Summer Relief

It’s been some four months since our last posting, and we have been hoping for an equally quiet summer. But then we came across a recent article in the American Banker about a new research report by the US Treasury’s Office of Financial Research.

The story and the report are on banks’ use of credit derivatives to reduce their capital requirements. It’s an interesting topic, to be sure, and it’s one that deserves proper consideration and analysis.

So in that spirit, let us offer some thoughts.

Banks constantly search for ways to manage their risk exposures and allocations, and they have different strategies for doing so. They might, for example, make loans and hold them to maturity, and/or they might sell those loans and recycle capital to make new loans, and/or they might buy credit default swap (CDS) protection on those loans to free up capital for new purposes.  All of this is important for economic growth.

If a bank’s risk management activity reduces its exposure (and hence its risk), it follows that its capital requirements should also be lower. That’s the primary motivation behind the credit derivatives activity in question. And it’s long been recognized as legitimate by prudential regulators.

Now, as the report and article state, banks are required to disclose to the Federal Reserve the notional amount of credit derivatives for which they “purchased protection that is recognized as a guarantee for regulatory capital purposes”.

It’s important to note that this information is available for all to see at the National Information Center (which houses data collected by the Federal Reserve System). The data is available on an individual firm basis (and can be accessed under the ‘Institution Search’ tab), as well as on an aggregated basis, segmented by peer group (under the ‘BHCPR Peer Reports’ tab).

What this means: regulators, shareholders and others can see exactly how much CDS protection a bank has bought to improve its regulatory capital position.

What about the counterparties to those credit derivatives trades? Do we know who they are? Firms in the US, European Union and other jurisdictions are now required to report their derivatives trades to trade repositories. In this way, as well as through the normal course of supervision, the answer is yes – regulators have the data in order to see who those counterparties are.

Also worth noting: under the bank capital rules, a bank that enters into CDS transactions needs to take the creditworthiness of its counterparties into consideration in determining the capital it needs to back the trades.

Another key point: under the new margin rules coming into effect, counterparties are required to post initial and variation margin on all non-cleared derivatives trades. Margining helps mitigate counterparty risk; it works to help ensure that a buyer of protection will actually get paid by a seller of protection.

The Credit Derivatives Mailbag

Some recent press articles have raised questions about the process for determining whether a credit event has occurred and therefore whether credit derivatives should trigger. Many of the articles have focused on the ISDA Credit Derivatives Determinations Committees (DCs). So, we thought we’d tackle a few of the most commonly raised issues.

Q: What are the DCs?

A: The DC process was rolled out in 2009 in order to ensure decisions over whether a credit event has occurred can be taken quickly by people with expertise in the credit derivatives market, based on an objective, rules-based review procedure. The process was developed to ensure both speed and certainty. These are important: market participants need to know as quickly as possible whether their trades will be triggered.

The DCs were part of a broader effort to increase standardisation in the credit derivatives market and facilitate central clearing. This included the hard-wiring of an auction settlement system into credit derivatives documentation to reduce operational complexity and increase certainty by creating a uniform, transparent and orderly settlement process. That, in turn, required an objective mechanism for deciding whether credit events had occurred. The entire DC process was developed in coordination with regulators and following market consultation.

Q: How does the DC process work?

A: There are two things that matter in determining a credit event. First, the decision can only be made based on publicly available facts submitted to the DC. Second, these facts need to be referenced to the ISDA Credit Derivatives Definitions – the standard legal terms used in the credit derivatives market – to determine whether a credit event has occurred. This is meant to ensure the process is objective and predictable, and decisions can be made quickly – providing certainty to market participants as to whether they have a hedge or not.

Q: How can you be sure it works?

A: The vast majority of DC questions considered to date have resulted in unanimous decisions. That’s because, in most cases, the application of the available facts to the relevant provisions in the credit derivatives definitions have been straightforward – it’s often as simple as confirming whether a company has paid what it owes on an outstanding bond, or whether it has filed for bankruptcy, with little or no room for ambiguity. A supermajority vote – 80% – is needed for a credit event to be determined, and this has only not been achieved twice over a period spanning nearly six years and well over 1,000 submitted questions.

Q: Why is the process being criticized then?

A: The firms that decide whether a credit event has occurred are the most active participants in the credit derivatives market. Some commentators have argued this results in conflicts of interest.

Q: How does the DC process mitigate these potential conflicts of interest?

A: The DC comprises 15 voting members: 10 from the sell side and five from the buy side (ISDA acts as a non-voting secretary), and a supermajority decision (80%, or 12 of the 15) is needed for a credit event to be determined. That ensures a single firm cannot influence the decision. In addition, the identity of DC member firms is publicly available, as are their individual votes. This transparency is an important point: anyone can see how any single DC member has voted.

Q: Is the credit derivatives market regulated?

A: The credit derivatives market, alongside other derivatives assets classes, is closely regulated following the introduction of the Dodd-Frank Act and other similar legislation elsewhere. Regulators have full transparency on the trades and positions held by all market participants as a result of rules requiring all over-the-counter transactions to be reported to trade repositories.

The standardisation of credit default swap (CDS) contracts and the development of a transparent process to determine whether or not credit events have occurred have also helped facilitate the move to central clearing – another key part of the post-crisis regulatory reforms. According to US swap data repository data, 74.4% of index CDS notional volume was cleared each day on average in 2014, while 62.2% was traded on a regulated swap execution facility.

Until the publication of any determination, DC members are subject to applicable securities laws restricting their ability to trade on material non-public information. Like all market participants, DC members are subject to any relevant anti-manipulation laws. In the US, for example, the Commodity Futures Trading Commission and the Securities and Exchange Commission have the authority to prosecute using their fraud and manipulation statutes.

Q: But don’t the dealers typically get their way?

A: It’s not a matter of buy side versus sell side. There have been some suggestions in the media that dealers are typically sellers of protection, and so they would usually be able to use their greater number on the committees to influence the vote in their favour. That suggestion is based on a faulty assumption: that dealers are always sellers of protection and the buy side is always a buyer, which isn’t the case. Banks have large loan books, which are often hedged through the credit derivatives market via their credit portfolio management desks. Conversely, buy-side firms are as likely to sell protection as they are to buy.

The supermajority requirement also means that even if all 10 dealers vote in favour of a credit event, at least two buy-side members must also vote in favour for that decision to be passed.

The facts also dispute the assumption. As already highlighted, the vast majority of DC questions considered to date have resulted in unanimous decisions. In the two instances where a supermajority vote has not been achieved, the two sides – those that had determined a credit event had occurred and those that thought it hadn’t – contained buy- and sell-side firms.

Q: What happens when the DC isn’t able to reach a decision?

A: If a supermajority is not achieved, then the question is passed to an external review panel comprising a minimum of three and up to five independent experts for consideration (the fourth and fifth members, if any, are essentially back-ups). Until recently, the external review panel had been convened once, back in 2009. The external panel nominations received at that time can be viewed here, the votes by DC members on whether to accept them is here (it was a unanimous decision), and the ultimate decision by the external panel, taken a month later, is available here. In this case, the external panel made a decision contrary to that taken by the majority of DC members during the original vote – the result of which is here.

The DC recently convened a new external review panel to decide a question related to Caesars Entertainment Operating Company. The vote on the composition of the panel can be found here. At time of writing, a decision had not been made.

If – and only if – new information comes to light, then the DC can decide by a majority to take back the question for consideration, but a supermajority vote is still required for a credit event to be determined.

The ISDA Credit Derivatives Determinations Committees were established following extensive consultation with market participants and regulators. The DC process was part of a series of measures to make the credit derivatives market more transparent and standardised – measures that ultimately helped facilitate central clearing and electronic trading in the credit derivatives market. ISDA remains committed to ensuring the process remains robust, and will continue to review policies and procedures and will make updates as necessary.

Storm Warnings

As the eastern US hunkers down in the face of a potential historic snowfall, a storm of a different sort hit the derivatives markets yesterday, courtesy of The Wall Street Journal.

The article claims there has been little change in the “murky” credit derivatives market since the financial crisis, and contains an unchallenged quote from one source that the market is “self-regulated” with “little adult supervision”.

Dodd-Frank, anyone?

Among other things, the law requires all over-the-counter derivatives to be reported to trade repositories. That means regulators can see who owns what. A high proportion of the credit derivatives market is now cleared through central counterparties and the more standardised instruments are subject to electronic trading requirements, which include pre- and post-trade transparency obligations. The reality is that the credit derivatives market is subject to more regulation than ever.

Over the years, ISDA has contributed to the development of standardised credit default swaps (CDS) contracts and a transparent process to determine whether or not credit events have occurred. This standardisation has helped facilitate greater levels of central clearing, and enabled firms to better manage risk.

Here are a few other facts that have been buried in the WSJ article.

1) In 2014, ISDA updated its Credit Derivatives Definitions. (The previous set of Definitions had been published in 2003.) The Definitions define the terms used in the documentation of credit default swap (CDS) transactions.

2) The 2014 Definitions introduced a variety of changes to the legal language governing credit derivatives trades – for instance, they established terms for new developments like bank bail-in or the possibility of a euro exit and made several upgrades to the 2003 Definitions. They did not, however, change the fundamental rules defining whether a company’s failure to pay what it owes, or a filing for bankruptcy protection, would trigger the settlement of CDS contracts.

3) To help market participants navigate the change, ISDA established a Credit Derivatives Definitions Protocol. Firms that adhered to the Protocol agreed to use the new Definitions for all eligible outstanding contracts with other adhering parties. Adherence was strictly voluntary, and adhering parties also had the right to revoke their adherence at any time up to the very end of the adherence process.

It’s fair to say most market participants would want as many of their counterparties as possible using the same standards. If not, the differences in the legal language would mean 2014 contracts would have to be managed separately to contracts referencing the same entity under the 2003 Definitions.

4) As part of the process to develop the Protocol, ISDA recognised that not all outstanding trades could be switched automatically to the 2014 Definitions via the Protocol. That included those that were considered to be too complex or where there was a near-term possibility of a credit event. As part of the Protocol, ISDA published a list of excluded reference entities after a consultation process with its membership and publication of the draft Protocol.

Two entities in the Caesars Group were added to the excluded list late in the process, but the additions were widely publicised, and those market participants that had already adhered to the Protocol had the option to revoke adherence if they didn’t agree with the change.

On top of the Caesars entities, the ISDA Credit Steering Committee – a group comprising buy- and sell-side representatives – agreed to exclude 194 other entities in total from the Protocol.

5) Exclusion from the Protocol doesn’t mean these reference entities could not trade under the 2014 Definitions. It just means contracts referenced to those reference entities wouldn’t automatically switch to the new Definitions as part of the Protocol. Individual sets of counterparties could choose bilaterally whether to move them to the 2014 Definitions or keep them trading under the 2003 language. Either way, as noted above, it wouldn’t affect whether those contracts trigger in the event of a default of the reference entity.

The process to bring standardisation and transparency to the credit markets is important. ISDA is committed to a transparent and fair process that is beyond reproach. Toward that end, ISDA will continue to review and update as necessary the policies and procedures to drive the highest standards of conduct.

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!

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….

More or Less?

Is the OTC derivatives market growing…or shrinking?  A recent Bloomberg BusinessWeek piece helps provide an answer.

The article reports on ISDA’s OTC Derivatives Market Analysis, Year-End 2012, which pulls together data from a variety of sources to show the impact of some key trends, like clearing, portfolio compression and netting, on the underlying market.

Over the past five years, OTC derivatives notional amount outstanding (excluding FX transactions) is up 6.7% from year-end 2007 to year-end 2012, according to the BIS.  If you eliminate the double-counting of cleared transactions (which occurs because one bilateral contract becomes two cleared contracts), it’s down 17.5%.

BUT:  if you then add back in the $214.3 trillion of notional that has been eliminated via portfolio compression over the past five years, the OTC derivatives market has increased 23%.

Shorter-term, the picture is a little different.  The total OTC derivatives market (excluding FX) declined 3.3% from year-end 2011 to year-end 2012.  After eliminating the double-counting of cleared transactions, the decrease was 10.9%.  If you take this number and add back in the impact of portfolio compression, the market was roughly flat year-over-year.

Another interesting stat from the Market Analysis has to do with the level of risk exposures in the OTC derivatives market.  At year-end 2012, gross market values (a more appropriate measure of risk than notionals outstanding) were 3.9% of notionals.

Netting significantly reduces those exposures; gross credit exposures after netting were 0.6% of notionals.  Factor in the widespread collateralization of OTC derivatives and the uncollateralized exposure after netting is about 0.2% of the notional outstanding.

We know that going through all of these numbers is a bit of a tough slog.  But it’s important to realize that sometimes there’s more to the story than what appears on the surface.

So the real answer is: more and less.