Isda's O'Malia: CFTC rules need reassessing

Six months after becoming chief of the global OTC trade body, Scott O’Malia discusses his plans for the cross-border derivative market

It's been a year of change for Scott O'Malia. In July he resigned as commissioner at the Commodity Futures Trading Commission (CFTC). A month later, he became CEO of the International Swaps and Derivatives Association (Isda). The Association he now heads has played a leading role in navigating the hurdles, and sometimes gaping holes, in post-crisis cross-border swaps reforms. The immense regulatory changes prompted by the G20 Pittsburgh summit in 2009 have often favoured national policy over international compromise. It follows that one of O'Malia's key mandates is to help regulators from around the world reconcile differences that could disrupt the global derivatives market.

Isda's latest initiative, the Resolution Stay Protocol, is a case in point. It intends to prevent swap counterparties simultaneously unwinding derivatives contracts with a failing bank. By creating a global protocol, Isda hopes to help bridge the gap between different market practices that could exacerbate a struggling bank's liquidity shortage.

Here, O'Malia speaks with IFLR about the protocol, the industry's future challenges, and the unintended consequences of CFTC requirements.

The industry has made real progress meeting the objectives agreed by the G20 – especially in the areas of clearing and trade reporting. What is missing, however, is a transparent and effective mechanism for substituted compliance or equivalence determinations by regulators. Without this, market participants will have to comply with multiple, duplicative and potentially contradictory regulatory regimes, needlessly increasing the compliance burden for firms.

The end result will be the fragmentation of liquidity along geographic lines, as firms choose to trade with counterparties in their own jurisdictions to avoid conflicting regulatory requirements. In fact, recent Isda research shows this fragmentation of liquidity is already occurring for certain products.

One of the main goals for Isda is to help address this fragmentation – for instance, by leveraging our global footprint to help provide data and analysis to regulators.

Our other goals include the implementation of margin rules for non-cleared over-the-counter (OTC) derivatives. As proposed, these rules will require market participants to post initial and variation margin on their non-cleared trades, in some cases for the first time. This will involve a major change to infrastructure, processes and documentation.

Isda has played a leading role in preparing for implementation. For instance, we've been working to overhaul standard collateral documentation, so it is compliant with the new rules, as well as define the standard business and technology practices for margin calculations, notifications and settlement, collateral eligibility and segregation.

Isda is also developing the framework for a standard initial margin model that will be available to all market participants. This is important because without a common model, agreement on initial margin calculations, and the required exchange of initial margin, will be very difficult. This will increase the number of disputes and the cost of compliance, and decrease the ability of some players to effectively manage their exposures.

However, there's a lot to be done in a short amount of time. The margin requirements are scheduled to come into effect December 2015, but final rules by national authorities in the US, Europe and Japan have not yet been published. That's why Isda has requested a short delay to the implementation date: two years from the point in time the final rules are published.

These examples illustrate our overarching goal of working to ensure markets are safer and more efficient.

The key things are coordination and cooperation. It's incredibly important that individual regulators defer to each other's rules, assuming those rules implement the principles identified by the G20. Equivalence or substituted compliance determinations should be based on outcomes, rather than a granular, rule-by-rule comparison of regulations.

"Substituted compliance determinations should be based on outcomes, rather than a granular, rule-by-rule comparison of regulations"

These decisions shouldn't be unilateral; the home and host regulators should be involved. Consultation with other regulators and market participants would also be helpful. On top of that, the decisions shouldn't be all or nothing. If a country has similar rules for clearing, but not for trade execution, for example, some level of equivalence should still be possible.

In terms of timeframe, it's difficult to say. Obviously, we'd like this to become a reality as soon as possible.

Regulators understand the importance of this issue, and there have been numerous attempts to foster greater cooperation. These good intentions, however, need to translate into action.

The Dodd-Frank Act stipulates that its swaps provisions shouldn't apply to activities outside the US, unless those activities have a 'direct and significant' effect on US commerce. In some cases, that requirement has been interpreted too broadly by the CFTC. This has led to circumstances where non-US participants have had to comply with Dodd-Frank related rules alongside their own, potentially different home country requirements.

Isda supports the systemic risk reducing requirements within Dodd-Frank, but certain CFTC rules that apply these requirements too broadly should be reassessed. The other thing to point out is that US rules allow for substituted compliance determinations, but, as discussed earlier, these should be based on outcomes, rather than a detailed rule-by-rule comparison. That said, substituted compliance requires two sets of rules that can be compared and deemed equivalent.

There are a number of answers to this. More than 20 platforms have now registered as Sefs, and volumes traded on these venues have increased significantly since the first made available to trade determinations in February 2014. Mandated products have to be traded on these platforms by all US persons, as regulators intended. According to an Isda survey earlier this year, a majority of end users think Sefs have had a positive impact on transparency, which is clearly encouraging.

On the other hand, a much smaller proportion of end user respondents think Sefs have had a positive impact on pricing and liquidity. In fact, fragmentation of liquidity has worsened since the Sef regime came into force. Isda research shows that approximately 95% of the European interdealer market in euro interest rate swaps is now conducted between European firms. Before the Sef regime in October 2013, roughly 25% was traded between European and US firms.

We think there's plenty of room for both exchange-traded and OTC products. Participants looking to tailor their hedge to exactly match the underlying risk they face will continue to turn to the OTC market. Those looking for more standardised, off-the-shelf products might choose the exchange-traded market.

Regulators are developing special resolution regimes in each of their jurisdictions, for instance, title II of the Dodd-Frank Act and the forthcoming EU Recovery and Resolution Directive. Under these legislative regimes, counterparties are suspended from terminating outstanding derivatives transactions with bank counterparties that have entered into resolution proceedings.

However, there is doubt over whether these stays would be enforceable in a cross-border situation. For example, if a US bank enters into resolution proceedings and it has an outstanding trade with a UK counterparty under English law, the stay imposed under Dodd-Frank may not apply to the UK counterparty under the English law contract.

"Certain CFTC rules that apply these requirements too broadly should be reassessed"

The Isda Resolution Protocol tackles this, as adhering parties agree to change derivatives contracts with other adhering parties to abide by the early termination stays, introduced by these statutory regimes. Doing this removes the uncertainty over whether a stay imposed by one country's resolution authority would be enforceable in a cross-border situation. The protocol also provides for an override of cross-default rights when an affiliate of a counterparty becomes subject to certain US bankruptcy proceedings. So far, 18 major global banks and certain of their affiliates have voluntarily signed the protocol. Regulators have committed to introducing regulations in their jurisdictions during the course of 2015 to encourage broader adoption of contractual stays. Those regulations are expected to be subject to the normal rule-making process in each jurisdiction. Longer term, regulators have said they will work towards a legislative cross-border recognition regime.

There are advantages in having multiple central counterparties (CCPs), as a single clearinghouse would pose a massive risk to the financial system if it were to fail. However, too many CCPs would reduce netting benefits and tie up the resources of clearing members (for instance, through multiple default-fund contributions). The right balance is probably somewhere in between.

The Isda Resolution Protocol was published in November 2014. By adhering to the protocol, the 18 banks that signed up in the first phase will extend the coverage of stays to more than 90% of their outstanding derivatives notional. The protocol comes into effect on January 1 2015.

The Financial Stability Board (FSB) has said that national regulators should introduce rules in their jurisdictions in 2015 that would encourage, directly or indirectly, a broader array of firms to adopt contractual stays.

Clearly, though, the most effective way to ensure that any stay on early termination and cross-default rights applies on a cross-border basis is through legislation. The FSB report agrees that a framework for statutory cross-border recognition would be preferable, but argues this a longer-term goal.

Buy-side representatives were involved in this initiative from the start, including trade groups that represent large numbers of firms. They were all sent drafts of the protocol and were encouraged to voice their opinions, throughout the process. Isda also organised and participated in several meetings between buy-side representatives and regulators.

Very early on, the buy-side raised concerns about any change to derivatives contracts that would result in the loss of a right to close out trades with counterparties that enter into resolution. They argued they have a fiduciary duty to their clients that prevents them from voluntarily signing away advantageous contractual rights.

Isda repeatedly made these points to regulators, including in a letter co-signed with the asset management group of the Securities Industry and Financial Markets Association (Sifma). These concerns were acknowledged and accepted by regulators, as highlighted in a September 29 report by the FSB.

As a result of these concerns being raised, buy-side adherence to the protocol was separated from bank adherence. That's why only 18 large global financial institutions signed the protocol, during its first phase.

As noted above, the FSB report said national regulators would introduce rules in their jurisdictions in 2015 to encourage a broader array of firms to adopt contractual stays. It is expected, that these rules will follow the normal rule-making process of each individual jurisdiction, meaning firms should have the ability to provide comment and feedback. This process may well result in the need for changes to the Resolution Protocol, and Isda is fully prepared to do that.

Ultimately, whether other firms sign is a matter for them to decide. Or, it is up to regulators to propose, issue and implement rules, requiring or incentivising their adherence. The protocol is not a rule, nor does it require firms to sign. Isda cannot and does not mandate adherence to its protocols.