This was reflected in the various panel discussions and the chatter on the conference floor and through the exhibition hall.
From the opening address and throughout the following two days, the event focused on the benefits derivatives can bring to end-users and the regulatory barriers that might prevent their continued use. This included the requirement to execute some trades on swap execution facilities (SEFs), as well as clearing and reporting requirements.
Many sessions referenced the recent ISDA survey of end-users on issues and trends in the OTC derivatives markets as evidence to suggest that whilst regulation has changed the market dynamic significantly, and has undoubtedly increased cost-of-trade, there remains a strong desire to utilize OTC derivatives as an effective way to manage risk. 86% of survey respondents defined them as very important or important to their risk management strategies. Crucially, more than three quarters expect to increase or maintain their current level of derivatives activity during the second quarter of 2014.
Market participants and academics highlighted the benefits of swap-based hedges, while corporate end users warned that new regulations were making it harder and costlier for them to manage their risks. While the over-riding sentiment was that regulation has improved market stability and had a positive effect on transparency, there continue to be concerns around the adverse or unintended consequences of the plethora of rule-making that has occurred since the financial crisis. According to the ISDA survey more end-users believe this new set of rules will have a negative rather than positive impact in three key areas: price, liquidity and ease of use.
The increasing costs could force some end-users to abandon hedging, leading to increasing exposures to previously hedged risks and hurting swap market liquidity. One panelist noted that increased regulatory and capital requirements could see some end users abandoning certain products due to cost which would force others to follow suit, resulting in a rapid downward spiral in the OTC markets.
Cooperation, clearing and CCPs
Unsurprisingly, the evolution of market infrastructures came under the spotlight, and while some discussions verged on the hyperbolic, they did reveal some very real concerns around what the future holds for derivatives in a post-EMIR world.
It was suggested that with the advent of central clearing, the cost of capital will fundamentally change the structure of banks, with one panelist commenting that the days of a “universal investment bank are over”. That evolution will naturally change the liquidity dynamics of the derivatives market and in particular affect the cost of the more bespoke OTC derivatives. Cost impacts may lead to market bifurcation and affect the cost of both highly liquid instruments and bespoke products.
Panel members urged European authorities to learn from the successful clearing roll-out in the US by phasing compliance and suggested that ESMA be given the power to postpone start dates. The staggered implementation of US clearing was crucial to its success and yet many firms did not begin responding to these regulations until just before the compliance deadlines. However ESMA currently has no power to grant no-action relief as the CFTC did, which it used to great effect to provide firms extra time to comply with certain obligations.
It’s here that recent experience could be a useful guide as the ‘big bang’ implementation of EMIR’s reporting rules caused some significant issues. As Harry Harrison of Barclays noted during one session: "I think if any lesson can really be learned, it's don't be late to the party. To get on-boarded and do proper systems testing takes weeks not days, so everybody needs to be up and ready.”
CCPs and the concentration of risk also came under consideration, in particular during a Keynote address by UniCredit’s head of corporate and investment banking, Jean Pierre Mustier. He expressed concern about the low capital levels at CCPs and suggested that users should provide unlimited contingent funding for CCPs. He offered an alternative course of action, suggesting that CCPs could be run akin to the DTCC as not for profit.
Concerns surrounding CCP capital levels were raised by the industry throughout the drafting process of the European rules. Given their importance to the integrity of the financial system, banks had called for CCPs to put up capital equivalent to 30% of the funds contributed by members into a default fund. That would have resulted in CCPs contributing more equity as the fund size increased, however those suggestions were rejected by ESMA, leaving clearing house capital requirements subject to a lower ratio. Given the projected timelines for EMIR, the rhetoric surrounding clearing and CCPs in Europe is likely to change by the time of next year’s AGM.
New derivatives taxonomy required
Another interesting narrative that ran throughout the conference concerned the language of the industry and its ability, or rather, inability to date to extol the ‘real world’ benefits they can bring.
ISDA acknowledged that in order to stem further attempts to regulate the market, changing the general public’s perception will be crucial. One academic speaking at the event, Ingo Pies, argued that the industry suffers from a chronic language problem, in which it mounts a defence littered with statistics, acronyms and phrases that mean little to the wider public. A new language is required to strip away the layers of ‘derivatives speak’ if this goal is to be achieved.
It will be interesting to see how ISDA and their assembled members pick up the mantle to educate the public and explain the real-world benefits of using OTC derivatives. As noted by multiple panelists, from banks and asset managers to corporates and pension industry associations, if OTC derivatives didn’t exist, the industry would need to invent them in order to function.
While progress is unlikely to happen overnight, with such a narrative running from the first keynote speech and throughout the conference, ISDA will need to show progress towards this aim by the time the industry reconvenes in Montreal for the 2015 AGM.
Jim Bennett is, vice president, business development at Sapient Global Markets