ISDA has many laurels to its credit – the development of standardised contracts for derivatives, ensuring the legal enforceability of netting in the world's major financial markets, and, most recently, implementation of various measures, such as the Novation Protocol and arrangements for cash settlement, that have considerably improved the robustness of the credit derivatives markets. Thanks to such achievements the derivatives markets have in fact matured into significant markets that offer issuers, investors and intermediaries the opportunity to manage their risks efficiently – be that to hedge risks taken elsewhere or to assume risk positions. Indeed, had ISDA not existed, it is not inconceivable that regulators would have either attempted to draft detailed rules and procedures or even have called a halt to the derivatives markets.
Impressive as these laurels are, there is no room for ISDA or for the industry to rest on them. Indeed, in our view the industry faces three challenges:
- The operational challenge: can the industry get the back office to move in tandem with the front office?
- The risk management challenge: can the industry really manage the risks in derivatives?
- The customer challenge: can the industry assure that the products it sells are suitable for the clients who buy them?
Let me say a few words about each challenge in turn.
The operational challenge
First of all, the operational challenge. A year ago, the credit derivatives market was a mess. It was an accident waiting to happen. The industry was initiating over one hundred thousand trades per month – but it was taking, on average, over forty business days to confirm a plain vanilla credit derivative transaction and considerably longer to confirm more structured transactions. Settlement breaks at quarterly roll dates were common, and took long periods to resolve. Settlements in the event of default by the issuer of a reference obligation also had in many cases to be negotiated after the event, adding to uncertainty and cost. To compound matters, some counterparties had fallen into the habit of assigning a trade to a new, third counterparty without receiving the prior approval of the other original counterparty to the deal. In the worst case, unconfirmed trades may have been assigned to third parties – at best a recipe for operational chaos and at worst an open door to fraud, possibly on a massive scale.
As is well known, regulators around the world simply told the industry "enough is enough". Regulators could not allow individual firms or the industry as a whole to run a market where counterparties did not know
- whether they in fact had a deal or not,
- who their counterparty was or wasn't,
- when or if their deal would settle.
All the ISDA documentation in the world is useless, if market participants cannot complete the basic operational steps of confirming transactions and obtaining approvals for assignments in a timely manner. Sheer sloppiness could have undermined all the good work that ISDA has done over the years. An unconfirmed trade is not necessarily a trade that can be netted. Neither is a trade assigned without approval.
"Clean up your act, or we will do it for you," was the not too subtle message given to firms at a meeting convened by the New York Federal Reserve Bank in September 2005. I am happy to say that the industry has responded well to this message and that the industry is well on the way to meeting the operational challenge, at least for credit derivatives.
ISDA's Novation Protocol, together with the thorough implementation of quick response times to assignment requests by the major dealers, effectively solved the assignment problem. By November 2005, almost 2000 counterparties – or practically all frequent traders of credit derivatives -- had signed the Novation Protocol. This provided counterparties with a simple straightforward way to request and to document assignments. Although many hedge fund managers were sceptical that dealers would approve assignments quickly, dealers have in fact approved practically all economically rational assignments within very tight timeframes. The successful implementation of the Novation Protocol corrected a serious lapse in risk management controls and further enhanced the liquidity of the market.
The confirmation backlog is taking longer to correct, but the industry is almost there. Essentially this has been a two-pronged effort, first to reconcile the legacy of unconfirmed transactions, and, second, to take measures to assure that new backlogs would not develop.
Industry literally attacked the legacy, with teams of operations experts pouring over old documentation and, in many cases, locking themselves in a room with similar groups of experts from their most frequent counterparties to confirm outstanding trades and/or to conduct a new trade that cancelled a large number of transactions.
More importantly, the industry took steps to assure that new backlogs did not occur. This involved changing the way in which dealers traded with each other and with their major counterparties, as well as continuing to submit monthly metrics on progress to the regulators. Major steps included:
- Setting standards for matching and confirmation. The industry agreed that all plain vanilla trades would be matched by T + 1 and confirmed by T + 5, and that all structured trades would be matched by T + 10 and confirmed by T + 30.
- Implementing electronic trading and straight through processing. Dealers agreed that they would conduct all plain vanilla trades among themselves electronically and that they would induce their clients to trade electronically as well. Dealers set and met targets for "on-boarding" clients into electronic systems. The dealers have "on-boarded" almost 3,000 clients since setting the targets. This had greatly reduced errors and facilitated matching and confirmation within the target dates mentioned earlier.
- Subjecting trades to economic affirmation. The industry agreed to positively affirm all structured trades by T+3. Any vanilla trades remaining unmatched after T+5 are also subject to economic affirmation.
These steps have resulted in dramatic improvements. Transactions remaining unconfirmed thirty days or more after trade date are now down to 19,500, a decline of 80% from September 2005. Transactions remaining unconfirmed after 90 days have declined by over 90%.
In addition, the industry has substantially reduced settlement breaks around quarterly roll dates. Settlement roll dates facilitate settlement netting on pre-defined roll dates (20th March, June, September, December) for all CDS index and single name transactions. The number of fails arising from roll dates has fallen from 48,000 in September 2005 to 12,000 in July 2006, a reduction of 75%.
Although significant progress has been achieved, it is too early to declare victory just yet. That declaration must, in my view, await three developments:
1. Eradication of the backlog of unconfirmed transactions. Although there has been a tremendous reduction in the backlog of unconfirmed transactions, the fact remains that there are still nearly 20,000 trades that remain unconfirmed thirty days or more after trade date. There are nearly 5,000 transactions that remain unconfirmed 90 days or more after trade date. This remains unacceptable, and you can expect the FSA to drill down with firms as to the value of such trades and query the netting and capital treatment of such trades.
2. Assurance that new operational snafus will not develop in credit derivatives. Such snafus could result from failures to match and confirm trades or from failures to settle trades, especially in the event of a default on a reference obligation.
The July data from the industry on matching and confirmations were not promising. After having met the June targets for backlog reduction, the industry exhibited some backsliding in July. Backlogs rose again, much like weeds in the garden.
In our view credit derivatives have to move to the same type of matching and confirmation standards that prevail for liquid instruments, such as foreign exchange and cash equities. The industry has the right targets for matching (T + 1) and confirmation (T + 5) and the right methods to reach those targets. The trick is getting the job done, day in and day out, and firms should expect regulators to focus on whether firms are in fact achieving their targets on an ongoing basis, and they should not be surprised, if regulators weigh action against firms that do not achieve these targets.
Achieving rapid settlement in the event of a default on a reference obligation is equally important. Buying protection against default is not productive, if firms incur severe delays or excessive costs before receiving compensation. ISDA has provided ad hoc protocols following recent credit events, which enable parties to amend documentation on a multilateral basis rather than bi-laterally. The protocols allow parties to cash settle trades on credit derivative indices, in order to address the problem of more derivative contract notional existing than outstanding physical bonds. So far, each protocol allows participants to amend their documentation for related index trades from physical to cash settlement, and to participate in an auction which determines the final cash settlement price, although participants can continue to physically settle or in other words, deliver the bonds. Following the default of the US auto parts supplier Dana, in March 2006, ISDA provided the 2006 Dana CDS Index Protocol, for which index traders gave a 95% participation rate. The industry and ISDA are further collaborating in order to extend these ad hoc protocols to include generic credit events and single name swaps, not just indexes. Some vendor systems help mitigate industry concentration risk to a single name credit event, by offering a service which reduces the number of closely matching trades referencing the same credit. These are all positive steps. However, banks should be stress testing their operations for a really large bankruptcy event, and the possibility that such an event would trigger further defaults.
3. Assurance that other derivatives markets will be operationally robust. Putting the credit derivatives market right has required an extraordinary amount of effort on the part of the industry. There has also been excellent cooperation among regulators as well as between regulators and industry.
On the one hand, one can marvel at the tremendous ability of the industry to achieve significant results, once the industry sets its mind to it. The industry has turned an accident waiting to happen into a near miss. But to leave our discussion here is rather like admiring the driving skills of someone who runs a red light and then swerves and weaves to avoid crashing into the oncoming traffic.
The point of course is that the driver should never have run the red light in the first place. Nor should the industry in general or individual firms in particular have allowed the front office to run so far ahead of the back office.
So the operational challenge to the industry is whether it can get it right the first time across the entire derivatives market. We do not expect firms to have to engage in such heroics again and would regard any requirement that they do so as a clear failure to observe, in FSA terminology, Principle Three, the need to maintain adequate systems and controls.
We are particularly concerned about the emerging operational shortcomings in the equity derivatives markets. We are conscious that this market is somewhat different to the credit derivatives market. Trades are generally more complex in structure and more diverse in the number of counterparties. Equity derivatives are mostly a bank and customer market rather than a dealer market.
But differences in the two markets cannot serve as an excuse for operational shortcomings. Banks need to operate their derivative activities without significant backlogs. They need to scale up their operations to the level of their trading or restrict the level of their trading to the capacity of their back office.
The risk management challenge
The second challenge facing the industry is risk management, especially the valuation of derivatives and the management of collateral as a means of mitigating counterparty risk.
As plain vanilla instruments become commoditised, margins are compressed and firms are shifting their activity toward products tailored to the circumstances of particular issuers or investors. These customised products tend to be illiquid and to stick to the bank's balance sheet. As a result, it is likely that at any one point in time illiquid instruments account for a high proportion of the value of derivatives on a bank's balance sheet.
This growth in illiquidity makes risk management more difficult. Correct valuation is one of the cornerstones of risk management. Recently, there have been several well publicised instances of mismarking by traders of their derivatives books, leading to multi-million pound losses for the banks involved. And, in the context of the discussion of best execution under MiFID, the industry is reported to have asserted that it "cannot create benchmark prices for derivatives as they tend to be one-off products with no market".
But, if there is "no market", how do firms mark to market? How does the industry value derivatives, and how can firms and their regulators be sure that firms are in fact valuing derivatives adequately for risk management purposes?
We expect to get greater insight into this question through thematic work that we are conducting with firms. We have already concluded a hypothetical portfolio exercise with a number of investment banks. This revealed a fairly wide dispersion in the value at risk that that firms considered themselves to have in connection with an identical portfolio of structured derivatives. Separately, we are now discussing with firms whether their valuation methodologies adequately reflect movements in underlying market factors as well as whether firms make adequate adjustments or take adequate haircuts for illiquidity. We expect to provide a statement of good practice back to the industry early next year as well as to take action against firms that are not employing proper valuation techniques.
A second aspect of the risk management challenge is collateral. ISDA has certainly created the legal basis for the mitigation of counterparty risk through netting agreements, provisions for margining and the introduction of a collateral protocol. However, this entire legal superstructure is meaningless, if banks do not manage collateral correctly. Specifically,
- do banks have sound collateral agreements in place?
- do banks value collateral correctly and impose appropriate haircuts?
- do banks review the correlation between collateral and the value of the underlying exposure to the counterparty, both in normal and in stressed environments?
- can banks realise collateral quickly, if they have to do so?
- can banks get their collateral back quickly, if they extinguish their underlying obligation to the counterparty?
These are complex questions, particularly in a world where collateral is pledged on a cross-border basis, where collateral pledged can continue to be traded; where collateral pledged by Bank A to Bank B can be re-hypothecated by Bank B to Bank C; and where cross-margining agreements allow counterparties to post collateral to a central pool against exposures in multiple jurisdictions.
Will all this work, and will it work in a stressed environment? That is the key question. If collateral cannot be counted on in a crisis, financial stability cannot be assured.
Accordingly, regulators have initiated discussions with leading banks regarding the strength of their collateral management systems and controls. The FSA is currently piloting some thematic work on collateral management and will be rolling this out to a number of large investment banks during the fourth quarter. We anticipate feeding the results of this study back to the industry early in 2007, perhaps in the form of a statement of good practices. We will coordinate this work with that of other regulators.
The customer challenge
The third challenge facing the derivatives industry is the customer challenge. Are banks treating customers fairly? Specifically, are banks selling products that are suitable to customers' requirements? Are banks providing customers with best execution? And, are banks keeping customers' confidential information confidential or using this to commit market abuse?
Derivatives are increasingly complex instruments tailored to a client's specific situation. This places a premium on the bank's understanding the nature of its counterparty, determining the ability of the counterparty to understand the complexity of what the bank is selling and ascertaining the suitability of the product for the client, not only at the time of sale, but over the life of the product.
Our primary concern under MiFID, as it is under the current Conduct of Business Sourcebook, is to assure that investment firms treat retail and professional clients appropriately. This means, among other things, providing best execution, assuring that products are suitable for clients and properly managing both conflicts of interest and confidential information.
Recently, there has been some discussion, both in and out of the press, about best execution. An investment firm is subject to best execution requirements when it carries out orders for retail and professional clients. MiFID sets a high level objective for investment firms to "take all reasonable steps to obtain the best possible result taking into account all relevant considerations". It also includes several process requirements that are intended to drive compliance with that high level principle, including requirements for an execution policy and arrangements, disclosure to clients, client consent, monitoring and review and an obligation to respond to requests from clients to demonstrate how execution of their orders complied with the firm's execution policy.
The FSA aims to implement these requirements in the simplest way possible. In the main, we intend to copy out the MiFID texts. Any guidance we offer will be to clarify and to assist firms with their compliance.
In recognition of the complexity of the issue and the benefits of a full debate, we published a discussion paper in May. In their responses, trade associations on both the buy side and sell side have put forward a range of views on how to interpret the MiFID provisions, particularly in terms of what kind of business will be subject to best execution. Our recent paper on client classification set out our view on the scope of the obligations. We are of course giving full consideration to all the views expressed to us.
In the May discussion paper, we canvassed the possibility of issuing guidance about "benchmarking" as one way for firms to demonstrate best execution. This would not be binding on firms but would provide a safe harbour. The generally negative feedback we have had on that possibility is being given full weight as we frame specific proposals, on which we plan to consult in October. However, given the seemingly widespread misconceptions about the DP's purpose, it is worth confirming to you now, that at no stage have we intended to make a rule or rules requiring firms to adopt benchmarking.
Suitability should be a fairly straightforward concept. Is the product appropriate for the client and does the client understand what he is buying as well as the risks involved in the product? Given the complexity of some derivative products and their pay-off characteristics, is this always the case? Ignoring suitability or glossing over the issue is a sure way to attract regulatory attention.
Managing conflicts of interest and confidential information are part and parcel of banks' everyday activity in the cash markets. They need to be part and parcel of the derivative markets as well, including the market for credit derivatives. Advising a corporate client on a bond buyback that will extinguish the reference obligation on which credit derivatives are based generates market sensitive information just as advising a client on a takeover does. The same type of information controls need to exist. That does not yet appear to be the case at all firms. Those who are lagging behind would be well advised to catch up quickly.
Treating retail and professional clients properly is the real challenge. Firms would be well advised to concentrate on this. That is what the FSA does now, and what we will continue to do under MiFID. We will have little patience with, or understanding for, firms that seek to hunt through MiFID for the magic combination of rules that might enable to them to avoid their real responsibilities to clients. We are and will remain a principles-based regulator.
Conclusion
In sum, the derivatives industry faces three challenges. Much has been done on the first, the operational challenge. But much remains to be done, on this as well as on the risk management and customer challenges. We look forward to working with ISDA and its members to complete the job.
