Moderator: Duncan Wood, editor, Risk
Stephen O’Connor, chairman, Isda
Eric Litvack, vice-chairman, Isda, and head of regulatory strategy,Societe Generale Corporate & Investment Banking
Eraj Shirvani, board member, Isda, and managing director, head of fixed income for Europe, the Middle East and Africa, Credit Suisse
Risk: Of the various changes affecting derivatives end-users – direct, in the form of clearing, execution, reporting and collateralisation requirements; and indirect, in the form of bank capital, leverage and liquidity rules – which are most significant?
Stephen O’Connor: I think the direct changes, for now, are front and centre. Parties caught by the clearing mandate, for instance, have to find a clearing broker and get all of the infrastructure set up to deal with that. Another direct impact will be the margin rules when they come in; a lot of corporate treasurers and fund managers are focused on what the ramifications of that will be, so I think margin and clearing will be two important issues
Eric Litvack: Certainly the direct impacts are going to be more obvious but, to some extent, all of these are hopefully teething problems. In some ways I’m more concerned about the indirect effects; the fact that prudential reforms will have taken capacity permanently out of the market, and the fact the market is likely to be durably fragmented due to uncertainty as to how rules work together across borders.
Eraj Shirvani: I’d agree with that. The over-the-counter derivatives market has been subject to such comprehensive regulation – touching on capital, margining, clearing, transparency – so I do worry about how the cumulative impact will affect the market’s accessibility to end-users.
Risk: Focusing on a few of these strands individually, clearing has come up a couple of times and the US is ahead of the curve here, with all three of its phased mandates taking place last year. How have end-users adjusted?
Stephen O’Connor: It’s good that the Commodity Futures Trading Commission (CFTC) took that phased approach – phasing by types of entity, phasing by product, and also there were quite long lead times, so clearing has been coming for a while. In the interbank markets, there had been a voluntary move in this direction already. Put all of that together and the net result, I think, is that people were generally surprised how smoothly it went.
For those that were left out, it really was their own fault – a few people were left out because they were too late to choose a clearing member or clearing house, and by law you had to have those things – but, overall, it went very well.
Risk: We’re not sure yet, whether Europe’s clearing requirements will be phased. The European reporting requirement wasn’t – it used a ‘big bang approach’ that turned out to be a kind of big splatter – it was not pretty. Do you think lessons will be learned from that?
Eric Litvack: In Europe, we’re talking about the first clearing mandates probably cutting in at the end of this year after the European Securities and Markets Authority (Esma) has re-authorised the major clearing houses. We know Esma is looking at the possibility of phasing, but whether it can phase by product or types of users is a question it is working on. But certainly the experience in the US has been helpful.
Risk: Moving to the execution rules, again, the US is ahead of the curve here but we have a much shorter track record. The execution requirement came into force for certain products on February 12. How are things going so far?
Eric Litvack: Clearly, the first days have been difficult – which is normal. But there is still confusion about when a product is subject to the US mandate. If it’s traded by a European end-user, with a US bank based in Europe, on a European platform that allows Americans in – those kind of combinations are giving rise to all sorts of confusion around what the scope of application is.
Ultimately, I think we all buy into the notion that this is going to create greater, broadly available transparency. But what’s also interesting is that we ran a survey among our end-user members in which we asked for their views on various reforms, including the execution mandate, and the overwhelming response was that they expected greater transparency but, on the other hand, also thought there would be a negative impact on price and liquidity. So it’s still very much a work in progress and the jury is still out.
Eraj Shirvani: We were expecting the world to just come to a halt but, while we held our breath, swap execution facilities (Sefs) generally worked. But our sense, unfortunately, is that while Sefs were built for our clients and for end-users, there is some indication there is a group of end-users that is trying as hard as possible to avoid using them, which is a little worrying. The reality is, if you’re a non-US customer, you have to think long and hard as to the cost benefit of connecting to a US platform.
Stephen O’Connor: That’s a great point. As Eraj points out, those that have a choice – so, European-based end-users – are choosing to trade in Europe under European rules and avoid the very tools that are designed to help them. So we’ll have to wait and see. We welcome the advent of Sefs but, from an end-user’s perspective, you have to ask whether it makes sense to force people to use a platform they don’t want to use. And, to Eric’s point, the initial findings from our survey were that the pricing and liquidity benefits are just not there for now, but that might change over time.
Eraj Shirvani: What we do know is that there is a cost to connecting to a Sef, so for many of the smaller customers – or bigger customers that don’t do so much US business – it’s getting pretty onerous. If you’re not going to get better liquidity and better pricing, then there’s a question there.
Eric Litvack: The cost is higher and, of course, there are a lot of Sefs out there and you don’t know which ones are going to succeed. If you’re able to stand on the sidelines over here in Europe or Asia and see which way the skittles fall, then that’s not necessarily a bad approach. So, this issue of whether this is a good thing for the market – I suggest we save that question for the roundtable that accompanies the 32nd Isda annual general meeting in 2017.
Risk: The fragmentation you mentioned earlier, Eric – and this determination to avoid trading with US persons – is, of course, a consequence of the way the CFTC’s cross-border guidance has been written. But that is now being challenged in court by Isda and two other associations. There is also a change of leadership in the offing at the agency, with Timothy Massad poised to take the chairman’s role. What are your hopes for a rollback of the agency’s extraterritorial approach?
Stephen O’Connor: I don’t think we should comment on the lawsuit – that wouldn’t be appropriate – but you’re right, certain CFTC rules have caused fragmentation of markets, which is harmful to liquidity and to capital flows, and has caused a lot of frustration for market participants.
Isda’s view has always been that we wanted all regulators to move to the same rulebook on the same day. The real world is nothing like that. My sense is that that there seems to be some warming of relations across the Atlantic. We welcome that and all of us are looking forward to working with regulators to try and achieve as much harmonisation as possible.
Risk: Have you met chairman nominee Massad? What expectations do you have of his approach?
Stephen O’Connor: I have not met him, but I have met acting-chairman Mark Wetjen, who is very reasonable and straightforward. My understanding is Mr Massad is similarly disposed, so that’s encouraging.
Risk: Still on the topic of Sefs, will agency trading take off in the OTC market – allowing derivatives users to execute on Sef, but without connecting directly? And do you have any concerns that it could be used as a screen to allow in high-frequency traders and other proprietary trading firms?
Eric Litvack: There’s naturally a cost to setting up the infrastructure, so there will be a threshold below which it doesn’t make sense for individual participants to connect. It seems fairly logical that there will be a business case for providing access to parts or all of the market for certain customers.
But I’ve always been a bit sceptical of the incipient nature of high-frequency trading arriving in OTC derivatives. You have plenty of low-latency trading on listed derivatives because the order books and the trade volumes facilitate it. The nature of the OTC derivatives market has traditionally been a block market that trades in large size and infrequently. That’s not a high-speed trader’s market.
Now, that could change because, as you move an OTC market onto trading platforms, what happens over time is that trade sizes get smaller and you rely less on market-maker counterparties to provide block liquidity and immediacy, and potentially more on the native resident liquidity of genuine client order flow. If there is enough small-order flow, or if orders break down into smaller sizes, then you could get a new class of market-maker stepping in, which would be high-frequency-type traders. But that would take a very significant paradigm change in the market’s microstructure and I don’t see that happening anytime soon.
Risk: Eraj, you’ve spent a lot of time in credit markets – if it’s going to happen anywhere, people have suggested it is most likely in index credit default swaps. Do you agree? And do you have any concerns about competing with a broader range of liquidity providers, possibly including high-frequency traders?
Eraj Shirvani: One of the things we’re worried about is having different classes of market-maker that are approaching the OTC market in a slightly different way. What we’d like to see is some level of parity in terms of how the market is addressed – by which I mean we provide an enormous amount of pricing to the market, and pricing information, and other participants obviously have access to that but don’t have to reciprocate. It creates a two-tier system. As long as we all have the same rights and obligations in terms of the market, we’re very, very comfortable with having new entrants, including high-frequency traders.
Risk: What kinds of rights and obligations?
Eraj Shirvani: At some point we’re going to have all-to-all markets. Some participants are expecting dealers to still provide pricing constantly in that context, but in an all-to-all market, dealers suddenly just become one possible source of liquidity – so we need to keep some level of parity.
As things stand, there is a reasonably clear separation of roles, with dealers acting as market-makers and having some consequent obligations to create liquidity and offer pricing information, while others are price-takers. My question, as we move to an all-to-all market, is whether other liquidity providers will offer the same kind of pricing information to the markets?
Eric Litvack: I absolutely agree. There’s a trade-off between access and obligations. If you are a market-maker, then you have certain obligations, which are onerous, to provide liquidity on a constant basis, even when you don’t necessarily feel like it, even when you think you’re probably going to lose money because the market’s too volatile or because there’s too much uncertainty. The counterpart of that is that you get a certain amount of trade flow. There is a trade-off – you’re being paid to provide a service and, provided that all actors have the same access to the same information with the same accompanying obligations, then there’s a level playing field.
Risk: At this point, I’d like your thoughts on some of the findings of the Isda survey that Eric mentioned earlier. The respondents were exclusively end-users and it found broad approval for prudential reform – reducing leverage, improving credit risk management, hiking capital requirements, and so on. All of these were seen as important or very important to financial stability by a healthy majority, some 70%–80% of respondents. When asked about the clearing mandate, the execution requirements and transaction reporting, approval drops dramatically – only around one-third see those changes as important or very important. Are you surprised by these findings?
Stephen O’Connor: Yes. It’s interesting that some of those reforms are not so popular. Clearing was one of them – it’s designed to improve systemic risk. Now, you could see it as a tax on the system, and those users that are caught by clearing might grumble about it, but they will build the pipes and get connected, and you might get a different answer if you ask them again in five years.
What is more interesting to me is that, in addition to rules that are designed to improve systemic risk, there are rules intended solely to improve life for the end-user – the execution rules, primarily. So, if we’re hearing from the survey that respondents don’t like being forced into a Sef, then something has gone badly wrong.
Eric Litvack: It may also reflect the fact that the prudential reforms affect someone else, whereas the market reforms – clearing, execution and reporting – affect everyone.
There’s a parallel here to a conversation that happens around clearing. Broadly, people are in favour of moving to clearing and getting the benefits of reducing counterparty credit risk, reducing balance-sheet exposure. But when you ask people about the extent to which they want to share in the responsibility if a clearing house goes wrong, there is suddenly a lot less enthusiasm.
The risk doesn’t go away; there is still risk in the system and you can concentrate it in the clearing houses, and you can mitigate it as much as possible in the clearing houses, but ultimately there’s always some tail risk. The question is who should bear that risk and, again, I think you’ll find that a number of participants feel it shouldn’t be their concern.
Risk: The way this debate is normally framed, there are only two answers to that question – either the clearing members take the risk, or their clients do. But there are also the central counterparties (CCPs) themselves – and their own capital contribution tends to be pretty thin. Would it be helpful if CCPs put in more of their own capital to the default waterfall?
Eric Litvack: To a degree, yes, but let’s be clear – CCP skin-in-the-game capital is there primarily to keep CCPs honest, to make sure they have a monetary incentive to manage risk properly and keep processes up to date. The amount of capital they put in will never be sufficient to cover the default of a major participant.
Risk: What about providers of capital from outside the system: insurers, for example, or investors? Some people have mooted contingent capital-type solutions for CCPs. Are those good ideas?
Eraj Shirvani: Our broad view is that strengthening the capital base of CCPs is something we need to start looking at. The reality is the risk waterfall right now could be deemed insufficient in certain cases, so it kind of goes back to that original comment I made on systemic risk – we’ve just moved that exposure from a bunch of banks to a bunch of CCPs. Now, we have to look at the CCPs to make sure they’re strong enough.
Eric Litvack: And it raises some very important questions about what CCPs do, what services they provide and, more importantly, what services they’re providing with the backing of the mutualised fund.
What a CCP does with its own equity is, to a certain degree, its lookout or its shareholders’ lookout. What a CCP does with the direct or implicit backing of mutualised contributions is a whole different issue. Most importantly, it raises the question of whether a CCP should be prefunding margins. Should margins be prefunded by a user before they trade or should they trade and then pay in margins on the next day?
If they only pay the margins a day after the trade date – which is the practice in most derivatives markets – then, effectively, the CCP is providing intraday credit to the broad user group on their trades without having any margin in front of that, so who is doing that lending? That lending is being done, not on the CCP’s capital but on the basis of the mutualised default guarantee. Should they be doing that? That’s a real question, and something that really deserves discussion because, ultimately, it is implicitly covered by the pool of existing clearing numbers, and not necessarily with their consent or with any remuneration.
Stephen O’Connor: Going back to the question about contingent funding – and whether a slice of that could be provided by insurance – I think you would need to look hard at that because one thing that is certain is that the CCPs, if and when they need that money, will need it immediately and with 100% certainty. If there is any negotiation process that begins with some insurance company, then it’s not the same as having cash in the bank. I think there is room to look at that product, but it has to be looked at very carefully.
Risk: Are you seeing end-users retreating from OTC markets at all – specifically the corporate universe that is, arguably, most inclined to see these reforms as obstacles or barriers? I ask because one common theme of two interviews we’ve conducted with corporates for this issue is that they are looking for ways to reduce rising hedging costs. In the case of the Airbus Group, as an example, they are doing it by persuading customers to pay for their planes in euros rather than US dollars – so looking for natural hedges, rather than using derivatives.
Eric Litvack: Well, there is certainly a perception of that at the moment and probably more than a perception in some cases. And some participants do have a choice, which might be trading with a counterparty that is not affected by the rules, or balancing currency inflows and outflows differently between suppliers and providers – so there are ways of addressing it, and they may be transitory measures to see you over the implementation hump or it may be the new normal for some participants.
But those risks don’t go away. If you’re selling planes in euros instead of dollars, then your airlines need to find euros, but their revenues and costs may be principally in dollars. Alternatively, if you decide you can only sell your planes in dollars and are therefore going to pay your suppliers in dollars, then you’re simply passing on the problems to the smaller companies that supply you. You’re just shifting the pieces of risk around the board but are not making them go away.
Shifting risks around the board is what derivatives do, so you have the choice of shifting them contractually to your suppliers and your customers or shifting them to a derivatives counterparty that wants the risk. Ultimately, we still think that’s the best way of doing it, but it means getting through this transitional phase.
Eraj Shirvani: The question you have to ask yourself is why would you want to do that? We have to again ask ourselves whether these reforms have created safer, more efficient, more liquid markets, or not. As you put more pressure on market-makers – firms that really help facilitate risk transfer – we no longer have either the mandate or the ability to do that in the way we used to in the past. I think that impacts OTC markets and the accessibility of OTC markets for corporates.
Eric Litvack: I think there is a perception that risk was too cheap – the ability to take on risk at the bank level and slice it, dice it, pass it on. That was seen as being too easy, too cheap, so the primary driver of most reform has been to raise the cost. So, add more equity, require more liquidity – throw some sand in the gears to slow things down. The question is whether that has been calibrated appropriately. The market will find a new equilibrium, and whether that is a better place is something we’ll find out over time.
Risk: As a final question – and I’m going to insist on yes or no answers to this one – let’s say we’re sitting here in five years’ time, ahead of the 34th Isda annual general meeting. Will we be looking at OTC markets and saying they are safer, more efficient, more liquid than they were pre-crisis?
Stephen O’Connor: Yes, absolutely.
Eraj Shirvani: Yes.
Eric Litvack: Unconditionally, yes.