Isda’s paper aims to be a guiding light to derivative market participants battling with a mountain of complex new regulatory requirements
Isda chief executive Scott O’Malia said the market relies on layers of old infrastructure and processes that have been accumulated over time, sometimes as a result of past acquisitions to grab market share, where systems were not fully integrated.
In a September 15 statement published alongside a white paper from his group entitled The Future of Derivatives Processing and Market Infrastructure, O’Malia said: “More recently, the sheer pace of regulatory change has meant firms have been under pressure to tackle the next pressing deadline. The result is a derivatives infrastructure that is duplicative and based on incompatible operating standards, and this isn’t sustainable.”
Collateral management singled out
When Lehman Brothers filed for bankruptcy in 2008, it placed a spotlight on the importance of collateral to manage counterparty credit risk in the derivatives markets. Whether posted to a central clearing house or directly between counterparties, collateral is a safeguard against the worst-case scenario of such a collapse.
But Isda singled out collateral management as an area where greater standardisation is “particularly needed”. While there are “significant challenges” for the industry amid new rules forcing participants to exchange collateral over derivatives transactions that do not go through clearing houses, Isda has spotted “numerous opportunities” for standardisation.
“Among these are opportunities for the development of standard account control agreements, publication of eligible collateral matrices, netting of swap obligations with collateral cash flows and segregation account standards for bilateral margin,” the white paper said.
As a word of caution, however, Isda also noted that “further exploration” is required to determine feasibility.
Standardisation is not just about best practice…
… it is also about making money. Nobody doubts that change was needed in the wake of the financial crisis and Lehman’s collapse, but in putting derivatives market reform at the top of the agenda at its September 2009 meeting in Pittsburgh, the G20 set into motion a process that has had burdensome implications – making derivatives markets safer and more transparent costs big money.
Isda’s white paper said: “The increased cost of supporting traditional post-trade activities and complying with new regulatory obligations, alongside reduced profit margins in many areas of the derivatives business, is not sustainable. Industry participants need to find new ways of operating.”
Amid uncertainty over the final rules on some issues, market participants have found it increasingly difficult to plan and invest for the future, Isda said, adding that its paper is aimed at helping develop a “common vision” of what the industry needs, if it is to cut costs and complexity.
Higher operating costs have unintended consequences
The reforms have led to much soul-searching. Higher costs and lower profits have forced investment banks to take a long, hard look at themselves and the services they offer. Being all things to all clients was in vogue in the years before the crisis, but that is an approach only a handful can afford to take in the new regulatory environment. Regulators promote central clearing as one way to better manage the risks in over-the-counter derivatives markets. But Isda’s paper notes that several investment banks have “stopped providing clearing member services for their customers in some jurisdictions”.
Higher operating costs are not the only reason, but they do play a part and Isda’s warning is stark: “It is unclear whether there will be enough capacity in the system to support all industry participants that are mandated to clear, let alone those that elect to clear for cost and efficiency reasons. Additionally, there may be too much risk concentrated in too few venues or critical functions, increasing concerns about ‘too big to fail’.”
The answer, according to Isda, is to “standardise, digitise and automate” from the back-office to the front. That should support profitability and help firms provide the services required by their clients.
There’s no ‘I’ in post-trade
Isda’s concerns are around data, documentation and process but it has called for more effective collaboration between market participants and their representatives, infrastructures and regulators.
The white paper said: “While market participants have collaborated on initiatives in the past, many firms continue to individually build and maintain the same functional solutions, particularly in post-trade activities. In many cases, there is no competitive advantage in continuing to do this and it only serves to increase the overall cost of supporting the derivatives market.”
Collaboration is important because it can help to ease the pressure of cutting costs in an environment of contracting profit margins.
Blockchain could hold the key, but don’t get it wrong
Distributed ledger technology, such as the blockchain that underpins the digital currency bitcoin, is a big hope for the industry. Clearing and settlement have been seen as the key areas that stand to benefit from the ledger. But nascent opportunities require thought, planning and careful management. Getting it wrong could lead to lasting limitations.
According to Isda, it is probable that there will be multiple ledgers within the derivatives market alone, and it urged the sector to ensure such technology is built to be as accessible as possible.
Isda said: “It is therefore critical that the industry learns from experience and ensures that this technology is delivered in an interoperable form. It may be that related parts of a derivatives process exist on different ledgers – for example, collateral management may exist on one ledger and trade performance on another.”
If the current state of the market unsustainable over the long term, it is important for the industry to plan ahead and to get it right. Planning for the long term is made all the more tricky because of uncertainties about incoming regulation but “to be unable to connect these ledgers seamlessly would be a significant missed opportunity”, Isda said.