For a long time PTRRS was out of the legislative limelight but a consultation from IOSCO may change that. Lynn Strongin Dodds explores.
Post trade risk reduction services (PTRRS) have escaped regulatory spotlight despite their increasing popularity and the important role they play in reducing systemic risks. The glare though may become brighter with the publication of the International Organisation of Securities Commissions (IOSCO) consultation paper which is full of potential policy considerations and guidance.
PTRRS mainly refers to portfolio compression and portfolio rebalancing which enable counterparties to manage their exposure to certain types of risk in existing derivatives portfolios without altering their fundamental market positions.
More specifically, the former helps firms to better manage their capital, risk and operational costs by aggregating and netting of multiple offsetting OTC derivatives trades. This in turn lowers the notional value of a portfolio while maintaining the same net risk.
The latter cuts risk exposures between counterparties by introducing new transactions into netting sets. This has the knock-on effect of easing liquidity strains from rapid margin demands, particularly in times of market stress.
While these services have similar attributes, jurisdictions differ in respect to rules and policy mandates. For example, the UK, US, Japan, and Australia have regimes that may partially or wholly cover PTRRS and their providers, while others have no or little oversight.
IOSCO’s hope is to level the playing field and create a more holistic and coordinated framework, given the sheer volumes of derivatives contracts that are exposed to these services and their possible material impact on the overall amount of initial margin (IM) posted.
The paper identified several challenges most notably concentration of PTRRS providers, particularly in the areas of portfolio compression and counterparty risk optimisation. It also highlighted the lack of transparency regarding the algorithms used by providers, plus limited data, regulation and direct oversight globally. Also mentioned was the lack of due diligence conducted by users of PTRRS as well as the absence of standardisation and predictability of runs and file formats.
The responses, which are due on 1 April 2024, are expected to help IOSCO form a foundation to build sound practices to mitigate these threats.
IOSCO is the latest organisation to take a deep dove into the inner workings of PTRRS, but the Europeans have been debating and discussing the topic for six years in light of the EMIR Refit. The ball started rolling with the International Securities Lending Association (ISLA), International Swaps and Derivatives Association (ISDA), European Banking Federation (EBF) and the International Capital Market Association (ICMA) circulating a joint whitepaper in 2018 on the benefits of PTRRS as a crucial risk management tool.
The group recommended that the newest EMIR version be amended to exempt transactions resulting from PTRRS from the clearing obligation. They said instead the European Securities and Markets Authority (ESMA) could be tasked with the job. The view was that PTRRS should be market risk neutral because these services are not designed to change the directional market risk of the portfolios concerned, but rather reduce counterparty, operational and systemic risk in respect of existing derivatives transactions.
The European Securities and Market Authority (ESMA) agreed with this position in its own paper in 2020. It maintained that exempting certain PTRR transactions from EMIR clearing obligation would yield several benefits. This ranged from reduced risk in the market to an opening for legacy trades to be compressed and increased participation in PTRR services of counterparties. This is because simplifying trades used for rebalancing would be more attractive than the current complex transactions that are typically employed.
These arguments were further voiced by ISDA two years ago. The trade group reiterated that a limited and targeted derogation from the clearing obligation would increase the effectiveness of PTRR rebalancing exercises that reduce counterparty risk, resulting in the flattening of potential spikes in margin requirements.
It also noted that it would lead to a wider range of market participants as well as enable new levels of risk exposure transfer from the uncleared to the cleared market. This it said would directly support the G-20 financial stability objective of increased central clearing of derivatives risks.
At the moment, European market participants are still waiting for answers. The European Commission published a response in April 2021 which concluded that further work needed to be carried out regarding PTRRS. In the meantime, ESMA and national competent authorities have no powers to supervise PTRRS providers.
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