Profile: Isda chair Stephen O'Connor on OTC market reform

Regulators are finalising in-depth rules on central clearing, margin requirements and central counterparty risk management standards, but plenty of questions remain. Nick Sawyer talks to Stephen O’Connor, chairman of the International Swaps and Derivatives Association, about some of the outstanding issues

The choice of Stephen O’Connor as new chairman of the International Swaps and Derivatives Association in April sends a very clear message. Isda has, in the past, tended to pluck its chairmen from the trading floor – the most recent was Eraj Shirvani, head of fixed income for Europe, the Middle East and Africa at Credit Suisse. O’Connor is different: he has spent a chunk of his more than 20-year career at Morgan Stanley working in central clearing. It’s a change of tack that speaks volumes about where the industry’s priorities now lie.

“The fact Isda has chosen somebody in clearing as chairman is significant, and it reflects the serious position the association has taken with regards to clearing and all the other elements of the regulatory drive,” says O’Connor, managing director and head of over-the-counter client clearing at Morgan Stanley in New York.

Central clearing of OTC derivatives holds prime position in both the US Dodd-Frank Act and European Market Infrastructure Regulation (Emir), something regulators believe will reduce systemic risk by mitigating counterparty exposures between derivatives users. However, clearing creates its own challenges – and responding to these has been a key focus for Isda and its dealer and buy-side membership.

One thorny issue centres on the type of collateral required by central counterparties (CCPs). Clearing houses only accept cash for variation margin, and typically insist on cash or sovereign bonds for initial margin. The problem is that many buy-side users of derivatives tend not to hold these assets, preferring to invest in higher-yielding instruments such as corporate bonds. Given the directional nature of many investor portfolios, the margin requirements in choppy market conditions could amount to billions of dollars a day, leaving them struggling to meet their obligations.

One option is to expand the list of eligible assets accepted for variation margin – something that has been discussed by legislators in Europe, but is fiercely resisted by clearing houses, which claim it will compromise their risk management standards (Risk June 2011, page 10). Another alternative is for clearing members to offer collateral transformation services to their clients – and many dealers are planning to do just that. Essentially, this means the client will be able to post non-eligible assets with the dealer, which will be switched into cash via the repo market and posted with the CCP (Risk July 2011, pages 17–20).

However, these services aren’t risk-free, particularly if the dealer is providing collateral upgrades to a large number of customers. If the repo market shuts down, the clearing member would need to ask the client to post eligible assets to meet the margin obligation. If the client is unable to deliver, its trades would need to be closed out – but the clearing member would be running a significant funding risk in the interim, and would ultimately be on the hook in the short term for anything that is owed to the CCP beyond the initial margin posted by the client. Given the potential size of variation margin calls in a crisis, this could result in a liquidity squeeze for the dealer, some participants warn.

O’Connor agrees these types of facilities pose risks, and says clearing members would need to carefully monitor the exposures associated with collateral transformation to ensure they do not over-extend themselves.

“I think any provision of services of that nature needs to be carefully planned by the clearing member. There will be a finite capacity. The contingent funding component can be addressed by making sure the term characteristics of the margin upgrade service offered to the client reflect what the dealer is doing on the other side, so it doesn’t expose itself to a term mismatch, and the whole liquidity management of banks in general is a very high-focus item at the moment for regulators globally,” he says. “But I think with the right parameters, controls and matching, that can be offered by the market to clients.”

The signing of portability agreements – where a client of clearing member A is able to transfer its portfolio of trades to clearing member B if the original dealer collapses – also poses contingent funding risks for banks. Regulators are keen for these agreements to be signed, as they would help ensure a smooth continuation of business in the event of a clearing member failure. However, clearing member B may need to stump up an additional contribution to the CCP default fund when the trades are ported – a commitment that could quickly add up if a number of large clients port at the same time. The clearing member would also need to hold more capital against its CCP default fund exposure. For this reason, portability works better in an environment where there is less reliance on default fund contributions, and more emphasis on initial margin requirements, says O’Connor.

“I don’t think you’ll see banks writing unconditional porting agreements to allow clients to move wholesale business from other dealers. There is a liquidity component associated with that, which is a function of contingent cash draws that may be caused by default fund contributions,” he says. “From that point of view, I think to the extent that the default fund is low relative to initial margin, that leads to a much better environment for porting, because the contingent capital draw on the dealers is less than in a model where it is much more default fund-orientated. So there are pros and cons to that mix between initial margin and default fund contribution, although this is definitely one area where a low default fund contribution is good for portability, which itself is good for systemic risk.”

Some clearing houses might decide to move the other way, though. In the race to attract new business, CCPs may opt to slash initial margin requirements – an approach that might appeal to clients, but puts a greater onus on the default fund contributed by clearing members. These concerns were voiced most publicly by the then-chief executive of LCH.Clearnet, Roger Liddell, in an interview with Risk in April 2010, when he described the margin required by US rival International Derivatives Clearing Group as “bordering on reckless”.

O’Connor does not name any names, but claims the banks themselves would avoid any CCP that has questionable risk management practices. “To the extent a clearing house doesn’t meet the requirements expected by banks, I think you would see the banks steer away from such a situation. I haven’t seen any of that yet, but the banks are essentially capitalising the clearing house. A typical clearing house may have a few tens of millions of its own equity, but the initial margin and default fund contributions paid in by the dealers typically amount to billions already. As more client clearing takes place, the bank capital at risk could in aggregate be more than $10 billion at each clearing house. So the banks really have a very high-stakes situation when using a clearing house, and they don’t take that lightly.”

Clearing is important, but it is by no means the only focus for Isda. Another key topic has been the potential extraterritorial application of Dodd-Frank – an issue that has come to the fore in recent months with the publication of proposed margin requirements for uncleared swaps. The draft rules, published on April 12 by five US prudential regulators, would apply to the non-US swaps operations of US banks, as well as trades between foreign covered swap entities and US counterparties. The only exception is for foreign covered swap entities trading with wholly foreign counterparties (Risk June 2011, pages 24–27).

Given the potentially high levels of margin that would need to be posted under the rules, non-US customers will have a real incentive to trade with European or Asian dealers, US banks claim – and some end-users have already confirmed they will steer clear of US firms if the rules are passed in their current form (Risk July 2011, page 6).

Some US politicians object to the fact that US dealers will be put at a competitive disadvantage, and a group of 18 congressmen wrote a letter to US regulators in May urging them to amend the proposals. Isda has also raised the issue on several occasions: O’Connor referred to extraterritoriality in testimony to the House Committee on Agriculture on May 25, and again to the House Committee on Financial Services on June 16.

“If derivatives transactions between an Italian company and the UK subsidiary of a US bank were subject to transaction-level Dodd-Frank rules, but similar transactions between that Italian company and a UK bank without a US parent were not subject to those same rules, the end result would be that foreign companies would avoid doing business with swaps dealers affiliated with US companies,” O’Connor said in his June 16 testimony. “They would instead transact with financial institutions not covered by the scope of these margin requirements. It could put US markets at a serious competitive disadvantage.”

A related concern is the divergence of US and European rules. Dodd-Frank was initially meant to come into effect on July 16 – although this has now been delayed until the end of the year (Risk July 2011, pages 44–46). In contrast, Emir is likely to be implemented at the end of 2012, in line with a deadline set by the Group of 20 nations. But timing of implementation isn’t the only issue – Dodd-Frank contains a number of clauses that don’t appear in Emir. These include a ban on proprietary trading via the Volcker rule, an obligation for banks that operate in the US to carve out parts of their derivatives operations into separate entities, and a requirement for clearing-eligible derivatives to be executed via a multi-dealer trading venue (Risk June 2011, pages 24–27). This raises the prospect that global banks operating in US markets could be required to comply with multiple sets of rules – a risk Isda has drawn attention to in several of its comment letters.

“Ideally, all jurisdictions would change their rules on the same day, and on that day the rules would be the same in each jurisdiction,” says O’Connor. “The reality is we are not in that world, so there are going to be differences in timing and substance between the US and Europe, for instance, resulting in temporary and permanent differences between the regulatory framework in those jurisdictions, which will be harmful to markets. To the extent that policy-makers can work together to try and get more convergence in the rules and to consider timelines that are more consistent with each other, that would go a long way to removing some of those inconsistencies that aren’t good for markets. The playing field needs to be level to avoid regulatory arbitrage and to avoid unintended consequences such as geographical relocations of market liquidity.”

Another key concern is the phasing in of the new rules. Applying rules on central clearing, reporting and trading for all instruments and all participants at the same time would cause major bottlenecks as everyone scrambles to get systems, processes and documentation in place, participants claim. Instead, the various requirements should be introduced gradually, with a focus on reducing systemic risk, Isda believes.

Specifically, the association suggests a phasing in by type of market participant and by asset class, with ‘better prepared’ asset classes such as interest rates and credit tackled first. Dealers and major swap participants should be required to clear initially, followed by financial end-users and, finally, corporate end-users. Regulators should also prioritise the clearing element of the rules, with execution and real-time reporting following later, Isda argues. Trying to do everything at once on aggressive timelines could result in significant disruption to markets, liquidity and pricing, and lead to smaller clients being left out in the cold, says O’Connor.

“Take clearing, for instance. There are bandwidth issues for the clearing houses and there are bandwidth issues for clearing firms with respect to getting all the clients on board. Banks will go for the clients with the largest portfolios first. It would be very unfair if smaller players risked exclusion because timelines were too short. All customers should be given adequate time,” he says.

The phase-in order of the different elements of the rules will be crucial – getting clearing up and running should be a prerequisite for the new margin rules for uncleared swaps, as well as high capital charges for uncleared exposures under Basel III, he argues. If implemented before clearing houses are operational, it would mean market participants have to hold capital and post margin on trades they may otherwise have opted to clear.

“To the extent that clearing houses are open for business, dealers could show terms for both cleared and uncleared transactions with clients. The higher costs associated with uncleared trades would encourage clients to clear. However, if clearing isn’t up and running in a particular instrument, to have punitive levels of margin in the uncleared space would seem unfair. So I hope the punitive treatments in the bilateral space will take into account whether the product is available to be cleared,” he says.