When you start the day reading a headline that so obviously misrepresents the reality of the world around you, sometimes all you can do is splutter into your morning bowl of cereal. For those of us at ISDA, this was the reaction to a Financial News front-page splash published on September 19 entitled ‘G-20 derivatives reforms show little results – seven years on’.
So, what’s behind the headline? Reading on into the article, it turns out the evidence cited to back this up is Bank for International Settlements (BIS) data that shows over-the-counter (OTC) derivatives trading has not significantly migrated to exchanges.
This represents a fundamental misunderstanding of the Group-of-20 (G-20) reforms. Yes, the 2009 G-20 statement included a commitment for standardized OTC derivatives contracts to trade on an exchange or electronic trading platform where appropriate, but there was no requirement for market participants to stop using OTC instruments and move to exchange-traded contracts like futures.
In fact, a huge amount of work has been done to meet the G-20 commitments and shift the trading of standardized OTC derivatives contracts to electronic trading venues. According to data from US trade repositories, 55.8% of interest rate derivatives and 76.5% of credit default swap index average daily notional volume in the US was traded on a swap execution facility in the second quarter of this year. Similar to US rules, the revised European Union’s Markets in Financial Instruments Directive will require trading of certain instruments on organized trading facilities or multilateral trading facilities when the rules come into effect from 2018.
Plenty of progress has been made on the other reform commitments too: clearing of standardized derivatives contracts, reporting of all OTC derivatives, an overhaul in capital requirements, and the introduction of margin requirements. Approximately 70% of total interest rate derivatives notional outstanding is now cleared through a clearing house. Reporting requirements are in place in virtually all financial centers, providing regulators with the ability to scrutinize individual derivatives trades and counterparties. And banks have significantly boosted their capital, liquidity and leverage ratios as a result of Basel III.
Most recently, the largest banks began posting variation and initial margin on their non-cleared derivatives trades, under rules that took effect in the US, Canada and Japan from September 1. Europe and a number of Asian jurisdictions are set to follow suit early next year, followed by the introduction of variation margin for all financial entities under the scope of the rules from March 1, 2017. The initial margin requirements will then be rolled out to other groups of users in phases through to 2020. The industry has worked extremely hard to meet the tight deadlines set for it so far, and ISDA has been instrumental in smoothing this process with the launch of the Standard Initial Margin Model (ISDA SIMM), as well as the publication of revised documentation that complies with the margin rules.
At the time the G-20 commitments were announced, some commentators speculated that derivatives users would start using exchange-traded futures and options contracts more frequently as a result of these changes. The BIS data shows this hasn’t happened. But that doesn’t mean the G-20 reforms have failed – far from it. The real thrust of the 2009 reform lay in making OTC markets safer and more transparent through on-venue trading, clearing, reporting, the margining of non-cleared trades, and the revision of capital, leverage and liquidity safeguards. And in that regard, a huge amount of progress has been made.