ISDA: ‘Granular’ Approach To OTC Clearing Obligations

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When Sweden’s NASDAQ OMX Group, Inc. (NASDAQ:NDAQ) was approved to act as central counterparty (CCP) under the European Market Infrastructure Regulation (EMIR) for several single-name, basket, and equity index futures and options two months ago, the European Securities and Markets Authority (ESMA) was tasked with figuring out which of those derivatives should have a clearing obligation.

In a recent whitepaper studying the issue, the International Swaps and Derivatives Association (ISDA), which represents dealers and other parties in the over-the-counter (OTC) derivatives market, argues that derivative customizability plays an important role in businesses’ risk management strategy and should be respected when setting clearing obligations.

ISDA equity derivatives

Total turnover of exchange traded market over $250 trillion

The notional amount of outstanding equity derivatives contract is comparable to the open interest in equity index futures and options, $6.56 trillion and $7.24 trillion respectively at the end of 2013, but the ISDA argues that this is comparison is misleading. Exchange contracts (which are standardized and already cleared through CCPs) are fungible, so the $7.24 trillion only measures trades that haven’t been offset by another deal, while the notional value measures the face value of all OTC trades. ISDA  prefers to compare notional value to the total turnover for the exchange traded market – $251.17 trillion in 2013.

ISDA Exchange traded market

On the one hand, more than $6 trillion is by no means trivial and a disruption to the OTC derivative market could make it harder for companies to hedge specific operational risks, but it is still a small fraction of the total derivatives market and would be subject to the other EMIR requirements (reporting standards and capital requirements), and the ISDA argues that these go a long way to mitigating systemic risk.

Overgeneralization creates its own operational risks

While the companies that use customized derivative contracts would be affected by broad clearing obligations, the CCPs that are forced to clear the contracts could also be burdened with a job that it can’t effectively perform.

To avoid this, the ISDA wants ESMA to follow three principles when evaluating OTC derivatives. First, it says that ESMA’s determination process should follow a “granular product taxonomy”. The main concern here is “the possibility that a clearing mandate could be applied to a futures product but also pull in non-clearable OTC swaps and forwards on that same underlying name.”

ISDA Variance and dividend swaps

Second, the ISDA argues that ESMA has to be careful about how it assesses liquidity. A given class of derivatives may appear to have plenty of trade volume over the last year, but if all the action is confined to a couple of weeks then the liquidity isn’t really there. ESMA has suggested the MIFID list of liquid shares, but some of the shares on this list have low trade frequencies.

Finally, ISDA says that accurately gauging how standardized a certain product has become will be critical to the success of the program, because “CCPs could end up having to clear millions of similar contracts, each structured to order, each slightly different, and each with limited trading activity, which would introduce significant operational risks and costs to CCPs and, ultimately, to the users of these products,” the IASD writes.

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