Ten years on from the adoption of the G-20 Commitments, in response to the Global Financial Crisis (GFC), many jurisdictions have made significant progress in implementing the commitments. However, inconsistences and over-reach in implementation globally have given rise to the potential fragmentation of markets. Scott O’Malia, International Swaps and Derivatives Association Chief Executive, highlighted the case for a global derivatives market and industry objectives to ensure growth – a strong legal infrastructure, including benchmark reform; adoption of global standards and solutions; and harmonization and cooperation between regulators and rule sets.
Global solutions for global challenges – highlights from the 2019 International Swaps and Derivatives Association AGM
It is now nearly ten years since the adoption of the G-20 Commitments in response to the GFC, which was designed to strengthen over-the-counter (OTC) derivatives markets. Those commitments include standardized OTC derivatives being traded on exchanges or electronic trading platforms and cleared through central counterparties, the reporting of OTC derivatives to trade repositories and higher capital requirements for non-centrally cleared derivatives.
The recent 2019 ISDA AGM in Hong Kong took the opportunity to reflect on the progress that has been made toward fulfilling these commitments. Consideration was also given to issues that have arisen due to the inconsistent implementation of such commitments on a global basis and the upcoming challenges for the global derivatives markets, including benchmark reform and the implementation of the final phases of initial margin (IM) requirements.
Fragmentation of markets
Although significant progress has been made on a global basis in meeting the G-20 Commitments, the implementation across jurisdictions has taken place at a different pace. This fragmentation has led to inconsistencies in substance, extra-territorial scope, application of rules and incompatibility of requirements. For market participants, this has resulted in increased inefficiencies, complexities and costs of compliance. The outcome is market fragmentation with respect to the management of liquidity, trading and clearing, and risk management.
Trade reporting requirements across jurisdictions is just one example of this fragmentation. Market participants are faced with obligations to report data in varying forms and formats in different markets, subject to redundancy and uncertainty with respect to reporting obligations. This issue is further exacerbated by the barriers to global information sharing and data reporting.
Another example is the requirement to trade derivatives on swap execution facilities, or SEFs, which is not yet implemented in all jurisdictions. The Commodity Futures Trading Commission (CFTC) Chairman has previously noted the overreach of the CFTC jurisdiction in relation to rules governing SEFs, and that “this overreach has contributed to fragmenting global markets into a complex series of ever more shallow pools of trading liquidity that, in a market crisis, may present significant global systemic risk.”
To implement trading mandates globally with minimum disruption for participants requires international co-operation and deference, in particular with respect to equivalence determinations. Rulemakers will also need to consider participants that have already allocated resources and built systems to comply with the existing rules.
Scott O’Malia, ISDA Chief Executive, highlighted the need to continue to make the case for adoption of global standards and solutions, as well as the harmonization and cooperation between regulators and rule sets, which will remain a primary focus.
Perhaps the most discussed topic at the ISDA AGM was the progress of transition from the London Interbank Offered Rate (“LIBOR”) and other “IBORs” to alternative risk-free rates (“RFRs”).
Our Baker McKenzie Report, LIBOR: What You Need to Know at the Beginning of 2019 published in January 2019 examines developments that have occurred in 2018 in response to the proposed discontinuation of LIBOR with respect to derivatives, syndicated lending, securitization and the bond markets, in the jurisdictions of each LIBOR currency. Regulators and central banks have continued to stress the need to develop robust RFRs and contractual fallbacks to cover cessation of LIBOR.
Issues remain with the move to RFRs, however, including insufficient liquidity in the markets for some RFRs, potential divide between legal documentation for new derivatives referencing RFRs and for legacy transactions, and basis risks arising from triggers to fallback rates for hedged cash products differing from those for derivatives products and occurring at different times.
Many industry concerns remain unresolved, such as the potential for a value transfer for legacy contracts at the time of change of the applicable rate and issues relating to accounting and tax treatments.
ISDA has led efforts to identify RFRs. In a letter to the co-chairs of the Financial Stability Board (FSB) Official Sector Steering Group on 10 April 2019 ISDA notes key milestones for 2019 include supplemental consultations on term and spread adjustments for additional key IBORs (including USD LIBOR), selection of a vendor to publish those adjustments, and the launch of amendments to the 2006 ISDA Definitions and of a protocol to include the amendments in legacy transactions. ISDA will also solicit market feedback on addressing certain pre-cessation events related to LIBOR in the event LIBOR is deemed to no longer be representative of underlying funding markets.
What should market participants be doing now? Market participants should be familiarizing themselves with these issues, preparing for adoption of the new RFRs into new trades and upgrading systems to accommodate the new calculation methods. Once the additional consultations are concluded and industry documents published, the clear message from regulators is that they will expect market participants to act promptly.
Initial Margin (IM)
The “IM big bang” – or the final implementation phase of exchange of IM – will occur on 1 September 2020. Industry estimates are that over 1,000 counterparties and 9,000 counterparty relationships will be affected, with many being smaller derivatives users required to post IM. Meeting this deadline will pose a significant challenge for those users to negotiate and document the new arrangements with counterparties and custodians.
There is some relief in the BCBS/IOSCO statement issued on 5 March 2019 confirming that the BCBS/IOSCO framework does not specify documentation, custodial, or operational requirements if the bilateral IM amount does not exceed the framework’s €50 million threshold. Despite this relief, market participants potentially caught should still act diligently, consistently monitoring whether the IM threshold is reached.
Other highlights legal infrastructure initiatives
Participation in derivatives markets depends on a strong legal infrastructure. A number of current and upcoming initiatives are worthy of note.
- Data standardisation ISDA launched the ISDA Common Domain Model, a digital blueprint for how derivatives are traded and managed across the trade lifecycle.
- ISDA Create an online platform that will allow firms to produce, deliver, negotiate and execute documents and capture, process and store data from those documents.
- ISDA Clause Library Project to build an industry-wide foundational clause library for the schedule to the ISDA Master Agreement.
- ISDA 2019 Interest Rate Definitions to be drafted in a manner that will be easier for coders to put into digital formats.
- Close-out netting uncertainly remains regarding the enforceability of close-out netting in three of the biggest economies in the Asia Pacific region – China, India and Indonesia. ISDAs work on this front will continue.
Teresa Lentile was one of four representatives from Baker McKenzie’s Global Derivatives practice in attendance at the ISDA AGM 2019, including colleagues from the US, UK and Thailand.