-compliant documentation. Awareness of the issue is improving, and firms are pushing hard to meet the deadline. The bad news is that there’s a finite legal resource to negotiate the changes, both within dealers and their clients – and those resources are stretched to the limit. There are just too many documents that need to change – approximately 200,000 – and too little time

While it is possible that some of the largest derivatives users may get enough done by March 1 to continue trading, albeit with fewer counterparties, it looks like many firms will not. Without regulatory action, those users may well be locked out of the derivatives market and unable to access the liquidity they need to hedge until they’re able to agree the necessary documentation changes with their counterparties. That could result in market disruption, fragmentation and pricing impacts

We think the answer is time-limited relief to give derivatives users the crucial extra months needed to get their documents in line with the requirements. Some regulators have already taken this approach. Hong Kong and Singapore, for instance, have introduced a six-month transition, during which in-scope entities will be expected to make progress towards meeting the rules. Regulators in Australia have also opted for a six-month transition, but with a requirement for all trades executed from March 1 to be subject to variation margin requirements by September 1.

ISDA is closely monitoring implementation progress, and we’ll feed that information to regulators regularly in the run-up to March 1. Dealers and their clients will continue to pull out all the stops to make the implementation deadline, but there simply may not be enough time.


Caution Required for Packages

It’s now less than a year until implementation of the revised Markets in Financial Instruments Directive (MIFID II), and European regulators are keen to nail down the last of the remaining policy details. One of the areas that looks close to being wrapped up is the transparency rules for package orders – but the proposed treatment, as it stands, could end up damaging the market for these important risk management tools.

Package orders combine several components – for example, a bond and a swap – in order to provide the end user with a tailored, specific hedge or trading exposure. By trading those components as a package, end users are able to achieve significant cost and execution efficiencies. While those benefits mean packages are regularly used as a whole, the fact each one can be so specific to a user means individual combinations might trade infrequently.

The fear is that these trades will become much trickier to execute under the proposed transparency framework. That’s because proposed rules published by the European Securities and Markets Authority (ESMA) in November would mean many highly bespoke and rarely traded packages are swept up in new pre-trade transparency requirements.

Why is this a bad thing? Simply, because requiring details of an infrequently traded product to be published before it is transacted is akin to a dealer showing its hand, giving market participants the potential to take advantage of that information. The end result would be greater execution risk and higher costs.

This, in turn, might force end users to abandon packages in favor of trading the components separately – a strategy that comes with more complexity and risk – or opt for simpler alternatives that do not exactly match their needs. In fact, European regulators themselves have accepted the negative consequences of a wide-scale pre-trade transparency regime for packages – which was what prompted the publication of the ESMA consultation on this issue.

We think ESMA should take a cautious approach, at least initially. For instance, we think it would be prudent to specify that a package should have no more than three components in order to be subject to pre-trade transparency requirements. All those components should be in the same currency, and they should come from the same asset class and sub-asset class (as specified under MIFID II). All the individual components should be liquid in their own right and should be traded on the same trading venue. Together, these changes will ensure that highly bespoke package trades that are unsuitable for pre-trade transparency will not get caught in the orbit of those rules.

It may be that once MIFID II is in place, and once ESMA has greater access to real-life data, these strictures might be relaxed, widening the pool of package trades that are deemed liquid. But, until there is more evidence, it would be wise to chart a conservative course to reduce the chance of market dislocation.

These technical recommendations may seem minor, but the effects of any misstep will echo far out into the market, possibly limiting end-user ability to perform legitimate and necessary risk management. The devil is in the detail, and these details will determine whether this market continues to function efficiently.

Critical Year Ahead for Trading Rules

Next year could end up largely determining how derivatives trade across borders. As the European Union (EU) puts the finishing touches to its revised Markets in Financial Instruments Directive (MIFID II) ahead of implementation on January 3, 2018, the need for regulators to consider whether the rules align with those in the US will become critical. Failure to find agreement could change the nature of the global derivatives market forever, transforming what was a single pool of liquidity into smaller, shallower, more fragmented pools.

This issue was very much front and centre at ISDA’s first ever trade execution conference last week, and our speakers gave some fascinating perspectives. Our first keynote speaker, Edwin Schooling Latter at the Financial Conduct Authority, stressed the importance of mutual equivalency, and argued that derivatives markets would be more liquid if European firms subject to the trading obligation can trade at the same venues as US firms subject to the swap execution facility (SEF) rules.

Our second keynote, the Commodity Futures Trading Commission’s (CFTC) J. Christopher Giancarlo, also warned about the risks of market fragmentation, and pointed out that liquidity pools have already divided between those in which US persons are able to participate and those in which they are not – a fact picked up in successive ISDA research reports.

The cause of this fragmentation in liquidity, he said, is “ill-designed rules and burdensome regulations”, and he called on the CFTC to revisit its SEF requirements. To get an idea of what those changes might be, it’s well worth looking back at Commissioner Giancarlo’s January 2015 whitepaper on the CFTC’s swaps trading rules.

We agree that targeted changes to certain elements of the SEF rules could help promote more trading and make cross-border equivalence and substituted compliance determinations more achievable. For example, in a petition that ISDA filed with the CFTC last year, we argued that the CFTC’s SEF rules – particularly an obligation for ‘required transactions’ to trade on an order book or a request-for-quote system where requests are sent to three participants – is unnecessarily restrictive and at odds with language in the Dodd-Frank Act, which merely requires trading to take place “by any means of interstate commerce”. The end result is a regime that discourages and restricts trading on SEFs, rather than encouraging it.

Emergence of further detail in the MIFID II rule-making would also be helpful to the goal of cross-border convergence. In particular, ISDA would like to see a high level of granularity in the setting of the trading obligation. This would ensure that firms have a clear and defined product list, and would avoid confusion about whether a particular product is in scope. It would also have the advantage of aligning Europe more closely with the US.

Even with changes such as these, however, US and European rules are unlikely to ever be identical. It’s therefore crucial that equivalence and substituted compliance decisions are based on broad outcomes.

The good news is, speakers at our trade execution conference recognized this point. Regulators and market participants on both sides of the Atlantic spoke about the importance of equivalence – and the need to make the necessary determinations based on outcomes. There was a broad consensus that the US and EU regimes are largely the same in in terms of objectives, even if the detail of the rules differ. That mirrors analysis ISDA conducted on the two regimes earlier this year.

This is positive news to end 2016. The challenge for 2017 will be to follow that through. The ability for derivatives users to trade safely, efficiently and cost-effectively by accessing a global liquidity pool depends on it.

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.