For the International Swaps and Derivatives Association (ISDA), margin was center stage for all of 2016 as the association focused on supporting the industry’s implementation of new margin requirements for non-cleared OTC derivatives with the development of the ISDA SIMM and the VM Protocol. In a DerivSource Q&A, Scott O’Malia, Chief Executive Officer of ISDA, reflects on the major milestones for the association in the past year and offers insight into some of the areas of focus, such as more support by WGMR for the variation margin ‘big bang’ and MIFID II, in 2017.
Q. Significant milestones for 2016. Can you briefly describe what you believe were the most significant milestones of 2016 for ISDA and the impact this had on the industry?
A. This past year saw the first stages of implementation for the new margin rules on non-cleared derivatives. This has been a huge project for ISDA, and will be one of the biggest changes to hit the industry in decades.
Many derivatives users already post variation margin on their trades. However, the new requirements will make variation margin posting compulsory for all financial entities, and set strict rules on eligible collateral, settlement timing, thresholds and other issues.
The exchange of initial margin was much less common, and was hardly ever exchanged between dealers. Again, the rules set strict requirements on margin calculation, eligible collateral, collateral segregation and other issues.
Together, the rules represent an unprecedented shift in derivatives trading practices. They require firms to make major changes to virtually all aspects of their derivatives operations, necessitating new infrastructure, processes and documentation to be developed, implemented and tested.
To help facilitate implementation, ISDA has developed the standard initial margin model, or ISDA SIMM, to reduce the problems created by each firm calculating initial margin requirements using its own methodology. ISDA has also developed multiple new legal documents that will govern the exchange of variation margin and initial margin under various legal regimes, as well as a protocol to help firms make changes to their collateral documentation quickly and efficiently.
Outside of margin, we’ve conducted several industry impact studies on aspects of the capital framework, including the Fundamental Review of the Trading Book (FRTB), net stable funding ratio, credit valuation adjustment and leverage ratio. We’ve published a number of important principles papers, including one that sets a path forward for the further standardisation of derivatives infrastructure. And we’ve published multiple protocols, including the ISDA Jurisdiction Modular Stay Protocol that allows firms to comply with new bank resolution rules.
Q. Market and geopolitical change and 2017. How the political change impacting the UK and Europe (Brexit) and the new US President impact ISDA’s plans or focus for 2017? How does ISDA plan to prepare for these changes?
A. In the run-up to the UK referendum, ISDA conducted detailed analysis on the possible impact, and determined that a vote to leave the EU would not have an immediate effect on the legal certainty of existing derivatives contracts, nor would it require any immediate contractual change or action from counterparties. Since the vote, we’ve been looking into the effects on the ISDA Master Agreement with regard to the choice of English law governing the contract, as well as how to cope with the loss of automatic recognition of English court judgements in EU/EEA member states. The answer will depend on the exit strategy adopted.
With regards to the US elections, it’s obviously very early days. As you know, ISDA supports effective and harmonised implementation of the rules between the US, Europe and Asia. The election will undoubtedly change the political landscape in the US, but, as a global Association, we will continue to work to ensure that the rules are as globally consistent as possible.
Q. Regulatory harmonisation. Regulatory harmonisation has improved in the last year. Is there still more work to be done in 2017 for harmonisation and if so, what role will ISDA play? What specific areas of regulation will you focus on?
A. The progress on central counterparty (CCP) equivalence between the US and Europe is positive. But ISDA research shows market fragmentation continues to persist in certain derivatives products, largely as a result of differences in the timing and substance of regulation.
The research shows 88.7% of regional European interdealer volume in euro interest rate swaps was traded between European dealers in the fourth quarter of 2015, compared with 73.4% in the third quarter of 2013. The change in trading behaviour coincided with the introduction of US Swap Execution Facility (SEF) rules, which required all electronic venues that provide access to US entities to register with the US Commodity Futures Trading Commission (CFTC) as SEFs. Many European platforms chose not to do this, resulting in a liquidity split.
A transparent substituted compliance/equivalence/deference mechanism for trading platforms based on broad outcomes, rather than a granular rule-by-rule comparison, would help minimise the compliance challenges and fragmentation of liquidity.
Q.Working Group on Margin Requirements (WGMR). With more margin deadlines coming up in March and September 2017, what initiatives or plans does ISDA have to help members and non-member firms meet these deadlines effectively?
A. As mentioned, ISDA has developed the ISDA SIMM to alleviate some of the challenges associated with initial margin calculation and help reduce the potential for disputes between firms. For the first time, a common, transparent and flexible model will be used to calculate initial margin in the non-cleared space.
ISDA has also developed a variety of new credit support annexes (CSAs) for variation margin and for initial margin under various legal regimes, a self-disclosure letter that allows firms to exchange information on whether and when they will be subject to margin requirements in specific jurisdictions (for the US, Japan, Canada, EU and Switzerland so far), and a protocol that will enable participants to make changes to multiple agreements to comply with variation margin requirements (published for the US, EU, Japan and Canada so far).
The variation margin ‘big bang’ on March 1, 2017 will be a particular challenge. In order to comply, thousands of financial institutions – banks, asset managers, insurance companies and hedge funds – will need to make changes to thousands of outstanding documents. Time is running out, and firms really need to start preparing now.
As part of their approval of the ISDA SIMM, US prudential regulators set out certain required enhancements during 2017, including the addition of new risk factors. The ISDA governance committee – which incorporates a forum open to all ISDA members subject to initial margin requirements – is working on those changes.
Q. Variation Margin (VM) Protocol. Is the update of the VM protocol as expected? I assume this will play a significant role in 2017?
A. The protocol was published for the US, Canada and Japan in August, and EU provisions were added on November 17, following publication of final regulatory technical standards by the European Commission in October. The protocol was launched on ISDA Amend – an online platform that automates the process – on November 25.
The protocol itself provides three options, which reflects the fact there are different preferences on how to tackle this in the market. As one option, firms can opt to put in place a new CSA with limited standardised terms that comply with the rules. If they already have collateral documentation in place, then there are two other possibilities. They can choose an ‘amend’ option that applies the necessary changes to the documentation to comply with the rules. Or they can opt for ‘replicate and amend’, which allows users to create a replica of the existing agreement, which is then amended and used for new trades only.
Obviously, market participants don’t have to use the protocol. They can choose to negotiate the necessary changes bilaterally. The downside is capacity. Renegotiating or setting up new contracts can take a lot of time, and each firm may need to change thousands of agreements before March 1. The protocol could help with that, as firms can alter multiple contracts with other adhering parties. That’s why the industry asked ISDA to pursue this, and why an industry group was convened to develop it.
The key challenge remains one of time. In-scope entities need to start work on the implementation process as soon as possible if they are going to make the March 1 variation margin deadline. There really is no time to lose.
Q.SIMM. What updates are planned and how do you plan to keep momentum up in terms of uptake and progression?
A. The ISDA SIMM methodology itself is relatively simple, designed to be used by the widest possible audience. Users need to determine their own sensitivity inputs for specified risk factors, but other parameters, such as risk weights, correlation and risk buckets, are centrally defined to help ensure consistency. These parameters need to be regularly reviewed and recalibrated.
This will all be done through a transparent governance framework, comprising an ISDA SIMM Governance Forum, which is open to all ISDA members that are subject to the initial margin requirements, and an ISDA SIMM Governance Executive Committee, which takes the decisions over alterations.
This governance committee will oversee an annual recalibration of these parameters and will conduct a yearly methodology review to ensure the model continues to perform as it should.
A key part of this process will be feedback from users. By reporting difficulties with reconciliation or significant margin shortfalls, market participants will give the governance committee the right information to judge the performance of the model and make changes as necessary.
The really important thing is making sure everyone continues to use the same version of the model. So, once vetted by regulators, any methodology changes will be published, and an appropriate time will be given to make the updates. The last thing anyone wants is to get to a situation where everyone is using different versions of the same model.
Q.MiFID II: With more clarification expected in 2017 from the regulators on MiFID II, what is the focus for ISDA for preparing for MIFID II in 2017? Do you have any specific initiatives planned that will address challenges members face as they work to comply with the new rules?
A. We’re now into the final stretch of rule-making for MIFID II. One of the big areas of focus is the trading obligation, which governs which instruments are to be traded on a venue. Here, we think there are a few areas where more detail would be helpful. In particular, it’s important that regulators set the correct level of granularity for the trading obligation. To give firms a clear and defined product list and avoid confusion over whether a specific product is in scope or not, the trading obligation calibration should be significantly more detailed than that used for pre-trade transparency.
As currently drafted, the rules could pull infrequently traded instruments into the trading obligation, which has the potential to hinder liquidity and reduce the availability of complex, bespoke trades. We have recommended that three tenor points in a currency should be deemed liquid before the currency becomes subject to the trading obligation.
We believe a more granular approach would have the advantage of aligning Europe more closely with the US SEF rules.
Q. 2017. If you would give one call to action for our readers as to what they should be focused on most in 2017, what would you suggest?
A. For financial institutions, the main focus for 2017 will be the margin rules, particularly the March 1 variation margin implementation date. It is hard to overstate just how significant a change these rules will be, and the extent of the challenge faced by firms in adopting them.
Capital will continue to be a major issue for the industry. It is important that regulators arrive at a broadly harmonised framework, which means that the Basel Committee should be willing to make adjustments to avoid severe divergence between jurisdictions. It is also vital that regulators hold to the commitment made by Group of Governors and Heads of Supervision (GHOS) not to significantly increase capital at a bank and business level, and correctly calibrate the risk sensitivity of the framework.
Data is another important topic for 2017. ISDA has argued strongly on the need for standard and globally consistent trade and product identifiers, and recently published a paper that sets out key principles for the creation of a universal product identifier, which we believe would be hugely beneficial for the industry. We’ll continue to push this forward next year.
Finally, the clock is really beginning to tick on MIFID II implementation. We have just over a year to finalise the fine details and make sure the rules work in harmony with their counterparts in other jurisdictions. That will be an area of significant focus for ISDA, and the wider industry in 2017, as it is crucial that these rules are introduced smoothly and successfully.
