07 Jun 2011

Where to now for OTC derivatives - lessons from ISDA's AGM

by Louise McCoach, Graeme Dennis, Romany Sloan

ISDA's 26th AGM examined the impact of Dodd-Frank on the OTC derivatives market.

Some of the most important challenges for the OTC derivatives industry were discussed at ISDA's 26th Annual General Meeting (AGM) in Prague this April, including industry concern over the future shape of regulation of the OTC derivatives market.

What will Dodd-Frank mean for OTC derivatives?

The global financial crisis has led to an upsurge of regulatory activity worldwide, but the implications for the OTC derivatives markets are still being worked out, as the panel discussion at ISDA highlighted.

Major issues for the OTC derivatives market in the near future will be the application of the US's major financial reform, the Dodd-Frank Wall Street Reform and Consumer Protection Act, and the regulatory climate in the US and the EU generally, in particular:

  • extra-territoriality – it is still largely uncertain whether the Dodd-Frank Act is enforceable in jurisdictions (other than the US) and how offshore regulation will be affected;
  • the proposed Volcker Rule – although aimed at prohibiting proprietary trading by US banks, there are concerns that legitimate market-making could be caught by the prohibition unless there are clearer guidelines to distinguish proprietary trading from genuine market-making trades that financial firms routinely engage in; and
  • lack of harmonisation – fundamental differences between US and EU regulation of clearing houses could adversely impact derivatives market participants that operate across a number of different jurisdictions. In particular, inconsistent requirements between different supervisors will increase costs for market participants and make it more difficult to develop a robust international standard in the long term.

Transparency in swap execution facilities – always a good idea?

In order to promote pre-trade and post-trade transparency in the swaps markets, the Dodd-Frank Act requires that all cleared swaps trade on either a contract market (ie. an exchange) or a "swap execution facility" (or SEF). The mandating of increased transparency has raised a number of issues which are yet to be resolved.

Pre-trade transparency requires parties to post trades as soon as possible within a prescribed period. The period currently prescribed by the Dodd-Frank Act is 15 minutes, on the basis that this should allow sufficient time for a party to match a trade before it is posted on an SEF. The concern with this approach is that 15 minutes may not be long enough, in most instances, for the matching process.

Also, post-trade transparency can be harmful for OTC products that are traded in lower volumes, particularly structured OTC trades, because there are fewer parties trading. This makes it easier to work out the identity of the parties who are trading, which may raise confidentiality concerns for the parties involved in the trades.

Central clearing facilities and the increased risk exposure

The use of central clearing facilities as a means of clearing OTC trades was a topic of much discussion at the ISDA AGM, with particular focus on the following key issues:

  • moving some (but not all) trades with a counterparty to a central clearing facility may change a party's exposure. For example, if party X is required to transfer half of its OTC derivatives portfolio that it has with counterparty Y to a central clearing facility, its exposure to counterparty Y will change as it will no longer be able to net across its entire portfolio with counterparty Y;
  • a party's exposure may also be negatively affected to the extent that it has entered into matching trades to hedge its positions in the market and those positions are subsequently required to be transferred (on an unmatched basis) to a central clearing facility;
  • where there are multiple clearing houses, it is likely that clearing houses will offer low margins as a competitive strategy, so clearing houses may have less margin and therefore offer less protection to participants;
  • clearing house participants need to be sound and transparent and more resources will need to be spent to ensure they participate in risk management; and
  • there is a growing need for standardisation of central clearing facilities – close international cooperation between various supervisory bodies is required with key standards being set and interpreted at the international, rather than the national, level.

Capital treatment for bilateral counterparty credit risk

The new capital rules under Basel III for credit valuation adjustments (or CVA risk), which were announced in December 2010, were subjected to scrutiny during the AGM session "Basel III: Implications and Incentives".

CVA risk is essentially the risk of loss caused by changes in the credit spread of a counterparty caused by changes in its credit quality (ie. the market value of counterparty credit risk).

At the time of ISDA's AGM, the final level and reasonableness of the standardised CVA risk capital charge was still to be determined by a final impact assessment.

That assessment has now been completed. On 1 June the Basel Committee announced that, as a result, the rules for the CVA charge would be modified slightly because the standardised method could be unduly punitive for low-rated counterparties with long maturity transactions. The weight applied to CCC-rated counterparties has been reduced from 18% to 10%, which narrows the gap between the capital required for CCC-rated counterparties under the standardised and the advanced methods.

According to the Committee, "with the addition of the CVA risk capital charge, the capital requirements for counterparty credit risk under Basel III will double the level required under Basel II (ie. when counterparty credit risk was capitalised for default risk only)".

This isn't the last development affecting the capital requirements for counterparty credit risk; the Committee is still reviewing capitalisation of bank exposures to central counterparties, with finalisation of its December 2010 proposals expected by the end of 2011.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.