Margin Settlement Blues

Our days at ISDA start pretty much the same as everywhere else: get into work, sip on a double macchiato, and get up to speed with the day’s events. Given the avalanche of emails and news alerts, the challenge is always deciding what to read and what to skip. But this opinion piece from Risk grabbed our attention – Regulators must scrap T+1 timezone tax.

The alliterative headline helped – we’re suckers for that kind of thing. But, more importantly, it chimed exactly with what we’ve been hearing ourselves, and have repeatedly drawn attention to. Over the past few months, derivatives users and regulators in the Asia region have become increasingly concerned – and increasingly vocal – about the timing of settlement for collateral posted under US and European margining requirements.

A quick word of explanation. As part of their forthcoming rules for the margining of non-cleared derivatives, US regulators have stipulated that initial and variation margin has to be settled on the day after execution of the trade, or T+1. Europe has taken a similar route in its proposed rules – although the final text now won’t be published until the end of the year following the announcement of a delay earlier this month.

So, why is this a big deal? In short, because timezone differences make it more or less impossible for derivatives users in Asia to meet the requirement when trading with counterparties further west. A margin call at 9am in New York, for instance, would be 9pm in Hong Kong, 10pm in Tokyo and 11pm in Sydney.

There is a way round this: the Asian counterparty could pre-fund margin to cover the time lag. But posting extra collateral comes at a cost – a “timezone tax” as Risk puts it. Asking Asian firms to pay more than other counterparties when trading with US banks, purely because of where they are located, seems deeply unfair to many Asian firms and even regulators.

Risk speculates on the ultimate outcome:

Asia-Pacific dealers have already voted with their feet with regard to the US Dodd-Frank regulation and opted to trade with European counterparties instead. If T+1 is imposed on cross-border trades, this trend will accelerate and expand to include Europe’s lenders.

Japan’s dealers don’t want to see a shift to Asian autarky, but the biggest losers in this scenario could well be Europe and the US.

This comes on top of cross-border challenges caused by the European delay. Global regulators have made real effort to ensure the margining framework in each jurisdiction is as closely harmonized as possible. After all that work to harmonize the national rules, it would surely be a failure if the end result is even more fragmentation.


Novo Banco: An Exceptional Story

Everybody loves a good credit derivatives story. And market participants and the media have had a very good one in recent weeks. It concerns CDS contracts written on Novo Banco, a Portuguese bank.

The Novo Banco story begins with Banco Espírito Santo (BES). The central bank of Portugal, in its capacity as a resolution authority, transferred various assets and liabilities from BES (which was in difficulty) to Novo Banco (a so-called good bank) in August 2014, under the Portuguese bank resolution regime. Sixteen months later, the central bank took the decision to re-transfer five senior bonds back from Novo Banco to BES, reportedly because the European Central Bank’s stress test had uncovered a capital shortfall at Novo Banco. To say this is unusual is an understatement.

Let’s now turn to the credit derivatives market. Credit derivatives contract terms set out the conditions for a credit event to occur, typically using the ISDA Credit Derivatives Definitions. Decisions about whether an event meets those conditions are made by the ISDA Credit Derivatives Determinations Committees (DCs). These committees, which each comprise 10 sell-side and five buy-side firms, make their determinations by gathering publicly available information and comparing it against the definitions to see if the relevant conditions are met (you can read more about the process here and here). A supermajority (12 out of 15 votes) is required to reach a determination. In the case of Novo Banco, the European DC was asked to resolve whether the transfer of bonds from Novo Banco back to BES constituted a governmental intervention credit event.

One of the cornerstones of the Credit Derivatives Definitions is that they are as precise as possible from a legal perspective to enhance predictability and objectivity. This protects both buyer and seller. But like any contract, unanticipated events occasionally emerge that aren’t neatly covered by the definitions. In the case of Novo Banco, the majority of DC members voted that the bond transfer did not constitute a credit event, but the majority fell one short of the supermajority threshold. As a result, the issue was (as per the DC rules) referred to an external panel of experts.

The panel unanimously agreed with the majority of the DC. The decision hinged on whether the transfer constituted a mandatory cancellation, conversion or exchange, or whether the transfer had an analogous effect to those defined events. Ultimately, they determined the transfer was neither a cancellation, conversion nor exchange, and was sufficiently different to those events to be not analogous to them. Taking a broader, catch-all interpretation of ‘analogous’ would mean this clause would “dominate the whole of the definition, which is inconsistent with the careful and detailed drafting”, the external panel decided.

So there it is. While most CDS credit event determinations in practice are clear cut, it’s clearly challenging (and perhaps impossible) to consider and explicitly address all possible future scenarios and contingencies that might occur in the credit markets. That’s why it is important to have a robust process (which includes industry definitions drafting committees, as well as the DCs and the external review panels) through which issues and uncertainties can be addressed and clarified. This enables market participants to gain the clarity they need and deserve, even in exceptional situations such as the one involving Novo Banco.

The Not-So-Secretive Circle

Thomas Jefferson once remarked: “When the press is free and every man able to read it, all is safe.” He knew how important an independent, critical press is to a free society.

He also knew the democratic process could be messy. “Error of opinion,” he said, “may be tolerated where reason is left free to combat it.”

It was in this spirit that we recently read and analyzed a Bloomberg News piece on ISDA’s Determinations Committee (DC) process. The more that people understand how the process works, the better. If the coverage leads to discussion of potential improvements (in addition to those that have been and are being made), then we welcome it. Transparency is essential to building trust in the DC process. That’s why the DC members, the DC rule book and every vote taken in every credit default swap (CDS) credit event is available to anyone on our website.

By the same token, though, when news coverage contains what we see as errors (either of opinion or of fact), then we need to exercise our right to point these out and correct them. Here are three worth noting.

The first is the article’s headline: Inside the Secretive Circle that Rules a $14 Trillion Market. We know headlines are meant to draw in readers. And we also know that Wall Street conspiracy theories are popular. But we’re not sure what the secret is here. The questions asked to the DC, the publicly available information used to make the determinations, and the CDS Definitions themselves are all available on ISDA’s website. A supermajority vote is needed for a credit event to be determined – that’s 12 out of the 15-strong panel of buy- and sell-side participants. The decision is made public. How each firm voted is also made public, which means these entities have to be sure they can justify their decisions internally and externally (and that includes to regulators). And where a supermajority decision is not achieved, the decision is referred to an external panel – the last of which was videoed and published on our website.

More importantly, though, the headline and the article make the credit event process seem arbitrary. They ignore the fact that the legal definition of what constitutes a credit event under an ISDA CDS contract is spelled out in ISDA’s CDS Definitions. The DC’s job is to look at publicly available information about a CDS reference entity, benchmark it against the Definitions and determine whether a credit event has occurred. The fact these decisions are taken by market participants with knowledge of the market and the sometimes-complex documentation used means these decisions can be taken quickly – important, as buyers of protection need to know whether their hedges will be effective. Uncertainty for months on end would dramatically reduce the effectiveness of this instrument as a hedge.

The second point relates to a quote offered by an “industry expert” that the article uses to advance its narrative: “You’ve got a self-regulatory organization that has handed authority over an entire market to those folks who have the greatest self-interest and have no prohibition for putting their interests ahead of the broader market.”

The third point relates to another quote in the story: “The problem is there’s no ability for an independent body to determine whether or not the process is fair.” This comes from the CEO of a “Washington-based non-profit watchdog group”.

The statements are so wrong in so many ways that it is difficult to figure out where to start in addressing them. But we will try: (1) ISDA is not an SRO; (2) no one handed anyone anything; (3) the CDS market is regulated; (4) in addition to regulatory oversight, market participants are also subject to fraud and anti-manipulation laws.

In other words, regulatory authorities are able to see the exposures and votes of the firms they supervise for each and every credit event.

Because the questions asked to the DC are published on the website, along with the publicly available information used to make the determinations, the CDS Definitions that set the legal definition of a credit event, and the votes of the DC members, anyone can do their own analysis and take issue with how a firm voted.

Now to be clear, we don’t think the DC process is perfect. While we do believe it’s robust and transparent, and that it has worked very well, we’re always thinking of ways to improve and strengthen it.

For example, the potential for a conflict of interest was recognized from the start. Rules were put in place to mitigate this issue (including the requirement for supermajority voting and transparency over how firms voted). But market sentiment has evolved since the DCs were created, and so additional measures are now being taken to further guard against conflicts. We think the ability to consider and make such changes underscores the strength of the DC process.

There’s more here that we could say, and we suggest that readers who want additional information click on the following links:

The Credit Derivatives Mailbag

Storm Warnings

The DC rules

Video of external review panel hearing

Summer Reading

We always like to pack a few good yarns to enjoy while on vacation in August…and this one is at the top of the list. It’s a tale of vanishing trades, shadow banking and international intrigue.

Kind of like The Da Vinci Code meets Wall Street.

Except…the trades in question did not vanish (the article admits as much, despite the scary lead) and nothing was done in the shadows.

The fact is, derivatives trades are required to be reported to trade repositories to ensure regulatory transparency, whether they are executed in the European Union or US. And a large proportion (approximately 75% of interest rate derivatives) is centrally cleared globally.

So why all the fuss?

The root of the issue lies in the need for greater cross-border harmonization of derivatives regulations – an issue that we’ve regularly flagged in research reports, magazine articles, speeches and testimonies.

The article claims US banks are shifting derivatives trades overseas in order to benefit from “weaker” regulation in Europe and elsewhere. It doesn’t mention that all trades with a counterparty classified as a US person have to comply with Dodd-Frank, irrespective of whether those trades reside at a US bank or an offshore affiliate.

The crux of the issue, then, is those trades conducted by US banks with non-US counterparties. These clients have to comply with their own country’s rules, and often prefer to trade with counterparties in their own jurisdiction to avoid the compliance burden of meeting multiple sets of regulations simultaneously (ie, their home rules and the regulations of their counterparty’s jurisdiction). Many banks have therefore organized their operations in order to serve those clients. As a result, some trades with non-US clients are being conducted through non-guaranteed, non-US affiliates. (The obligations of a non-guaranteed affiliate are not guaranteed by the parent company.)

It’s important to note that the trades in question are subject to the regulatory requirements of the location in which they and the affiliate are based. The affiliates are also subject to the regulatory and capital mandates of their host jurisdictions.

Critics, however, believe this is merely an attempt to avoid Dodd-Frank regulatory requirements and instead benefit from weaker regulation overseas.

Now, the article doesn’t actually give any specific examples of how the regulatory framework on one side of the Atlantic is ‘weaker’ or ‘stronger’ than the other. Both jurisdictions have implemented, or are in the process of implementing, the commitments made by the Group of 20 nations in 2009 to reform derivatives markets. Both have introduced regulatory trade reporting requirements. Both have committed to mandatory clearing of standardized derivatives. Both jurisdictions have passed bank recovery and resolution legislation to ensure troubled banks can be wound down in an orderly way without resorting to public funds. And stricter capital and margin rules have been developed at a global level and are intended to apply to all banks. Our recent report on progress in regulatory reform details the advances that have been made.

If there is a problem here, it’s the need to ensure regulatory frameworks are consistent across borders to support deep, liquid global markets. Global regulators have determined that their respective rules are equivalent in some areas, which would allow a counterparty to trade with an overseas entity and comply with equivalent overseas rules, without the need to also comply with its home regulations. However, equivalence/substituted compliance determinations have stalled in some cases because of technical, highly granular differences in the two sets of rules.

ISDA believes greater harmonization on the detail of the rules would help. But these equivalence decisions should be based on broad outcomes, rather than word-by-word comparisons of two sets of rules. Only then will the incentive for a fragmentation of liquidity pools be removed.

We know that story isn’t exactly a summer blockbuster. But non-fiction rarely is.

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.