Global Financial Industry Promises Key Systemic Changes to OTC Derivatives Clearance and Trading
In a letter to the Fed and SEC, and with federal legislation regulating OTC derivatives looming, a consortium of global financial institutions and asset managers said they would implement a framework for OTC derivatives risk management and market structure in accordance with principles enunciated by the G-20, the European Commission and the U.S. Treasury.
The framework will expand the use of central counterparties, strengthen risk management, improve transparency and ensure strong coordination with the SEC and other regulators. Key elements will include establishing, for the first time, deadlines for recording all credit, interest rate and equity derivatives transactions in trade repositories and expanding credit default swap central clearing to buy-side firms.
The financial institutions promised to act quickly and decisively to implement these important measures in recognition of the key strategic and systemic importance of the OTC derivatives markets. The changes to risk management, processing and transparency will significantly transform the risk profile of these important financial markets, noted the letter, and deliver a risk management and processing infrastructure that includes the additional characteristics and benefits of a traditional clearance model.
The letter was signed by, among others, Bank of America-Merrill Lynch, HSBC Group, Deutsche Bank AG, ISDA, Goldman, Sachs & Co., and the Managed Funds Association. In addition to the Fed and the SEC, the letter was sent to BaFin, the UK FSA, the OCC, and the FDIC.
The goal of the framework is to reduce systemic risk in the OTC derivatives markets by a number of measures, such as implementing data repositories for non-cleared transactions in these markets to ensure transparency and disclosure, and to assist global regulators with oversight and surveillance activities. The measures will also clear OTC standardized derivative products in these markets and enable customer access to clearing through either direct access as a clearing member or via indirect access, including the benefits of initial margin segregation and position portability.
The changes are also designed to deliver robust collateral and margining processes, including portfolio reconciliations, metrics on position and market value breaks, and improved dispute resolution mechanics. More broadly, industry governance will be enhanced.
Registering the complete universe of OTC derivatives trades in either central counterparties or trade repositories is designed to improve the ability of regulators to monitor the OTC derivatives market and will increase transparency to the public. The signatories have committed to record all of their credit derivatives trades by mid-July and to establish centralized reporting infrastructures for interest rate and equity derivatives.
The institutions will engage central counterparties to broaden the range of cleared products and market participants. Products that will be added in 2009 include liquid single name credit default swaps and overnight indexed swaps. Further products will be added in 2010, including tranche credit default swaps. The consortium fully supports the regulation of the central counterparty with particular emphasis on financial strength to absorb market shocks, including the bankruptcy of a major market participant. As central counterparties expand their offerings, the financial institutions pledged to work with regulators to deliver a set of performance targets for central counterparty usage by August 31, 2009.
To further increase market transparency so that regulators and investors have access to relevant data, the financial institutions have committed to universal recordings of certain trades that are not cleared through a central counterparty. This would mean universal recording of credit default swap trades in a trade repository by July 17, 2009 and universal recording of interest rate derivative trades in a trade repository by December 31, 2009. It would also mean the universal recording of OTC equity derivative trades in a trade repository by July 31, 2010.
Another goal of the consortium is to provide customer access to credit default swap clearing through either direct central counterparty membership or customer clearing with customer initial margin segregation and portability of customer transactions no later than December 15, 2009. The legal and regulatory analysis to achieve customer access will be completed and delivered to regulators by June 30, 2009.
The signatories also pledged to perform daily electronic portfolio reconciliation of all collateralized OTC inter-dealer derivative transactions. This will mean that combined with other regular portfolio reconciliations between dealers and others, in the period between October 2008 to June 2009, the OTC derivative market will have progressed from a state where there was no well-defined standard for reconciling portfolios to one where 70% of the outstanding transactions across all derivative asset classes are reconciled frequently.