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INTERVIEW BENCHMARKS BREXIT
The EC’s Patrick Pearson The Case for BMR Impact of a Cliff
on CCP Supervision Transition Extension Edge Exit
ISDA® Quarterly
Vol 5, Issue 1: January 2019 | www.isda.org
* TIME FOR
RECALIBRATION
Evidence suggests the margin rules are not appropriately aligned with the policy
objectives of incentivising clearing and reducing systemic risk
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FOREWORD 03
A Few Predictions
It’s traditional to start the New Year with a few predictions. When it comes to forecasting the
priorities for derivatives markets, however, this year’s list is easier than most to put together: Brexit,
benchmark reform, margin, cross-border issues and technology.
On Brexit, 2018 ended with some positive news – the rollout of the European Commission’s
contingency plan for a no-deal Brexit on December 19. Crucially, this included a temporary
equivalence decision aimed at reducing disruption in the central clearing of derivatives. But with
the Brexit date fast approaching, there’s still plenty of uncertainty about the form of the UK’s exit
from the European Union (EU) and what it will mean for derivatives users.
Significant progress was made on benchmark reform in 2018, but this will continue to be a key
priority in 2019 – particularly with the transition period for the EU Benchmarks Regulation set to
expire at the end of the year. Work to implement robust fallbacks for derivatives referenced to certain
key interbank offered rates will also be a focus, building on the final results of an ISDA consultation
on technical issues related to new benchmark fallbacks, published in December.
On margin, preparations for the September 2019 and 2020 phase-ins of initial margin
requirements will pick up pace, as market participants get ready for a much larger universe of in-
scope entities. Industry solutions – such as ISDA Create – IM, a new online platform for producing,
delivering, negotiating and executing initial margin documentation – will be crucial. But there are
also growing voices calling for the phase-five compliance threshold to be reviewed, following evidence
showing that the bringing of a large number of small entities into scope will not contribute to a
reduction of systemic risk – contrary to one of the key policy objectives of the rules.
Cross-border harmonisation has long been a key priority for ISDA, but the issue is likely to come
to further prominence with the Japanese presidency of the Group of 20. Eliminating regulatory and
market fragmentation has been identified by the incoming presidency as a key issue, and ISDA will
continue to contribute by providing data, analysis and proposed solutions.
Finally, the adoption of new technologies will pick up pace, as firms look to reduce costs and
improve efficiencies. Developments like the ISDA Common Domain Model will help ensure
standardisation and facilitate interoperability across firms and platforms.
These issues – and many others – will form the basis of ISDA’s work for 2019. A last prediction:
ISDA will continue to develop standards, documentation and mutualised industry solutions to help
firms meet the challenges for this year and in the years ahead.
Nick Sawyer
Head of Communications & Strategy
ISDA
International Swaps and Derivatives Association | www.isda.org
NEW YORK | WASHINGTON | LONDON | BRUSSELS | HONG KONG | SINGAPORE | TOKYO
Head of Communications & Strategy, Nick Sawyer, nsawyer@isda.org
Global Head of Public Policy, Steven Kennedy, skennedy@isda.org
Art Director, Nick Palmer, nick@sidelong.co.uk
IQ: ISDA Quarterly is an official publication of ISDA. Statements of fact and opinion expressed are not intended as endorsements.
Copyright 2019 by ISDA with all rights reserved. Published January 2019
ISDA® | www.isda.org
04 WELCOME
CONTENTS
REGULARS ALSO IN THIS ISSUE
03 Foreword 26 AGM
Preview of ISDA’s 34th annual general meeting (AGM),
06 Letter from the CEO due to be held in Hong Kong on April 9-11, 2019
Huge progress has been made in reforming derivatives
markets over the past 10 years, but further work is 28 Q&A
needed to create a consistent and predictable cross-border Proposed revisions to the European Market Infrastructure
regulatory framework Regulation could see third-country clearing houses having
to comply with certain European rules. Patrick Pearson,
07 In Brief head of financial market infrastructure and derivatives at
• IM Threshold Should be Reviewed, Say O’Malia the European Commission, explains the importance of
and Litvack regulatory cooperation in successful policy-making
• More Focus Needed on Fragmentation, Urges
Japanese Regulator 32 Benchmarks
• ISDA CDM Nears Completion for Rates and Credit A newly convened working group made rapid progress
• ISDA Updates Model Netting Act last year in selecting ESTER as the euro-denominated
• ISDA Publishes Final Results of Benchmark risk-free interest rate benchmark, but without an
Consultation extension to the EU Benchmarks Regulation, there may be
insufficient time for adoption
PAGE 40
36 Brexit
Given the risk of clearing disruption in the event of a
no-deal Brexit, publication of a temporary equivalence
determination to allow EU participants to continue
clearing at UK CCPs should ensure near-term stability,
but a hard Brexit has other potential implications that
should be addressed
40 Smart Contracts
Smart contracts offer the potential to bring greater
automation and efficiency to the derivatives market. But
can a derivatives contract ever be fully automated? Will
PAGE 46 smart contracts take the place of paper contracts? ISDA’s
Ciarán McGonagle explores the issues
44 10 Questions With…
IQ speaks with Jack Hattem, an ISDA board member and
managing director, global fixed income, at BlackRock
46 ISDA Office Locations
48 ISDA Board
50 ISDA Conferences
51 ISDA Mission Statement
ISDA® | www.isda.org
WELCOME 05
Volume 5, Issue 1: January 2019
*TIME FOR
THE COVER PACKAGE
RECALIBRATION
11 Introduction
Margin requirements for non-cleared derivatives were designed to incentivise
clearing and reduce systemic risk, but evidence suggests the rules are not
appropriately aligned with these goals
12 All Eyes on 2020
The 2020 implementation of the margin rules will capture a large number of
entities, but most will not post initial margin due to the small size of their
exposures. A recalibration of the compliance threshold is being proposed to
ensure the rules meet the policy objective of mitigating systemic risk
16 Weighing Incentives
Capital and margin requirements for non-cleared derivatives were explicitly
calibrated to incentivise a shift to central clearing. But with clearing volumes
running ahead of what is mandated, is it time to review the incentives?
20 Paper Weight
The September 2020 rollout of initial margin regulations will require thousands of
firms to negotiate and execute new margin documentation. How is the industry
preparing to meet this compliance challenge? Can ISDA Create – IM help?
24 Getting Ready for the IM Rules
Complying with regulatory initial margin requirements will entail significant lead-
time to put the necessary systems and documentation in place. ISDA sets out the
steps for compliance
PAGE 44
“There always seems to be a lot going on and we cannot
become complacent. Benchmark reform and cross-border
equivalence are the two issues that are top of mind.
Markets are moving and innovation will continue”
Jack Hattem, BlackRock
ISDA® | www.isda.org
06 LETTER FROM THE CEO
Predictable Regulation
Huge progress has been made in reforming derivatives markets over the past 10 years, but
further work is needed to create a consistent and predictable cross-border regulatory framework
Over the past 10 years, a remarkable event has occurred in the Capital markets are used to managing economic risk, but tackling
world’s political and financial capitals. Policy-makers in the European political risk or fragmentation as a result of regulation is a different
Union (EU), the US and elsewhere embarked on a largely consistent challenge altogether. Markets want regulatory and legal certainty.
agenda of regulatory reform to make derivatives markets more robust To achieve this, UK and EU policy-makers should continue to
and resilient, based on a set of commitments agreed jointly by the take all necessary steps in advance of Brexit to avoid disruption by
Group-of-20 (G-20) nations. ensuring mitigating actions take effect from the date the UK leaves
The resulting national requirements are not identical, but they are the EU. That includes taking all available preparatory steps and, where
comparable – they all achieve similar objectives of increasing possible, accepting applications and adopting advance formal
transparency and mitigating systemic risk. Where we decisions so they take effect at the point Brexit occurs.
have fallen short is creating a framework that Medium-term, EU policy-makers will need to
allows entities from two different jurisdictions provide clarity on the process and standards
that have applied comparable requirements for third-country regimes to gain access to
to trade under a single set of rules. There the EU post-Brexit – not only for the UK,
has not been sufficient appreciation that but for other countries like Australia,
complying with two sets of similar but “The ability to trade Canada, Hong Kong, Japan, Singapore
not identical requirements is extremely and the US, where financial reforms
difficult and costly. across borders under a based on the G-20 commitments are
The ability to trade across borders consistent and predictable well established.
under a consistent and predictable Long-term, these countries
regulatory framework is crucial for regulatory framework is need to establish a consistent and
end users. Derivatives markets were
developed to facilitate the transfer of
crucial for end users” transparent cross-border recognition
regime that is comprehensive and covers
capital from where it is to where it is both risk-based activities, such as capital
needed. Without an effective process for and margin rules and central counterparty
recognising comparable overseas rules, global regulation, and non-risk related rules, like
liquidity will ultimately fragment into regional trading, public reporting and various post-trade
pools, increasing costs and complexity. services. This cross-border equivalence regime should
Fortunately, there has been recent progress on this front. rely on overseas rules that are comparable in outcomes, and
The first was an agreement between the European Commission the regulatory review and approval process should be both consistent
and the US Commodity Futures Trading Commission (CFTC) to and certain.
recognise each other’s trading regimes. This means a firm in one Global derivatives markets enable firms to efficiently and cost-
jurisdiction can satisfy local trading requirements by trading on a effectively raise financing and manage their risk. For this to work
venue in the other location. The second was a proposal by the CFTC properly, we need regulatory consistency, trust, cooperation and
chairman, J. Christopher Giancarlo, to revise the agency’s cross-border recognition. Failure to achieve this will ultimately serve no one –
framework to defer more to overseas regulators and recognise rules not the firms looking to raise the capital and investment needed for
that are broadly comparable in outcomes as equivalent. This would be economic growth, nor the entities that need to manage their risk.
a big step in reducing complexity, duplication and costs for end users.
Unfortunately, a number of forces are pushing in the other
direction – a loss of faith in the benefits of globalisation, regional Scott O’Malia
rivalries, trade negotiations and Brexit. ISDA Chief Executive Officer
ISDA® | www.isda.org
IN BRIEF 07
IM Threshold Should be Reviewed,
Say O’Malia and Litvack
The final phase of global margin materially reducing the volume of initial Along with preparing for the adoption
requirements for non-centrally cleared margin posted. of new risk-free rates, market participants
derivatives will capture a large number “We need to ensure the rules are also need to prepare for the possible
of small entities without meaningfully targeted appropriately and meet the stated discontinuation of an existing rate,
increasing the overall amount of margin policy objective of mitigating systemic risk,” underscoring the importance of robust
posted, and the rules should therefore be said Litvack. fallbacks for derivatives contracts. ISDA
recalibrated as they are not meeting a key The final phase of the margin rules is carried out a detailed consultation last year
policy objective of reducing systemic risk, not the only challenge that will confront the on technical adjustments that would need to
according to ISDA chief executive Scott industry next year – benchmark reform also be applied to fallback rates in the event of
O’Malia and chairman Eric Litvack. looks set to come to a head in 2020, as an IBOR being discontinued, and published
Speaking at ISDA’s regional conference the transition period for the EU Benchmarks the results in December.
in London in September 2018, O’Malia and Regulation (BMR) is scheduled to expire “Having robust fallbacks is critical for
Litvack expressed concerns that when the and adoption of new risk-free rates in the stability of the financial system. If an
threshold for posting initial margin falls from place of interbank offered rates (IBORs) IBOR permanently ceases to exist, it is vital
€750 billion to €8 billion in aggregate non- continues. that market participants have certainty that
cleared derivatives exposure in September The European Central Bank will begin their existing IBOR contracts will fall back to
2020, it will bring a disproportionate number publishing the newly selected euro short- a robust and clearly defined reference rate,”
of new firms into scope. term rate (ESTER) later this year – by October said O’Malia.
“Without a change to the €8 billion
level, these smaller companies face a
significant compliance burden without “Without a change to the €8 billion level, these smaller
actually posing enough of a systemic risk to companies face a significant compliance burden without actually
require margin to be posted. The pressure
on resources across the industry will also
posing enough of a systemic risk to require margin to be posted”
be severe, potentially leading to disruption Scott O’Malia, ISDA
in the non-cleared derivatives market,” said
O’Malia.
ISDA estimates that more than 1,100 at the latest – but that will leave a very short The implications of Brexit will also be
new entities will be caught by the slashing window of time for market participants to a major focus for the industry over the
of the threshold, equating to roughly 9,500 prepare for adoption of ESTER, prompting coming years, O’Malia added, whatever the
trading relationships and 19,000 initial calls for an extension of the BMR transition terms of the UK’s exit from the European
margin custody accounts. But analysis period. Meanwhile, work continues to Union (EU). At the point the UK becomes
also shows that a sizeable number of build liquidity in markets referencing new a third country to the EU, equivalence
these newly in-scope entities are unlikely risk-free rates before LIBOR’s possible determinations will need to be immediately
to actually exchange initial margin as their discontinuation after 2021. adopted to avoid the interruption of trading
counterparty exposures will fall below the “ISDA has been working to raise and clearing activity (see pages 36-39).
posting threshold of €50 million (see pages awareness about the issue and support the “This will be a real acid test for the
12-15). industry as it prepares to adopt alternative cross-border framework. Given the fact the
An industry association letter sent to risk-free rates,” said O’Malia. “But it’s vital rules between the two will be the same,
regulators in September 2018 called for everyone engages with this now. Develop an anything other than a quick equivalence
the phase five threshold to be raised from IBOR transition programme, allocate budget determination would be a massive setback
€8 billion to €100 billion, which would cut and resources, assess your firm’s exposure for cross-border harmonisation,” said
the number of new entities by 83% without to the IBORs. Don’t get left behind.” O’Malia.
ISDA® | www.isda.org
08 IN BRIEF
More Focus Needed on Fragmentation,
Urges Japanese Regulator
Derivatives market fragmentation can of these cross-border issues in derivatives Second, when jurisdictions incorporate
impair financial stability, reduce liquidity markets should come as welcome news to extraterritoriality into their regulations,
and trap scarce resources, and more must be practitioners, particularly as Japan assumes different requirements can be imposed on
done to fulfil commitments made by Group- the presidency of the G-20 this year, which the same market or transaction.
of-20 (G-20) nations to implement global may add momentum to efforts to resolve Third, implementation of globally agreed
standards consistently and promote a level cross-border concerns. standards on different timetables leads to
playing field, a senior Japanese regulator has Also speaking at the Tokyo conference, de-synchronisation, which can increase risk
warned. ISDA chairman Eric Litvack reflected that to financial stability during transition and
Speaking at the ISDA regional while cross-border coordination had been increase costs to market participants and
conference in Tokyo in October 2018, Ryozo relatively effective in the margin framework, regulators.
Himino, vice minister for international
affairs at the Japanese Financial Services
Agency (JFSA), reviewed key sources of “As the financial regulations grow in their body and
market fragmentation and suggested a
balance should be struck between global
complexity, myriad technical differences in national regulations
standard-setting and national tailoring of are creating unintended impediments to cross-border
rules. transactions and activities”
“As the financial regulations grow
Ryozo Himino, Japanese Financial Services Agency
in their body and complexity, myriad
technical differences in national regulations
are creating unintended impediments to
cross-border transactions and activities,” it has been “less fruitful” elsewhere. Noting the diverse timelines adopted
said Himino. “We cannot and should not “While there have been several important by jurisdictions and repeated slippage in
aim for full harmonisation of regulations. successes in agreeing substituted compliance implementing margin requirements for
More and more goods, services, people, and equivalence, the determinations have, non-centrally cleared derivatives, Himino
information and money flow across borders. for the most part, been based on granular, called on standard-setting bodies to consider
The benefit of globalisation continues to rule-by-rule comparisons that take time how the standard-setting process might
grow exponentially, but the side effects of and can ultimately result in frustration and encourage timely implementation across
globalisation grow as well.” added complexity,” said Litvack. jurisdictions. “Simpler and clearer standards
Every area of regulation, he said, has If global derivatives markets are to with limited need for institution-specific
unique reasons for cross-border consistency function effectively, he added, there must authorisation would have a greater chance
and for tailoring to national specificities, and be a robust cross-border framework that of timely implementation,” he said.
those factors should be weighed against one recognises overseas rules that are comparable Fourth, Himino noted that some
another to determine the best approach in in outcomes and avoids competitive jurisdictions use regulations to secure
each case. distortion, without requiring the rules to be resources or activities within their own
As an example, Himino suggested there identical. jurisdictions. Such competition “can be
is no need to promote identical capital “This was recognised by the G-20 back heightened by a lack of trust between
adequacy regulations for community banks in 2009, which stressed that the reforms authorities or the desire to attain regulatory
in all jurisdictions, whereas harmonisation should be implemented in a way that ensures autonomy over the markets that are critical
is much more important for non-cleared a level playing field and avoids fragmentation to the jurisdiction”, he said.
derivatives margin requirements. of markets, protectionism and regulatory Welcoming the attention paid by the
“Cross-border consistency in margin arbitrage,” said Litvack. Financial Stability Board to these cross-border
requirements on OTC derivatives is a In his own speech, Himino explored challenges, Himino cautioned that this was
prerequisite for a cross-border transaction. four particular sources of regulatory only the beginning. The JFSA would like to
Inconsistencies can fragment the market, fragmentation that unduly increase the risk make sure the initiative is forward-looking
while the need to differentiate requirements of market fragmentation. First, discrepancies and action-oriented, addressing future risks
among major financial centres is relatively arise when incompatible requirements are and finding practical solutions, he said.
low,” said Himino. imposed by different authorities on the same “Combatting market fragmentation
The JFSA’s recognition of the importance financial institution. should be our common goal,” Himino said.
ISDA® | www.isda.org
IN BRIEF 09
ISDA CDM Nears Completion
for Rates and Credit
The ISDA Common Domain Model representation across trades, portfolios As the industry prepares for the
(CDM) will shortly be made available to and events and is compatible with any final phases of the implementation
all market participants for core interest programming language. of IM requirements for non-centrally
rates and credit products, with the next ISDA published an initial digital cleared derivatives in September 2019
priority being to extend the model to representation for interest rates and and September 2020, ISDA Create
equities over the next six months. credit derivatives products in June 2018. offers smaller entities a valuable way
“By creating a standard representation This included a first set of core business to manage the documentation burden
for events and products, we will have events, including ‘new transaction’, ‘rate associated with the posting of IM.
a consistent, transparent and accurate reset’, ‘partial termination’, ‘allocation’, “This will massively cut down on the
blueprint of the market that can be used ‘novation’ and ‘compression’. Since amount of time it takes to negotiate IM
by all market participants, infrastructures, publication of the ISDA CDM 1.0, ISDA documentation, as well as allow firms to
platforms and regulators. This will allow members have been able to test and store the resulting data in digital form,” said
firms to achieve greater automation and further refine the model. In September O’Malia. “Creating a more standardised
innovation – at scale – which will transform 2018, Barclays hosted a hackathon that language and common menu of choices
the back office and make it much more brought together 140 coders to use the will cut down on the time it takes to
efficient,” said Scott O’Malia, chief executive CDM to develop solutions that increase negotiate an agreement, and will contribute
of ISDA, speaking at the ISDA Technology the efficiency of derivatives processing. to the creation of a standard, industry wide
Forum in New York in November 2018. “The hackathon gave us the chance to legal agreement data model, which can
Development of the ISDA CDM began in test specific use cases, and prod and poke then be part of the CDM.”
February 2018, with the goal of supporting the model to see how it performs in the real Meanwhile, work continues on
greater consistency and interoperability in the development of smart contracts,
the derivatives market. Historically, firms “By creating a standard which could dramatically reduce the
have established their own systems and level of manual intervention involved in
representations for standard trade lifecycle
representation for events derivatives processing. Early proofs of
events. Recognising there is no commercial and products, we will have a concept suggest smart contracts have
advantage to companies maintaining consistent, transparent and real potential in the derivatives market,
these individual representations, and that but the vision is still some way from reality.
this actually increases costs and required
accurate blueprint of the Consensus must be reached on which
resources, the model offers the opportunity market that can be used by contractual clauses can be automated
to improve efficiency and create greater all market participants” and which involve too many complex
standardisation of processes. permutations and should therefore
Scott O’Malia, ISDA
“Today, market participants spend continue to be managed manually. Legal
huge sums to reconcile vital trade data. issues must also be tackled to determine
It is wildly inefficient, it suffers from world. The 31 teams totalling 140 coders, which laws apply to assets with no
inaccuracy, and it is labour intensive,” split between London and New York, set physical location. A legal working group
said O’Malia. “Year after year, firms to work on a number of tasks. Several within ISDA is exploring these issues and
are slashing front-office headcount, demonstrated the application on different a whitepaper will be published in the
reducing the universe of products they blockchain and cloud environments, and coming months.
offer, and cutting regional services. In one person even theorised about enabling “This effort, along with our work
contrast, back-office processes – and, in Amazon’s Alexa to help navigate and on the CDM, is intended to create the
particular, legacy IT systems – have been learn about the CDM,” said O’Malia. foundations for a more automated and
left untouched, as there has been no Elsewhere, efforts to standardise and efficient derivatives market. Technology
alternative to the current inefficiencies.” digitise documentation processes have can fundamentally revolutionise
Driven by new regulations on trade gathered pace with the development of derivatives markets by creating significant
execution, clearing and data reporting, ISDA Create – IM, a platform that allows efficiencies. What’s more, it’s becoming
market participants are looking for the firms to produce initial margin (IM) more and more important for banks to
highest levels of accuracy and automation documents and share them electronically realise these efficiencies at a time of
to meet the new requirements. The ISDA with multiple counterparties at the same constrained growth and profitability,” said
CDM enables a consistent hierarchical time. O’Malia.
ISDA® | www.isda.org
10 IN BRIEF
ISDA Updates Model Netting Act
ISDA has published an update of its Model Netting Act, designed close-out netting under the local law in each jurisdiction – hence the
to provide a template that can be used by jurisdictions considering importance of netting legislation.
legislation to ensure the enforceability of close-out netting. “Close-out netting is the single most important risk mitigation
The Model Netting Act draws on ISDA’s 30 years of experience tool in derivatives markets, and results in drastically lower credit
of working with policy-makers and regulators across the globe exposures between counterparties. We believe the development
on close-out netting legislation, and provides guidance and of close-out netting legislation creates more certainty for financial
model provisions for those legislators looking institutions, and encourages more participation.
to increase legal certainty under local law for Once these elements are introduced, the
netting. The 2018 act and accompanying “Close-out netting is the conditions are in place for local derivatives
guide expand upon previous versions, with markets to thrive,” says Katherine Tew Darras,
updates to reflect the widespread adoption of
single most important ISDA’s general counsel.
bank resolution regimes, the introduction of risk mitigation tool in ISDA has long campaigned for netting
mandatory margin requirements and the growth derivatives markets” certainty, and has worked with authorities across
of Islamic finance. the globe to help them draft legislation on the
Katherine Tew Darras, ISDA
Close-out netting enables firms to terminate enforceability of close-out netting and collateral
outstanding transactions with a counterparty arrangements. ISDA has published netting
following an event of default and calculate opinions on more than 70 countries. The act and
the net amount due to one party by the other. Without close-out guide reflect various international legal and regulatory standards on
netting, firms would need to manage their credit risk on a gross basis, netting, and include a list of jurisdictions that have enacted netting
dramatically reducing liquidity and credit capacity. legislation or are in the process of doing so.
Regulators allow close-out netting to be recognised as risk-
reducing for the purposes of regulatory capital requirements, so long The 2018 Model Netting Act and guide is available on the ISDA
as there is a high degree of legal certainty over the enforceability of website (bit.ly/2PySJVF).
ISDA Publishes Final Results of Benchmark Consultation
ISDA has published the final results of adjustment methodology for all benchmarks As part of this work, ISDA will publish
a consultation on technical issues related covered by the consultation – sterling LIBOR, the results of sensitivity analyses to provide
to new benchmark fallbacks for derivatives Swiss franc LIBOR, yen LIBOR, TIBOR, all market participants with a better
contracts that reference certain interbank euroyen TIBOR and the Australian Bank understanding of the range of parameters
offered rates (IBORs). Bill Swap Rate. ISDA expects to launch a in the historical mean/median approach.
The consultation – which was launched supplemental consultation on US dollar ISDA and its independent advisers will
in July 2018 – covered the proposed LIBOR and potentially other benchmarks also work to address technical issues
methodologies for certain adjustments early in 2019. that need to be resolved to finalise the
that would apply to the fallback rate In line with the results, ISDA will precise formula for calculating the spread
in the event an IBOR is permanently proceed with developing fallbacks for adjustment and the compounded setting
discontinued. inclusion in its standard definitions based in arrears rate.
The results of the consultation – on the compounded setting in arrears Before implementing fallbacks in its
summarised in a report prepared by The rate and the historical mean/median standard definitions, ISDA expects to
Brattle Group in December – show that approach to the spread adjustment solicit additional feedback from market
an overwhelming majority of respondents for the benchmarks covered by the participants on the final parameters of the
prefer the ‘compounded setting in arrears consultation. In the coming months, ISDA historical mean/median approach to the
rate’ for the adjusted risk-free rate (RFR), and its independent advisers will work to spread adjustment.
and a significant majority across different determine the appropriate parameters
types of market participants favour the for the historical mean/median approach Read the anonymised narrative
‘historical mean/median approach’ for the to the spread adjustment (including, summary of responses to the ISDA
spread adjustment. for example, whether to use a mean or consultation on term fixings and spread
Most respondents would prefer to median calculation and the length of the adjustment methodologies at
use the same adjusted RFR and spread historical lookback period). bit.ly/2R0ljEW
ISDA® | www.isda.orgMARGIN RULES 11
THE COVER
PACKAGE
Time for
Recalibration
Margin requirements for non-cleared derivatives were designed to incentivise clearing and
reduce systemic risk, but evidence suggests the rules are not appropriately aligned with these goals
When the Basel Committee on Banking Supervision and the International Organization of Securities
Commissions published their margin requirements for non-cleared derivatives, they were explicit in
describing what the rules were trying to achieve – to promote central clearing and reduce systemic risk.
More than two years after the rules first came into effect, and with three phases of the five-phase
implementation complete, a quick look at the data might suggest those objectives are being met.
Notably, clearing volumes have increased across asset classes, and – in the case of the US – exceed
what is required under the Commodity Futures Trading Commission’s clearing mandates.
But scratch below the surface and it gets more complicated. Recent research by the Financial
Stability Board shows that the opportunity to reduce regulatory capital costs, manage counterparty
risk and benefit from netting opportunities are stronger incentives for clearing than non-cleared
margin requirements (see pages 16-19).
Similarly, there is evidence that the final phase of implementation in September 2020, which
will see the threshold for compliance fall from €750 billion to €8 billion in notional non-cleared
exposure, will bring into scope a large number of smaller firms without actually reducing systemic
risk (see pages 12-15).
These are important findings, and have prompted both regulators and industry participants to
question whether the rules are calibrated appropriately and achieve the original policy objectives
without being excessively punitive.
While discussions over whether and how to recalibrate the rules continue, market participants
still need to prepare for a larger universe of entities coming into scope of the rules. ISDA has
supported industry preparations for the final two phases by clearly setting out the steps that must be
taken in advance (see pages 24-25). Meanwhile, ISDA Create – IM, a new online platform, offers
an automated way of negotiating initial margin documents (see pages 20-22).
“We would define the most appropriate scope for phase five
to be those firms that pose some systemic risk, but the analysis
suggests that nearly 80% do not pose any”
Tara Kruse, global head of infrastructure, data and non-cleared margin, ISDA
ISDA® | www.isda.org12 SYSTEMIC RISK
* All Eyes
on 2020
The 2020 implementation of the margin
rules will capture a large number of entities,
but most will not post initial margin
due to the small size of their exposures. A
recalibration of the compliance threshold is
being proposed to ensure the rules meet the
policy objective of mitigating systemic risk
A subtle shift in policy-making in recent times has non-cleared derivatives. The rules were calibrated with
seen the official sector take a critical pause, reflect on nearly the explicit intention of reducing systemic risk and
a decade of frenzied regulatory change and review what is promoting central clearing. But the framework, which
working and what might need revisiting. From Basel to began a phased implementation in September 2016,
Brussels and Washington, DC, regulators have been willing is scheduled to extend to a large pool of small, non-
to consider recalibrations to the regulatory framework if systemically important entities in September 2020 as the
warranted by both qualitative and quantitative industry threshold for inclusion plummets to its fifth and final
feedback. level of €8 billion in aggregate notional value of non-
One such area where the body of information from cleared derivatives.
the industry suggests a change should be considered is Crucially, ISDA analysis shows many of these newly
in the implementation of margining requirements for in-scope entities will not be required to exchange initial
“One of the key policy objectives of the margin
requirements was to reduce systemic risk, but
analysis shows the rules are not appropriately
aligned with this goal”
Scott O’Malia, ISDA
ISDA® | www.isda.orgSYSTEMIC RISK 13
Illustration: James Fryer
€8
margin (IM) due to the small size of their has fallen each year in September – to €2.25
exposures – indicating the rules are not trillion in 2017 and €1.5 trillion in 2018.
aligned with the policy objective of It is now set to drop to €750 billion in
reducing systemic risk. The scale of 2019 and just €8 billion in 2020.
billion
industry upheaval that could be Drafting of the margin
unleashed by phase five without requirements at an international
materially reducing systemic risk level dates back several years,
or even increasing the amount with the first iteration of the rules
of posted collateral is such that The threshold for compliance published by the Basel Committee
many market participants feel the with phase five of the initial on Banking Supervision and the
calibration of the final threshold International Organization of
should be revisited. margin requirements from Securities Commissions (IOSCO)
“One of the key policy objectives of September 2020 in September 2013, with subsequent
the margin requirements was to reduce amendments made in March 2015 before
systemic risk, but analysis shows the rules implementation began in 2016.
are not appropriately aligned with this goal. While larger market participants have
The smaller companies captured by the €8 billion managed to overcome the operational challenges
threshold face a significant compliance burden without associated with the calculation and posting of IM and
actually posing enough of a systemic risk to require variation margin (VM), it will inevitably be more difficult
margin to be posted,” says Scott O’Malia, chief executive for smaller firms that don’t have the same internal resources
of ISDA. and budget to devote to the project.
“Phase five will capture a vast tail of market
Thresholds participants, and I’m not sure the additional cost of
When the first phase of implementation began in margining will make sense for them because it’s a
September 2016, it applied to those firms with a notional significant operational lift to repaper contracts, set up
value of non-cleared derivatives exceeding €3 trillion, custody accounts and move to the daily exchange of
effectively capturing only the largest dealers. That threshold margin. If you have a relatively small number of
ISDA® | www.isda.org14 SYSTEMIC RISK
transactions, the operational
costs translate to a much higher “It is hard to next two years.
“The timing and scope is a
cost per trade than for larger market challenge, and the industry got a little
participants,” says Eric Litvack,
chairman of ISDA.
imagine that sense of that in 2017 when we were
implementing the variation margin
Given these operational
and compliance costs, and with
forcing new margin aspect of the protocol, which brought
to light some key issues regarding the
data showing that phase five
implementation will have little requirements number of relationships everyone
has to deal with on a bilateral basis
impact on systemic risk reduction, as new parties come into scope,” said
industry participants argue there is a
strong case to be made for reviewing
on thousands of Biswarup Chatterjee, global head of
electronic trading and new business
the €8 billion threshold.
“It is hard to imagine that
buy-side firms development for credit markets at
Citi, speaking at the ISDA regional
forcing new margin requirements
on thousands of buy-side firms and funds will conference in London in September
2018.
and funds will make a meaningful An ISDA fact sheet published
reduction in system risk,” says
Darcy Bradbury, a managing
make a meaningful last year sets out the key steps that
must be taken to prepare for the
director at DE Shaw & Co. “Many
asset managers already voluntarily
reduction in IM exchange deadlines, including
identifying in-scope entities, making
clear their liquid non-mandated
swaps, and many hedge funds system risk” disclosures to counterparties,
exchanging compliance information
already post initial margin amounts and identifying any special cases that
on their non-cleared swaps. If the Darcy Bradbury, DE Shaw & Co may apply (see pages 24-25). Firms
threshold were raised, hedge funds must also establish relationships
would continue to post margin in with custodians, build the necessary
the way we have done for years but internal capabilities to calculate,
would not need to completely refit our systems.” post and receive initial margin, and negotiate and execute
documentation. Final preparations and testing must be
Impact completed well ahead of deadlines.
In a paper published in July 2018, ISDA and the Securities “It’s not only two parties dealing with each other about
Industry and Financial Markets Association (SIFMA) their legal and operational issues, but there are a host of
shone a light on the challenges that lie ahead if the middleware providers that help us in posting, receiving
threshold is not recalibrated. and storing of initial margin, and there are custodian
Once the final stage of the framework is implemented, agreements to be set up – these are third parties that people
the paper warned, the cost and operational scale of were never dealing with in the bilateral chain. You also
compliance could mean that newly in-scope counterparties have to deal with model validation, risk and a host of other
would find themselves unable to trade non-centrally issues,” said Chatterjee.
cleared derivatives, which would limit their hedging
options and potentially impact liquidity. Systemic risk
Based on data gathered by ISDA from most of the The margining rules for non-cleared derivatives were
currently in-scope dealers, it is estimated that more than developed with two key policy objectives in mind:
1,100 entities will be caught by the fifth phase in 2020. to incentivise clearing and to reduce systemic risk.
This equates to roughly 9,500 new relationships with other Nonetheless, the evidence suggests that bringing roughly
counterparties, each of which will require new or amended 1,100 new entities into scope of the framework will do
documentation to be tested and uploaded into systems. On little to mitigate risk. Depending on the IM calculation
that basis, it is projected that as many as 19,000 segregated method that is used, ISDA estimates that 26-45% of
initial margin custody accounts will need to be set up and the smallest counterparties and 69-78% of counterparty
tested for the posting and collection of margin. relationships are unlikely to exchange any IM at all, as they
Given the operational bottlenecks that occurred when will fall below the $50 million threshold that is set for the
larger entities began posting IM in September 2016 and all exchange of IM.
participants began posting VM in 2017, there is concern Deeper analysis of ISDA’s research shows a significant
that the market infrastructure may not be able to cope with cliff effect between phase four – the €750 billion threshold
the influx of smaller entities that will suddenly require new – and the phase five threshold of €8 billion. While it might
documentation and onboarding with custodians over the be expected that the entities caught by phase five will be
ISDA® | www.isda.orgSYSTEMIC RISK 15
of varying sizes, the analysis suggests 83% of firms will the policy objective of reducing systemic risk will not be
have a notional of non-cleared derivatives of less than €100 undermined.
billion, while only 17% will fall between €100 billion and Raising the threshold to €100 billion would slash the
€750 billion. number of counterparties caught by phase five by 83%.
In addition, 19% of phase five counterparties and 14% Based on a calculation using the ISDA Standard Initial
of phase five relationships will fall into scope only because Margin Model, the amount of IM posted by parties in the
of the inclusion of foreign exchange swaps and forwards band between the €8 billion and €100 billion thresholds
in the calculation, even though those products are not two years into their obligation would be $75.7 billion – only
actually subject to the IM exchange requirements. 13.5% of the projected total $564.3 billion in callable IM
“We would define the most appropriate scope for – highlighting the minimal impact of the threshold change.
phase five to be those firms that pose some systemic risk, The industry letter also recommends that physically
but the analysis suggests that nearly 80% do not pose any. settled foreign exchange swaps and forwards should be
When you remove FX swaps and forwards, the average removed from the aggregate average notional amount
amount of IM posted would be very minimal. This data calculations, as their inclusion is currently increasing the
is very valuable in highlighting what the industry is facing number of in-scope counterparties. These are typically
in phase five and how we might work to address that,” says short-dated, liquid and low-risk contracts, so it is suggested
Tara Kruse, global head of infrastructure, data and non- they should be excluded from the calculation, just as they
cleared margin at ISDA. are for the IM exchange requirements.
“The data shows a really compelling trade-off between the
Recommendations number of counterparties that could be de-scoped to reduce the
Following the publication of the ISDA research, concerns challenges of phase five and the amount of IM that would be
over the implications of phase five have gathered lost as a result of that. In our view, this would not undermine
momentum, and a detailed letter was submitted to the the policy objectives. Even if regulators remove FX swaps and
Basel Committee and IOSCO in September 2018 by forwards from the calculation and raise the threshold to €100
a group of industry associations including ISDA and billion, we will still have 200-300 counterparties coming into
SIFMA. scope in September 2020, which is a big step beyond what we
On the basis that phase five will sweep in so many have dealt with before,” says Kruse.
counterparties that don’t pose systemic risk, and they will As the industry moves towards the penultimate phase
have to go through the extensive process of repapering of the margin framework in September 2019, it is hoped
documentation and setting up custodial accounts but regulators and policy-makers take note of the research that
ultimately exchange little or no IM, the group recommends has been carried out and review the phase-in thresholds on
several changes to the framework. a consistent, global basis. The alternative would be to risk
Firstly, given that most of the phase five counterparties destabilising a framework that has many virtues but now
fall towards the lower bounds of the gross notional requires some recalibration.
threshold, the letter recommends this should be raised “Swaps are used for very important economic
from €8 billion to €100 billion, or the equivalent in other reasons and they play a key role in hedging strategies and
currencies. This would not only reduce the overall industry investment portfolios. These measures have the potential
compliance burden and avoid capturing so many smaller to increase costs and penalise users without reducing
firms, but the analysis also shows it should not result in a systemic risk, which only stands to hurt investors and real
large reduction in the total amount of IM posted, meaning economy users,” says DE Shaw’s Bradbury.
“We would define the most appropriate scope
for phase five to be those firms that pose some
systemic risk, but the analysis suggests that nearly
80% do not pose any”
Tara Kruse, ISDA
ISDA® | www.isda.org16 CLEARING
* Weighing
Incentives
Capital and margin requirements for non-cleared derivatives were explicitly
calibrated to incentivise a shift to central clearing. But with clearing volumes
running ahead of what is mandated, is it time to review the incentives?
Imagine that a derivatives trader left the industry in ranging from regulatory mandates to changing risk
2006, with absolutely no knowledge of what the following management practices and more nuanced regulatory and
13 years of financial crisis and regulatory reform would economic incentives. Analysis shows that clearing volumes
hold. Returning in 2019, he or she would notice many in the US are now running ahead of mandates as a result.
changes, not least that the vast majority of a largely Nonetheless, it was never intended that all derivatives
bilaterally negotiated derivatives market had moved onto products should be cleared. Certain end users are exempt from
trading venues and central counterparties (CCPs). clearing mandates – for instance, non-financial corporates.
What might be less obvious to the veteran trader, even Many products are also not yet accepted for clearing, particularly
after catching up on years of regulations, negotiations outside the interest rate and credit derivatives markets.
and policy speeches, is exactly how this had happened, These non-cleared instruments play an important risk
particularly when it comes to central clearing. The transition management role, allowing end users to customise their hedges
to clearing has been a seismic shift for the swaps market, and to meet their particular needs. Consequently, both regulators
has resulted in a reduction in counterparty risk and systemic and market participants are starting to look closely at the various
risk. But simply assuming that the market was driven by the incentives to clear to ensure they are calibrated appropriately.
Group-of-20 (G-20) commitment to the central clearing “For a large proportion of the market, there is a significant
of standardised contracts would be an over-simplification. advantage to clearing because of the offsets and economies
In fact, clearing has been adopted for multiple reasons, that can be obtained by using a CCP. Given the high volumes
“As clearing volumes grow each year, there is a
need to review the capital and margin incentives
and where they are set at a punitive level rather
than an incentive level, there should be a case
for recalibration”
Steven Kennedy, ISDA
ISDA® | www.isda.orgCLEARING 17
of clearing we now see, we must recognise that success is not incentive level, there should be a case for recalibration,”
necessarily moving 100% of the market into clearing. There says Steven Kennedy, global head of public policy at ISDA.
are some end users and products that are still not well-suited
to clearing,” says Eric Litvack, chairman of ISDA. Clearing vs mandates
Evidence suggests that while regulatory mandates may have
Assessing incentives been the catalyst to drive trades into clearing initially, other
The regulatory mandates for central clearing derive from incentives have also played their part in accelerating the
the G-20 commitments on derivatives reform in 2009, transition. Analysis published by ISDA in July 2018 shows
and have filtered down to the industry through rules that clearing volumes in interest rate derivatives (IRD)
like the US Dodd-Frank Act and the European Market reported to US trade repositories have grown consistently
Infrastructure Regulation. The clearing mandates within since 2014, and crucially that market participants
those and other regulations have naturally driven increased have been clearing more than what is mandated by the
use of CCPs over the past decade. Commodity Futures Trading Commission (CFTC).
The incentives that drive the voluntary adoption of Of the total trading volume in US IRD, 88% was cleared
clearing are more complex and often less well understood, in 2017, while only 85% was mandated for clearing. This is not
with multiple inducements serving in different ways to unique: a gap between mandated and actual clearing has been
make clearing an attractive option for market participants. observed every year since 2014 (see Table 1). As overall clearing
For example, firms can derive benefits from multilateral volume has grown – from $111.1 trillion in cleared IRD
netting by moving a greater proportion of business into notional in 2014 to $169.3 trillion in 2017 – the additional
clearing – so while those firms subject to clearing mandates non-cleared portion of the market has steadily shrunk – from
will have to clear a certain amount, they may look to add $32.7 trillion in 2014 to $23.9 trillion in 2017 – suggesting the
non-mandated business where possible for the sake of balance is tilting conclusively towards clearing.
netting. There are risk management benefits that can be “The regulatory mandates were originally important
derived from clearing too. in bringing a critical mass of business into clearing, but
“If a hedge fund is trading liquid derivatives and once firms have the systems and documentation in place,
already posting initial margin, there is a strong incentive clearing becomes the desirable option for many products
to clear,” says Darcy Bradbury, managing director at for economic and risk management reasons,” says Bradbury.
DE Shaw & Co. “Clearing reduces counterparty credit While clearing volumes are most obviously running
exposure and avoids margin being tied up with a defaulting ahead of clearing mandates in the IRD market, the trend
counterparty, as was the case for many hedge funds during can be observed in other asset classes too. In credit default
the Lehman Brothers bankruptcy. Clearing also can allow swap indices, traded notional has declined over the past
funds to reduce notional exposure and related risk more few years, but a consistent, albeit small chunk of business
easily through compression and netting.” has continued to be cleared voluntarily. In 2017, $5.3
Other incentives to clear derive from the calibration trillion was cleared, versus $5.1 trillion that was actually
of capital and margin requirements. For example, capital mandated for clearing.
charges are much lower for exposures to qualifying CCPs, Clearing has also increased in foreign exchange
with a flat 2% risk weight rather than the full bilateral derivatives, with a particularly marked increase after
risk weight, adding an extra incentive to increase clearing the first phase of margin requirements for non-cleared
beyond what is mandated. In a cleared environment, derivatives came into effect in September 2016. Notional
market participants will also see no or reduced credit outstanding of cleared FX derivatives jumped from $178
valuation adjustment capital charges. billion in the third quarter of 2016 to $312 billion in the
In addition, the margin rules for non-cleared last three months of that year, and peaked at $473 billion
derivatives have been explicitly set to encourage more in the third quarter of 2017.
clearing (see pages 12-15).
The key question is whether these incentives are
calibrated at an appropriate level, and whether the capital TABLE 1: P
ERCENTAGE OF US CLEARED AND MANDATED TO
and margin rules make it overly punitive to trade non- BE CLEARED IRD TRADED NOTIONAL
cleared derivatives – a situation that would deprive end Total US IRD Trading Cleared (%) Mandated to be
users of a valuable risk management tool. Volume (US$ trillions) Cleared (%)
“There are obvious netting benefits and capital 2014 143.8 77 73
efficiencies that can be gained from clearing and once a
firm reaches a certain tipping point, it will look to put as 2015 142.2 78 73
much volume of clearing-eligible products as possible into 2016 166.3 84 77
the clearing house. As clearing volumes grow each year,
2017 193.1 88 85
there is a need to review the capital and margin incentives
and where they are set at a punitive level rather than an Source: ISDA analysis based on DTCC and Bloomberg SDRs data
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