The industry will need to start preparing quickly to meet the challenges facing the derivatives market, which will reach a critical point in 2020, says ISDA (International Swaps and Derivatives Association) CEO Scott O’Malia.
In his keynote speech at the ISDA Europe Regional Conference, O’Malia pointed to three “enormous challenges” facing the the derivatives market, namely the roll-out of the final phase of initial margin requirements for non-cleared derivatives, the expiry of the transition period for the EU Benchmarks Regulation (BMR), and Brexit.
The requirement to post initial margin on non-cleared derivatives trades has been implemented in stages since 2016, but in September 2020, the threshold for compliance drops from EUR 750 billion to just EUR 8 billion, a change that will “exponentially increase the number of entities subject to the rules,” O’Malia said.
ISDA estimates more than 1,000 new firms will come into scope, impacting more than 9,000 trading relationships between counterparties. Many of the newly in-scope firms will be smaller banks and buy-side firms that pose little or no systemic risk, and will ultimately have to post little or no initial margin because their derivatives exposures fall below the EUR 50 million initial margin exchange threshold, according to O’Malia.
Nevertheless, they will need to adapt or build new systems and processes, put in place new documentation, enter into new third-party custodial relationships, and adopt initial margin calculation models to comply with the requirements. Resources across the industry will come under severe pressure, said O’Malia, and unless firms start their implementation efforts now, there is a “real risk of a compliance bottleneck” which could lead to market disruption in 2020.
ISDA’s published guidance indicates that some steps to prepare for compliance require as much as 18 months lead time, making it “absolutely vital that firms start thinking about this now,” he added. To help firms with compliance and reduce the potential for disputes, ISDA in July published its latest version of the Standard Initial Margin Model (SIMM), a well-tested common methodology for margin calculations that newly in-scope firms can use.
ISDA is additionally working to automate the process of creating, negotiating and executing collateral documents for derivatives with multiple counterparties simultaneously. A beta version of the online tool will be launched in the coming days, O’Malia said.
Benchmark reform is another huge task facing the derivatives industry, unprecedented in terms of scale and impact, according to O’Malia.
The UK FCA (Financial Conduct Authority) has said that it will not compel panel banks to make submissions for LIBOR calculations after the end of 2021. Between derivatives, loans, mortgages and deposits, total exposure to LIBOR and other key IBORs is estimated at more than USD 370 trillion.
“The adoption of risk-free rates as alternatives to the IBORs will therefore be felt by virtually everyone,” O’Malia said, adding that 2020 will be a “crunch year”, compounded by the December 2019 expiry of the transition period for BMR compliance, and the ECB’s introduction of a new euro short-term rate called ESTER in October 2019, only a few months earlier.
ISDA published a report in June on benchmark reform which includes an implementation checklist for market participants.
But according to O’Malia, progress has since been made in the US and UK, with the emergence of futures products and clearing services for swaps linked to the new rates, the issuance of cash bonds linked to SOFR and SONIA, and several public-/private-sector working groups looking at developing forward-looking term rates.
“These are all critical developments that will help build liquidity in the alternative risk-free rates and encourage adoption,” he said. “But it’s vital that everyone engages with this now. Develop an IBOR transition program, allocate budget and resources, assess your firm’s exposure to the IBORs. Don’t get left behind.”
ISDA is leading an initiative to implement robust and clearly defined fallbacks for derivatives contracts currently referenced to certain IBORs, which O’Malia said is critical for the stability of the financial system. Consultations with the industry, regulators and the FSB (Financial Stability Board) have determined that these fallbacks will be the risk-free rates identified by the relevant public-/private sector working groups, but it is important that fallbacks take effect with “the minimum amount of disruption,” he added.
ISDA’s July consultation setting out potential options for adjustments to reflect the differences between IBORs and overnight risk-free rates is still open for comment until 12 October. In addition, its Benchmarks Supplement, published last week in response to the BMR, will help ensure that derivatives referencing interest rate, FX, equity and commodity benchmarks specify the fallback arrangements that would apply.
With regards to Brexit, it is not yet clear what the rules will be, nor whether a withdrawal agreement and transition period will be agreed before 29 March 2019.
But according to O’Malia, the UK may seek equivalence determinations from the EU given their identical regulatory frameworks. “Anything other than a quick equivalence determination would be a massive setback for cross-border harmonisation – not just for the UK, but to all third countries trying to access the EU,” he said.
Even a short delay to the UK being deemed equivalent could cause disruption, whereby EU counterparties would be unable to act as clearing members at UK CCPs (central counterparty) and will not be able to clear products or exercise important lifecycle events for themselves or their clients – which is “vital to the efficient functioning of the derivatives market,” said O’Malia.
Without equivalence, these contracts could only continue if they were transferred to a locally authorised entity. But, a transfer of this scale has never been attempted and operationally it needs regulatory and legislative support from both the EU and UK, he added.
ISDA is working to identify the possible impacts of Brexit on the derivatives market and to recommend solutions, such as a temporary permissions and recognition regime as a backstop to enable firms to carry on their business until a permanent authorisation or equivalence determination is achieved, thereby minimising the market disruption of a hard Brexit scenario.