Fry: Isda equity derivatives definitions: challenges and opportunities

Fry: Isda equity derivatives definitions: challenges and opportunities

To achieve transparency, product and process standardisation are being carefully scrutinised as trade documentation must become consistent enough for electronic processing—a mandate of such legislation as the Dodd-Frank Act and the European Markets Infrastructure Regulation (EMIR).

Creating OTC trade documentation that enables electronic matching is fundamental to achieving standardisation in this asset class and is the key driver behind the 2011 ISDA Equity Derivatives Definitions, due to be published this year.

The new definitions represent the single largest overhaul of OTC trade documentation taxonomy since definition booklets were introduced. Their goal is to create a standardised documentation structure fit for the 21st century and built to facilitate electronic processing across the full range of equity derivative products. The magnitude of these changes, however, is not to be underestimated as their implementation will significantly impact technology, processes and people across the front, middle and back office.

The Approach

To achieve standardisation, market participants recognised dramatic changes would be required to:

  • Ensure a smooth path between legal agreement of terms and electronic processing
  • Increase the number of products that can be processed electronically
  • Increase the number of participants agreeing to market standard defaults
  • Provide a future-proof model that can accommodate inevitable new products and terms

The 2011 terms break new ground with the following:

1.     FpML-compliant format. The new Definitions are the first to be created and published in a machine-readable format, having been developed in Financial products Markup Language (FpML) and specifically engineered to facilitate electronic processing for both confirmation matching and reporting purposes.

2.     Matrix approach. This method will replace the old MCA structure, propagating an approach already proven in credit derivatives. Matrix terms are merely adhered to by parties on ISDA’s website, thus eliminating the need for prolonged bilateral negotiation and greatly minimizing paper-based processing.

3.     Modular structure. The new approach enables many additional products and complex exotic combinations to be built within the existing structure and language of the definitions. It allows for changes and additions that will occur to the terminology over time and the terms will be adaptable enough to incorporate enhancements within the existing framework—something with which previous ISDA definitional booklets have struggled.

Key Challenges

Before the Definitions’ full potential can be realised, several major hurdles will need to be addressed.

  1. The need to implement quickly. The process to adhere to and implement these Definitions has yet to be approved. It has been suggested that the new terms will not be actively used until a matrix is in place for that product. If this is the case, there will be pressure to agree upon and implement the matrix in a timely fashion so the extensive legal negotiation has not gone to waste.

  1. Handling bespoke documentation. Conversely, if participants can utilize the Definitions without a matrix using any of the menu items, questions arise as to how matching platforms will cope with electronic versions of bespoke documentation.

  1. Engaging the business. Traders must now focus time away from revenue generation in order to agree to default elections from the list of menu options and create the matrix for each product.

  1. Spoilt for choice. The proliferation of elections under the new definitions creates a headache for the market in trying to agree defaults for matrices.

  1. Managing transition. For a period, there will be cross over between the old 2002 terms and the new Definitions. This could cause considerable legal basis risk if not coordinated across the market.

  1. Retail products. The terms impact goes beyond the OTC market. Participants will be required to update legal prospectuses for retail and securitized products so they mirror the new Definitions and avoid legal basis risk.

  2. Change management. Participants will have to complete internal analysis to determine how to make these changes within the required timeframes. The scope is considerable and will impact the front-to-back trade life cycle.

  1. Resourcing the change. Market participants are already addressing other key initiatives and will be hard-pressed to find the budget and staffing needed to make necessary changes. This could impact their ability to meet the proposed deadlines.

Taking the First Step Towards a More Secure Marketplace

The 2011 ISDA Equity Derivatives Definitions promise participants the tools to rectify past problems, harmonise current templates, and standardise new products. They also promote electronic processing and provide a sound framework for OTC equity derivatives well into the 21st century. However, it is clear that the publication of these terms is only the start of a long and potentially arduous road towards a more secure marketplace.

Nick Fry is a director at Sapient Global Market

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