Resolution Protocol: Staying Power?

The launch of ISDA’s Resolution Stay Protocol*, which opened for adherence last week, has inspired a variety of comments in the press. Among them are articles reporting on concerns expressed by some buy-side firms – an important element of our membership – about the process of drafting the Protocol. Others have touched upon whether a contractual approach is the best way to deal with cross-border resolution issues. Both are valid points to raise, but we are particularly concerned that some misperceptions have crept into the coverage.

Buy-side representatives (including trade groups that represent scores of firms) were involved in this initiative from its outset, and participated in a Protocol working group that ISDA established. As such, they were sent all drafts of the Protocol and were encouraged to voice their opinions throughout the process. ISDA also organised and participated in several meetings between buy-side representatives and regulators.

Very early on, the buy side raised concerns about any change to derivatives contracts that would result in the loss of a right to close-out trades with counterparties that enter into resolution. They argued they have a fiduciary duty to their clients that prevents them from voluntarily signing away advantageous contractual rights. And they’re right.

ISDA repeatedly made these points to regulators, including through a letter co-signed with the asset management group of the Securities Industry and Financial Markets Association. These concerns were acknowledged and accepted by regulators, as highlighted in a recent report by the Financial Stability Board (FSB).

This brings us to an important point: as a result of these concerns being aired, buy-side adherence to the Protocol was separated from bank adherence. That’s why only 18 large and global financial institutions signed the Protocol during its first phase.

The FSB report has proposed that national regulators should introduce rules in their jurisdictions in 2015 that would encourage – directly or indirectly – a broader array of firms to adopt contractual stays. It is anticipated that the development and imposition of these rules will follow the normal rule-making process of each individual jurisdiction. It is also expected that ISDA may publish amendments to the Protocol to reflect these rule-makings, so that if and when buy-side firms do adhere, they will adhere strictly to the language of the regulations in a particular jurisdiction.

In addition, it is important to point out that this Protocol has a ‘sunset clause’, and requires regulation to ensure the continuity that market participants and regulators would expect from such an important remedy. If the rest of the market is not subject to a particular special resolution regime within a specified time, the 18 banks can give notice that they are no longer bound by that regime. A contractual approach is a useful short-term solution – a point that a number of market participants can accept so long as there is a level playing field.

Clearly, the most effective way to ensure that any stay on early termination and cross-default rights applies on a cross-border basis is through legislation – a point ISDA has made repeatedly. The FSB report also agrees that a framework for statutory cross-border recognition would be preferable, but argues this a longer-term goal.

Until a legislative solution is implemented, the Protocol establishes an effective mechanism for those firms that choose to use it to quickly and efficiently alter their outstanding contracts. The Protocol is not a rule, nor does it require firms to sign – ISDA cannot and does not mandate adherence to its protocols.

Whether other firms sign is a matter for them to decide – or for regulators to propose, issue and implement rules requiring or incentivising their adherence.

Going forward, ISDA will remain the neutral broker and clearing house of ideas regarding the implementation of the Protocol, as well as responding to the expected regulatory and legislative proposals. Ensuring we have a well-defined and workable recovery process that is consistent with the regulatory objectives and protects the rights of creditors is in the best interests of all market participants and the stability of the global financial system.

*Editor’s Note: The Protocol was developed at the request of global regulators to ensure cross-border derivatives transactions are captured by existing and forthcoming statutory resolution regimes. By signing the Protocol, adhering firms are agreeing to change derivatives contracts with other adhering parties to abide by the early termination stays introduced by these statutory regimes. By doing so, they remove uncertainty over whether a stay imposed by one country’s resolution authority (which would cover all derivatives trades subject to local law contracts, without need for the Protocol) would be enforceable in a cross-border situation. The Protocol also provides for an override of cross-default rights when an affiliate of a counterparty becomes subject to certain US bankruptcy proceedings.

Fireworks!

Around the world, fireworks traditionally mark special holidays and events, and people in the US will see their fair share this weekend as the nation celebrates the 4th of July.

The New York Times must also be in a celebratory mood as it has launched its fireworks a day early. Have a look at today’s editorial. It breathlessly states:

“The aim of the Dodd-Frank law is to prevent gambling in derivatives, financial contracts that are supposed to manage risk, but that have long been misused for catastrophically excessive speculation.”

Ka-boom!

We have heard many explanations about what Dodd-Frank is supposed to be about, but none as breathless as this one. Have a look at this document from the Senate Banking Committee: Nothing about preventing gambling.

With regard to “long been misused for catastrophically excessive speculation,” we would ask a simple question: what does this mean? If it refers to derivatives-related losses that brought a firm down, which ones does the editorial have in mind? Barings? Orange County? MF Global? They were all about exchange-traded products or securities. Lehman? Countrywide? Washington Mutual? Fannie and Freddie? These were real-estate related, in the form of either mortgages or mortgage securities. None of these situations stemmed from OTC derivatives.

And then there’s AIG, which certainly did involve OTC derivatives. But whatever AIG was, it wasn’t speculation that led to its bailout. Inadequate risk management and margining practices were at the core of the problem.

Now we know the editorial represents the conventional wisdom in many circles. We are clearly swimming upstream. The actual facts are, in some sense, nothing more than an annoyance to this story line. Positing them creates a risk of being tarred and feathered as anti-regulation or anti-Dodd-Frank. But this too would be inaccurate.

One more important item we should point out: the statement quoted above is not the main point of the paper’s editorial, which is about derivatives trading outside the US by certain foreign affiliates of US banks. But the thinking behind it shapes and informs the views expressed on the main issue, which is why it invites (nay, demands) comment. And we are happy to oblige.


As for the main issue: it is clear today that a growing number of non-US companies and firms are looking to ensure that they operate within the regulatory frameworks of their home jurisdictions (e.g., firms trading in the European Union regulated by EU rules and rule-makers).

They do not want to trigger US regulatory requirements because it would add another layer to their compliance efforts without any countervailing benefit. Their view is that this additional layer is unnecessary because the regulatory frameworks in each major jurisdiction are basically equivalent (albeit there are differences in timing). It’s a view shared by US firms who operate under US rules and who do not want to face duplicative rules elsewhere.

Policymakers around the world are currently trying to hash out how to make a global system of equivalency work for a product set — OTC derivatives — that is truly global.

None of this is mentioned in the editorial.

Happy 4th of July!

Protection Racket

How many times have you read a story in a newspaper or magazine and thought, “The headline is pretty negative, but the story is OK”?

We thought (and hoped) that might be the case when we came across this New York Times Dealbook piece – authored by an outside contributor – that has this alarming headline: Derivatives Markets Growing Again, with Few New Protections.

We were wrong. Here’s why…

The piece cites statistics from the recently released BIS semiannual survey and notes that the notional value of over-the-counter (OTC) derivatives at year-end 2013 is 20% larger than year-end 2007.

That’s true.

But left unsaid is one of the primary drivers of that growth: an increase in central clearing of OTC derivatives. As the BIS survey states, clearing doubles the notional outstanding related to a transaction, as, for example, one $10 million trade that’s bilaterally negotiated becomes two $10 million cleared trades between each of the counterparties and a clearinghouse.

If you eliminate the effect of double-counting of cleared OTC interest rate derivatives, then (all else being equal) the size of the overall OTC derivatives market actually declined by a bit more than 10% from year-end 2007 to year-end 2013.

Here’s where another key trend – portfolio compression – comes into play. Compression has eliminated some $170 trillion (on a net basis) of OTC derivatives over the past five years. In other words (again assuming all else remains equal), the global OTC derivatives market would be larger by that amount if compression had not occurred.

Clearing and compression have been going on for some time, but it’s safe to say that there’s an additional sense of urgency to them amidst global regulatory reform. In fact, clearing mandates in major jurisdictions will ensure this is the case (although the reality is that the actual amounts cleared are well ahead of those mandated for clearing).

So it’s pretty evident that regulatory and market reforms are behind big changes in the OTC derivatives markets. This cuts against the first of the author’s main concerns, namely the market’s growth.

But it also speaks to the other concern – the claim that there are “few new protections.” After Dodd-Frank, EMIR and MIFID, after all of the new rules and regulations being implemented in the US and Europe and around the world, how can anyone say this?

Which brings us to our last point. The article reasons that management of OTC derivatives can be complex and opaque. It then uses two well-known scandals to show how large the losses can be from poor management. In both examples, though, those losses stemmed from illicit trading of listed, exchange-traded derivatives — not the OTC derivatives the author is so worried about.

So here’s a question: How do you protect against this type of logic?

Mondays always get me down

A decent weekend. Not much going on…

And then, on Monday morning, bam! Breaking news from The Wall Street Journal: “Big U.S. Banks Make Swaps A Foreign Affair”. The story basically posits that US banks are using their overseas affiliates to write some swaps with non-US counterparties without a parent company guarantee. This means that the transactions would not fall under the purview of US regulators.

Sounds troubling.

But as the infomercials say: Wait! There’s more!

A lot more.

First, the transactions would in fact fall under the purview of regulators in the jurisdictions in which they are done.

Second, on the major systemic risk issues (clearing, trade reporting, margining), there is likely to be little to no substantive difference between major jurisdictions.

So this clearly is not a case of regulatory arbitrage. It’s really about the fact that some customers do not want or have the capacity to understand and comply with regulations in two different jurisdictions. These non-US customers prefer doing business with non-US firms. They don’t want to trade on SEFs. So the US firms are structuring their businesses to meet this demand.

Most people know all of this, as the Journal article acknowledges.

So what’s really the issue? Apparently, it’s the fact there are some differences between jurisdictions in the timing and substance of trade execution rules. So some see the shift to trading overseas as a way for firms to avoid trading on SEFs, which they view as a bad thing, because:

“For US regulators, the new rules aim to bring swaps trading into the open and protect the US financial system from firms amassing huge derivatives positions in non-US markets.”

But that’s not the role of SEFs – that’s what clearing and trade reporting are all about. And as we noted, on these issues there’s not much if any difference between jurisdictions.

One final thought: the article begins with a chart that purports to show concentration in the derivatives markets. The data in question, however, is for the US only and includes only US banks. As we have written, the derivatives markets are truly global, and a look at our report here shows a more accurate picture.

Misperceptions like this… that’s why we’re hangin’ around, with nothing to do but frown….

Beware Blaming Bad Bond Bets!

The debate about speculation vs. investment has gone on at least since the Sumerians traded wine forwards five or six millennia ago. More recently − five or six decades ago −  one of our most famous value investors put it this way:

ben graham


“The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices.”

- Benjamin Graham
The Intelligent Investor

Graham’s words of wisdom come to mind after reading this piece from CNBC.com. It keys off a “study” by the Services Employees International Union about derivatives usage by municipalities.

The central premise: if a municipality (and by extension, a corporation, asset manager, pension fund, sovereign or other entity) decided to lock in rates a few years ago with an interest rate swap, it made a “bad bond bet.” That’s because rates stayed low, meaning there was no need to hedge and so the premiums spent on the hedge could have been spent elsewhere.

The logic (?) of this position is: it’s better to stay exposed to market fluctuations than to manage the risk of those fluctuations.

But isn’t that betting (or speculating)?

Well, yes, actually, it is.

But wait…what about the fact that terminating that hedge can mean big payments from a hedger to its counterparty? Isn’t that another sign that it’s just a bad bet?

Well, no, actually, it is not. Here’s why:

Assume a hedger issues floating rate debt and then does a swap to lock in a fixed rate (by paying fixed and receiving floating).

Rates then go lower, which means the cost of the floating rate debt declines. The hedger pays less in interest income on the debt.

At the same time, the hedger continues to make the same fixed rate payments on the swap (and continues to receive floating rate payments from its counterparty). The market value of the swap has changed, because the hedger’s fixed rate payments are more valuable now that rates have gone down.

So if the hedger wants to terminate the swap, its counterparty wants a larger termination payment to compensate for the loss of those fixed rate payments.

Keep in mind that the hedger is under no obligation to terminate the swap. Its decision to do so is voluntary.

So why would a hedger voluntarily pay a large termination fee to exit a swap?

The most likely reason: It has determined that it could save money by issuing new debt — and by calling in its existing debt and terminating its existing swaps.

So, to summarize: a hedge enables a hedger to optimize its financings while protecting against changes in rates. The effectiveness of the hedge is a function not just of its cost but also of the cost of the hedger’s debt. Termination payments reflect changes in value of the swap hedge and are made voluntarily when the hedger has determined that there’s financial value in calling old debt, terminating swaps related to that debt and issuing new bonds.

See How They Run

Are financial regulators still flying blind when it comes to derivatives exposures?

It depends on who you ask.

On the one hand, there’s the Financial Stability Board’s paper – OTC Derivatives Market Reform: Sixth Progress Report on Implementation. It states (on page 29) that the Depository Trust & Clearing Corporation’s (DTCC) trade repository has captured 99% of all interest rate derivatives contracts outstanding and 100% of credit default swaps outstanding, when compared to the Bank for International Settlements’ semiannual survey.

That’s pretty good – and it shows the tremendous improvement in regulatory transparency since the global financial crisis.

To see for yourself, have a look at ISDA’s new website – ISDA SwapsInfo.org – which takes all of the public information reported by DTCC and transforms it into user-friendly charts and graphs. You can view activity and notional outstanding by currency, product type and maturity. This includes, by the way, market risk activity for the range of credit derivatives products.

IRD 300dpi

It’s worth noting that the information available to the public on this site and through the DTCC warehouse is only part of the data available to regulators.

So that’s the good news. There is, however, “the other hand” to consider. And it includes a collection of stories like this one from Bloomberg View. These articles claim transparency is still not where it should be and much more work remains to be done.

And you know what? In some cases, they are spot on. There is, for example, an increased threat of fragmentation in trade reporting because of competing trade repositories in different jurisdictions. As the Bloomberg article notes, this could impede the goal of greater regulatory transparency.

It’s also true that data alone is insufficient to give regulators the information and knowledge they need and require. In fact, in some cases, data alone might do more harm than good by providing a false sense of security without providing a true level of understanding.

So what’s the bottom line here?

Improvements – real improvements – have been made in ensuring data regarding activity levels and risk exposures are appropriately reported. We have come a long way since 2008.

But now, derivatives industry market participants and regulators need to work together on an important goal. It’s to ensure the information being requested is on point, addresses key public policy and risk management needs, and is timely.

Otherwise, we won’t be flying blind…but we will be running around in circles.

Disgusted, Tunbridge Wells

Letters to the editor are a common feature of most news publications. Often they are penned by outraged readers. Sometimes they are not. According to the BBC, staffers at the former Tunbridge Wells Advertiser wrote their own to fill space: “One [staffer] signed his simply ‘Disgusted, Tunbridge Wells’, and a legend was born.”

We note this because of a recent letter we came across in the Financial Times. It, too, appears to have been written by someone with an unusual sense of humor (though this time, no newspaper staffer or pseudonym is involved).

The FT letter is entitled “Fragmented derivatives market may cut global risk.” It’s written in response to an article about the lack of global coordination of derivatives regulations: “US rules ‘endanger’ derivatives reforms.”

So what’s the beef?

It’s this – the letter articulates the view that geographic fragmentation is a good thing:

“So, the global derivatives market could fragment along regional lines. That might be anathema for some – yet might make for a safer, less globally connected and also more constrained market… the mere decline in the extent and inter-regional connectedness of derivatives trading could make for less global risk.”

And it does so apparently because global reform is the brainchild of special interests:

“Until recently, ‘reform’ implied action in the public interest. However, the adoption and globalisation of the reform agenda by special interests merits a second glance…”

It would be great if the derivatives industry could take credit for the idea that markets are global, but we must give credit where it is due. It’s not a particularly new idea. But it is one espoused by global policymakers. As the 2009 G20 Pittsburgh Summit Communique stated:

“Continuing the revival in world trade and investment is essential to restoring global growth. It is imperative we stand together to fight against protectionism… We will keep markets open and free… We will not retreat into financial protectionism, particularly measures that constrain worldwide capital flows, especially to developing countries.”

Economic theory posits that globalization increases economic growth and reduces poverty. As a recent issue of The Economist stated:

“According to Amartya Sen, a Nobel-Prize winning economist, globalisation ‘has enriched the world scientifically and culturally, and benefited many people economically as well’. The United Nations has even predicted that the forces of globalisation may have the power to eradicate poverty in the 21st century.”

We think the benefits of global financial markets also accrue to users of derivatives. It enables counterparties who do not want a particular risk to more easily and more cheaply find someone better able to manage that risk. That could be the firm next door or the firm across the ocean.

If derivatives markets were not global, then that risk would be transferred to someone locally – or not at all.

In either case, the risk is likely to be less effectively managed. Which ultimately means that risk in the system might increase, rather than decrease, if markets are fragmented. And while that may not be a reason to be disgusted, it’s certainly a reason to be dismayed.