26 Apr 2012, Nick Sawyer, Risk magazine
Moderator: Nick Sawyer Editor-in-chief, Risk
Stephen O'Connor Chairman of Isda and global head of OTC client clearing at Morgan Stanley
Michele Faissola Vice-chairman of Isda and global head of rates and commodities at Deutsche Bank
Eric Litvack Isda board member and chief operating officer of global equity flow at Société Générale and Investment Banking
Guillaume Amblard Isda board member and global head of fixed income trading at BNP Paribas
Risk: There is a lot for the International Swaps and Derivatives Association to think about over 2012 and beyond. Can you summarise some of the key priorities?
Stephen O'Connor: Isda’s mission is to promote safe and efficient markets and, to that end, there is a continual focus on matters that will improve efficiency and liquidity. While we are always focused on those kinds of improvements, 2012 is particularly important with the Group of 20 (G-20) deadlines looming, so we are very focused on working towards that, with a specific focus on systemic risk reduction through clearing, and regulatory transparency through the data repositories.
Risk: Will the end-2012 G-20 deadline be met?
Michele Faissola: There are a lot of different issues that need to be dealt with, and the amount of work that banks and clients need to do across the industry is quite extraordinary and unprecedented. I think the deadlines are very ambitious – in some cases, there will be some postponement. There has already been a postponement in the application of some of the Dodd-Frank rules. If you look at Basel III, the Markets in Financial Instruments Directive, the European Market Infrastructure Regulation (Emir), the Dodd-Frank Act and the Volcker rule, there is a bottleneck developing. Our firms and our clients have limited resources that we can throw at this, so I suspect there will be some phasing – but that doesn’t mean the industry isn’t fully committed to achieving what the G-20 has stated in principle.
Eric Litvack: Clearly, not every aspect of the legislative framework will be in place by the end of the year – it is very ambitious and we have seen how various deadlines have slipped for the delivery of rule-makings. In Europe, negotiations between the Council of the European Union and the European Parliament on Emir have taken longer than anticipated, which is putting significant pressure on the European Securities and Markets Authority (Esma) to formulate the technical standards within the time frame it has. So, it is unlikely we will have everything in place by the end of 2012. That being said, we will have a very significant amount of clearing between dealer firms and the framework for reporting to regulators. So, regardless of whether the legislative framework is finished, the key planks of the G-20 deliverables will be in place by the end of the year.
Risk: The Dodd-Frank Act in the US was finalised in July 2010, but the final version of Emir was only agreed in February – and there are still a lot of technical guidelines that need to be drawn up by Esma. Will Europe end up implementing at a much later date than the US?
Guillaume Amblard: The US is a bit ahead of Europe in terms of the legal framework, but I would expect convergence between the US and Europe in terms of implementation, probably by the end of the second quarter of 2013, at least for the first category of counterparts – in other words, interbank counterparts.
Michele Faissola: The legal and legislative frameworks of Europe and the US are profoundly different. The legislation in the US tends to be principles-based, and the regulators have a significant amount of flexibility in how to implement it. In Europe, it is much more prescriptive, so the work done at the legislative level is much deeper and, to a certain extent, more technical. It is very important when you develop new legislation in Europe to get it right, because otherwise it will take three or four years to change if there are unintended consequences. In the US, the regulators have the ability to dynamically adjust the rules if something is incorrect or not anticipated.
Risk: Originally, Esma was charged with coming up with the technical standards at the end of June, but the deadline was delayed until September. What is a realistic time frame for implementation in Europe now?
Eric Litvack: The deadline for Esma has been pushed back to September – that is still pretty ambitious, because it needs to define how clearing houses will be authorised, the operational standards they will have, the process for making a given product obligatory to clear and how the corporate exemption will be defined. They are all technical issues that are rich with consequences. My sense is Esma will try to stick to the timetable, and it has been very aggressive about the timelines. In fact, it launched its first discussion paper before the actual Emir text was published, so it is really trying to move as quickly as possible in order to meet the deadlines. They are still ambitious, though, because a lot of the things that need to be put in place are completely new.
Stephen O'Connor: It is worth pointing out that the regulators have an enormous challenge. Esma is a new agency, and it has an overwhelming task because it has to staff-up at the same time as beginning to write rules. It is a similar situation with the Commodity Futures Trading Commission and the Securities and Exchange Commission. They are not new agencies, but they are writing rules for products they haven’t regulated before. There is an enormous body of work that needs to be done, and we have been working with them, but it is going to be a hard slog.
Risk: So are you advocating that regulators should ignore the deadlines if necessary to ensure the regulations are right?
Stephen O'Connor: Regulators should be given more time where appropriate, and Isda is on record saying exactly that.
Eric Litvack: You might say ‘financial institutions would say that, wouldn’t they?’ But, at the end of the day, it is more important to get this right than to get it out on time, because there is nothing magical about December 31, 2012. This is going to shape the way the industry works for the foreseeable future – it is important we get this right.
Risk: Isn’t that a difficult position to put to the public and regulators?
Michele Faissola: We need to work on education because many of these issues are extremely technical and complex. We don’t fully understand the aggregate impact of all these initiatives – the impact to the real economy is unknown because these changes are unprecedented. We need to get this right, otherwise we are going to have a serious problem in an economic cycle that is already relatively weak. This is not just about the industry – this is about the entire credit intermediation process. This industry provides the majority of the credit to the real economy, and there will be a significant impact if we get it wrong. But it is very important to highlight that Isda and its members are absolutely committed to ensuring we have a more solid and transparent market. I believe the majority of these initiatives are in the right place. The challenge is getting the correct balance between having a safer environment and retaining the liquidity that is necessary for the market to work.
Risk: A number of regulators have published rules on central clearing – the Dodd-Frank Act was passed into law in July 2010, the final version of Emir has been published, and regulators in Canada, Hong Kong, Singapore and Australia, among others, are consulting on the issue. There appear to be several areas of difference in those rules – in particular, some regulators have proposed a location requirement for local currency derivatives. What implications does this have?
Stephen O'Connor: There is academic research out there that essentially says one clearing house per asset class is the most efficient and systemic risk-reducing model – that should be the aim. If you get to the situation where each country has its own clearing house for products in its own currency, then that introduces massive inefficiencies, both from a risk perspective and from a capital and liquidity consumption perspective. It will also have a knock-on effect on liquidity in those markets, so it becomes much more expensive to trade. As an association, we would prefer to have one clearing house per asset class. However, we are respectful of local regulatory needs and wishes, so I think we’ll have to strike a balance.
Guillaume Amblard: Today, LCH.Clearnet clears 17 different currencies. The systemic risk and the liquidity drain on the industry would increase quite a lot if there were 17 different central counterparties (CCPs). If you have a proliferation of CCPs, you start creating a very fragmented, dislocated market. If you cannot net risk from one CCP to another, it will result in a greater liquidity drain, greater risk concentration and less transparent markets. People sometimes mix up the notion of CCPs and trade repositories. At the end of the day, it is not so important – except maybe for national pride – to have a CCP in your country. What is crucial is for regulators to have access to the risk, so it is important for every regulator around the globe to have access to a trade repository. In that sense, the consultation paper by the Monetary Authority of Singapore is quite welcome, because it recognises the risk of fragmentation and shows openness to the idea of a global CCP, as long as the regulator has access to a trade repository. That is why the process of education is so crucial.
Stephen O'Connor: I would agree 100%. The data repositories should be seen as a giant spreadsheet that regulators can access and sort by any row and any column to see exactly who is doing what in their currency. That is an enormously powerful tool, which doesn’t necessarily have to accompany a clearing house. The other thing is that the global clearing-house model at LCH.Clearnet has been tried and tested during the Lehman default. If that book was spread around 17 different clearing houses in different countries, with longs and shorts in different places, it would have been chaotic from a close-out perspective.
Risk: Nonetheless, it does seem as though regulators are moving towards a scenario where there are domestic CCPs. Assuming that is the model, how can this be dealt with? Is interoperability the answer?
Eric Litvack: The short answer is: not exactly. In theory, interoperability gets you there, but it has never really been done – not with derivatives. It would be very complex to have a framework in which the different CCPs interact and offset risk between each other. The problem is, you run the risk of creating a tremendous amount of complexity, where the whole system effectively becomes subject to its weakest link. So I would be reticent to put too much faith in interoperability, which is unproven at this stage. That is reflected in the text of Emir, which has pushed all consideration of interoperability for derivatives into the future, because it is just too complicated at this stage.
Michele Faissola: All of these proposed clearing houses at a national level are start-ups, so you need to start thinking about different legal systems, different regulatory systems and different operational systems. The complexity you might end up with is such that the original G-20 desire to reduce risk is actually going the opposite way – definitely from an operational perspective. These are very large, very complex new companies starting from scratch. I think we need to be careful and very sensible.
As an industry body, we clearly welcome some sort of competition. At the same time, there has to be a discussion about how we regulate the systemically important CCPs and we need to ensure there is consistency in risk management.
Guillaume Amblard: It is quite important to harmonise all the different risk and control procedures across CCPs. Fundamentally, these are systemic entities, and each one needs to be controlled in a very industrial fashion. One thing to realise is that interoperability is not an easy process. It took five years for the cash equities market to establish interoperability, so it doesn’t happen overnight. Interoperability will probably also create an extra liquidity drain, because CCPs will have to charge extra protection to take the risk of other CCPs.
Stephen O'Connor: I see this fragmentation as a backward step for systemic risk reduction. If you think about the drivers for clearing in the first instance, the market was a web of dealers each dealing with its own clients – it was a tangled plate of spaghetti. One clearing house takes that mess and puts it into a hub-and-spokes system, so each market participant does not contaminate other market participants if it defaults. Moving to a system where you have multiple, fragmented CCPs with interoperability goes back towards the tangled web approach.
Interoperability also gets very complicated when you start to consider CCP resolution, because clearing houses will potentially be the biggest counterparties of other clearing houses. They will probably be in different jurisdictions, so resolution becomes very challenging.
Risk: There are a lot of models up for discussion, and the European Central Bank, for instance, has suggested that clearing houses should be domiciled in the country of the currency in which they clear. That seems to suggest the end of multiple-currency clearers such as LCH.Clearnet, which clears 17 currencies. What is the industry response?
Stephen O'Connor: I think this is a tricky question. CCP resolution is a hot topic right now, and there is a natural hesitancy on the part of central banks over whether they should be lenders of last resort to clearing houses. I think efforts should be made to avoid that – essentially, the members of the clearing house need to work with clearing houses to come up with an end-game that doesn’t call for central bank liquidity. At that point, you are not tied to the jurisdiction of a clearing house.
Michele Faissola: It is a controversial point right now. The UK has taken this issue to the European court, and we shall see how this develops. In my mind, if we think the CCP is the most systemic entity, then there has to be some connectivity to a lender of last resort. The jurisdiction angle might create a further complexity but if the CCP is well designed and well capitalised and the clearing members have high minimum requirements, then you have a system that can work. One of the issues that needs to be addressed is how CCPs are regulated and the identity of the clearing members, because that is the first line of defence.
Guillaume Amblard: I think we all agree we should limit the number of CCPs. I would agree we need to ensure all the clearing members have enough capital and that the CCPs are very solid on a stand-alone basis and have very solid risk management procedures. At the end of the day, it is important for the market to think CCPs are safe. As a last resort, central banks should be there in the background, but we need to make sure we don’t have to rely on them. Central banks and regulators need to communicate with each other globally and we need to make sure that internal politics doesn’t create systemic risk.
Stephen O'Connor: I would add that, in a world where there is an international clearing house that dominates a certain asset class, the central bank for that country doesn’t necessarily need to be the one to step in if the robust processes and capitalisation fail for some reason. Some international solution is probably more appropriate in that case.
Risk: To broaden the discussion, there has been a lot written about the extraterritorial reach of some of the rules – in particular, the Dodd-Frank Act. There have been attempts by regulators to co-operate, but is enough being done to eliminate some of the extraterritorial impact?
Eric Litvack: As yet, clearly not, because it hasn’t been resolved. It is a thorny issue and there is a lot to be done in a very short period of time. One of the things that is not explicitly on the menu but is implicit in most subjects is the issue of extraterritorial reach. Most of the regulators are busy drawing up final rules and technical standards, and they are primarily looking at their domestic markets, which is natural enough. Those that are more used to the issue of dealing with multilateral memorandums of understanding are perhaps incorporating that more into their language, but none of them have yet satisfactorily resolved the issue.
Every time we go in to discuss this issue with regulators, the answer we get is ‘oh yes, no problem, we are speaking to our peers’. They are speaking to their peers, and they have been speaking to their peers for the better part of two years now – but we’re still not there, and there is a lot that needs to be done before we cross the finish line. Just to implement Dodd-Frank for an individual dealer, you need to register your firm as a dealing house, which is not necessarily a concept that exists in the equivalent form in Europe. If you are a European bank and you register as a swap dealer in the US, you are taking on a number of disclosure requirements that may be illegal in your home country.
There needs to be more recognition of home country supervision and a more defined framework for co-operation between regulators – particularly on a transatlantic basis. Until that is sorted out, we won’t be able to have a functioning cross-border G-20-compliant framework, because Dodd-Frank won’t work for non-Americans and Emir might not work for certain non-Europeans.
The Volcker rule is an example of where the devil is in the extraterritorial detail. One of the poster-child issues has been the exemption granted from the Volcker interdiction on proprietary trading for government and municipal debt. One might ask what sort of activity has been touched by grace, so it is okay to speculate with depositor money. The answer that US regulators have come up with is US debt because ‘we need to protect our home territory’. I’d say that is a somewhat cynical answer and, clearly, it could pose problems for other jurisdictions – it prevents US banks from acting as dealers in similar assets of foreign governments, and it potentially creates restrictions on foreign dealers that want to register in the US, as they would then take on a significant burden of US compliance when they are dealing with their home country or non-US assets. So it is a real crossed web that needs to be simplified for it to work properly.
Risk: As you say, the Volcker rule is one example of extraterritoriality, but another might be the margin requirements on uncleared swaps, which were proposed by US prudential regulators in April last year. Regulators are looking at this issue on a global basis but, as it stands, it is a US rule that may have extraterritorial reach. What issues does this raise?
Michele Faissola: This is a critical issue that needs to be resolved. It will potentially have a huge impact on liquidity, particularly if you think about the impact on second-tier firms, which might have a modest business in the US and really need to decide if it is worthwhile to continue to have that business. That touches on other aspects, such as capital charges for non-collateralised transactions. We have clearly been asked to put an excessive amount of capital against that. If I look at the crisis, the bilateral credit support annex has worked pretty well, and we have not seen any significant problem. But we are moving towards a model where the cost of transacting is reaching a level where the clients might simply decide not to hedge, and that is not desirable.
The biggest impact is on liquidity, and it comes from all different angles. The Volcker rule, capital requirements, compliance, reporting obligations and transparency are all going in one direction, and that is to make the cost of transacting much higher than before. I’m not convinced the end-user will ultimately pay for it. You will probably end up with some form of consolidation across the industry, because you are essentially raising the bar. The membership cost is becoming much higher, and only the firms with very large businesses can justify that kind of entry-point fee. Second, you will see lots of clients using other instruments. We are already seeing that to some extent – some clients are moving out of derivatives and into cash instruments.
Risk: Is anyone else seeing this trend of clients deciding not to hedge with derivatives because of additional costs?
Guillaume Amblard: Having to post collateral on a daily basis is a big operational issue, especially on the corporate side. Clearly, it will decrease the hedging activity. I don’t think we want to get to a system where our way of reducing systemic risk is giving an incentive for people not to hedge their risk. This liquidity drain is a huge issue, because it comes at a time when the public and politicians want a bank such as BNP Paribas to lend more to the real economy. Clearly, the greater the liquidity constraints, the less banks will be able to lend to the real economy.
One thing to keep in mind is that the goal of these regulations is reducing systemic risk. Will having small and medium-sized enterprises post initial margin really reduce systemic risk? I think it would fundamentally worsen their risk management, because it could force them to sit on risk rather than hedge it or take mismatch risk.
Risk: Touching on the Greek issue, some commentators have questioned the performance of the sovereign credit default swap (CDS) market during the Greek debt restructuring and have suggested the instrument didn’t work as many people had expected it to work. How effective has the CDS market been?
Eric Litvack: Whether the CDS market functioned as people expected it to – I’m not sure that’s really the issue. The CDS market performed precisely as it was designed to. If there were expectations that it should do something different from what the contract said, then there was an issue with people not actually understanding what the product was and what sort of risk cover they were buying. The CDS contracts on Greece have functioned as they were designed to do. They did not trigger for certain events that were not credit events, and the determinations that came through on that were pretty much unanimous. When there was a forced restructuring, it then triggered the CDS contract. So in that respect, the CDS performed precisely as it was designed to do – no more, no less.
We’ll probably take away a number of lessons from the event and, having looked at this through the prism of how a sovereign restructuring occurred, there are probably some lessons as to how we want to change the rules slightly to make the market more efficient in the future.
Michele Faissola: It is important to stress the CDS market did exactly what was written on the tin. The problem is there has been a lack of understanding on the dynamics. I read press reports before the auction saying there will be a huge payment now the CDS contracts have been triggered, but people failed to understand that everything is almost fully collateralised, so the cash was already paid as the CDS was deteriorating. There wasn’t any big surprise for the seller of protection.
Risk: What lessons do you think the industry can learn from the Greek situation?
Stephen O'Connor: Through each credit event, there are observations along the way and the potential to improve things for next time. Once the dust has settled, people will look back and ask how it could have worked better. This is the first instance of a big sovereign restructuring, with various new instruments being part of the package. People will say ‘given those factors, 80% of which we had thought about but 20% maybe we hadn’t, then what have we learned?’ And the market will come together – buy side and sell side – and make certain changes, so that next time it is even better.
But I would agree that no market participant has really been surprised. External observers perhaps might be surprised that the aggregate positions were quite low. If you add up everybody’s net position across the whole market, it was only about $3 billion, and that was fully collateralised. So not much money changed hands on the settlement date.
Risk: Is it too early to identify the areas that will change?
Michele Faissola: One area where we have learned we need to do a better job is educating the general public. When you have a large event, the level of interest goes well beyond the industry specialists. In some respects, we need to do a better job in educating the general public in terms of how these things work. This is not like an insurance contract – it is slightly different, and we need to ensure people appreciate the differences. But I don’t believe there has been anybody who is a heavy user of the instrument that is disappointed at this point.
Risk: What are your key concerns at the moment?
Guillaume Amblard: My key concern is the unintended consequences of certain regulations. A lot of the regulations are aimed at reducing systemic risk, but if every sector of the financial industry has more constraints, it reduces the liquidity and the capital of the overall market. That has unintended consequences for liquidity, which results in increased volatility, increased illiquidity and increased costs of hedging for corporates, sovereigns and hedge funds. That is an important thing to keep in check.
Eric Litvack: What concerns me most is that we may be missing the forest for the trees. There is a lot of attention being given to the role of markets – the role of derivatives – and trying to reduce the amount in which banks can interact in the market. I think that is taking the wrong conclusions from the crisis. If you go back through the crisis and look at the institutions that got into trouble, most of them managed to do it without any market exposure. The Icelandic banks bought all sorts of industrial assets, but weren’t particularly active in the markets; the Irish banks were heavily into property developers, but weren’t particularly active in markets; a number of US banks got into trouble over origination rather than markets; a number of UK banks got into trouble with very traditional banking activities, not markets. When you look at all that, what you have got is thinly capitalised institutions financing long-term illiquid assets with relatively short-term unstable funding – that is the real issue, and it is being addressed by the Basel III reforms. That is what we should be concentrating on, rather than trying to decide what kind of market activity is good activity and what kind of market activity is bad activity. I don’t really think there is such a thing as good or bad market activity – there is just market activity.
Stephen O'Connor: It all comes down to the need to get these rules right across the globe. If we get them wrong, they can be very harmful. If there are measures that take liquidity from markets and cause draconian levels of capital or margin to be taken out of the system, then that is harmful to liquidity. When liquidity is harmed, it reduces investment returns and has consequences for the real economy as well. So there is a pendulum here. Isda is very supportive of measures to improve the safety and soundness of markets but if that pendulum swings too far and liquidity is affected, it reduces investment returns for asset managers and it is more expensive for corporations to trade. Some of them might not hedge, which could be catastrophic.
To the extent banks are required to either withhold liquidity reserves through initial margin or capital reserves, it is a form of quantitative tightening, and there are estimates just in the US of more than $1 trillion that might be taken off bank balance sheets that could ordinarily be deployed into the economy. So, overall, the most important thing is to strike the right balance between safety and soundness on the one hand, but preserve liquidity and market access on the other.