Lynn Strongin Dodds looks at ISDA’s blueprint for a safer and more efficient derivatives market
Birthdays are always a time of reflection, and this has certainly been the case for the International Swaps and Derivatives Association which marked its 40th year in May. The trade group has taken the opportunity to consider the challenges and opportunities faced by the global derivatives markets. The result is a whitepaper targeting reforms to safeguard liquidity and risk management.
It certainly has been an eventful four decades with rapid growth, continued innovation, regulatory reform, central clearing, margining, LIBOR transition and a commitment to enhancing the resiliency of markets. The next 40 years will no doubt be equally as eventful but as the paper points out, the need for economic growth and jobs creation is driving a renewed focus on ensuring financial institutions can channel funding to the real economy and productive investments.
This requires strong, deep financial and hedging markets for financial institutions, corporations and governments around the world. The past is a good guide, but new lessons must be learnt to tackle the current environment which has seen spikes in volatility, ongoing geopolitical tensions and political upheavals.
The paper cites notable examples that have raised concerns over the liquidity in the system. This includes the Covid fuelled March 2020 “dash for cash” where investors rapidly sold off a wide range of assets, including even typically safe and liquid assets like government bonds, to obtain immediate, highly liquid cash or short-term government bills.
This was due to the uncertainty and disruption caused by the pandemic and the associated public health measures.
ISDA also highlighted the September 2022 UK gilt crisis which was triggered by the then prime minister Liz Truss’ mini-budget of unfunded tax cuts, which caused a sharp, swift spike in gilt yields and led to a liquidity crisis for pension funds using leveraged liability driven investment (LDI) strategies. The crisis was averted only by an emergency intervention by the Bank of England.
It wasn’t just crises unfolding but the market also saw greater competition as well as great strides in technology that fostered innovation and greater efficiency. Against this backdrop and as part of its mission to foster safe and efficient derivatives markets to facilitate effective risk management, ISDA made four recommendations for policymakers and market participants to consider.
First on the list is ensuring robust, resilient markets to support capital formation and allocation to the real economy. While there will be variations on a theme depending on the region., on a global basis, this involves finalising the Basel III capital rules without increasing capital rules for large banks and implementing consistently across jurisdictions.
It also means addressing issues in the Fundamental Review of the Trading Book, such as the capital treatment of collective investment undertakings and the need for a more uniform and risk-sensitive application of the residual risk add-on with respect to the scope of instruments captured.
The guidance also includes examining and potentially enhancing the flexibility that market participants have in the types of collateral posted/received for cleared and non-cleared derivatives, easing the pressure from collateral demands. Greater transparency is a high priority to ensure regimes are appropriately calibrated to support smooth market functioning, particularly in periods of market stress. In addition, firms need to assess ways to overcome portfolio margining obstacles.
Next on the recommendation list is promoting more effective and efficient risk management to assist market making and hedging. This consists of allowing increased use of internal models for calculating capital requirements, while ensuring the standardized approach is risk sensitive. Flaws should also be addressed in the profit and loss attribution and non-modellable risk factors frameworks.
In addition, a globally consistent and proportionate counterparty credit risk framework will be required to safeguard financial stability while supporting market intermediation. Market participants will also need to facilitate appropriate innovation and links between digital assets/traditional finance while maintaining appropriate safeguards, including when trading outside traditional business hours.
The third piece of advice revolves around mitigating negative impacts of cross-border inconsistencies to help cross-border capital flows and risk hedging. ISDA believes that authorities should establish a structured dialogue to harmonise the implementation of key standards with high capital impact and material divergences that drive competitive disparities and/or market fragmentation. notes the standardised approach for counterparty credit risk (SA-CCR) is a prime example.
Last but not least is reducing redundancies and simplifying regulatory requirements. This translates into making better use of the existing data reported by firms to understand market dynamics and avoid duplicating information. It also consists of improving the quality of existing required data and information flow by harmonising reporting requirements across jurisdictions. Global standards should be adopted, while machine readability and semantic accuracy should be implemented. It also encourages greater use of the Common Domain Model for standardized digital regulatory reporting.
