The fifth birthday of Dodd-Frank: ISDA's assessment

During the course of this week several articles have appraised and criticised the five years of implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). This post highlights the ISDA's assessment of the implementation of the Dodd-Frank Act, particularly the rules governing the derivatives market. 

Some of the key requirements and fundamental changes that have been implemented the derivatives market as a result of Dodd-Frank Act include clearing of standardized derivative products, the trading of mandatory products on regulated foreign exchanges or swap execution facilities, reporting of derivatives products to a swap data repository. The US  is in the final stage of implementing the margin for uncleared derivatives, and the implementation of tougher capital rules is on the way.

Some of the reported advances are:

1. In clearing there has been a tremendous success, the industry has readily adapted to a new clearing environment. Approximately the 75% of interest rate derivatives today, and 75% of CDS index daily notional was cleared on average in the first half of this year.

2. In the trading space roughly 75% of interest rate swaps and 59% of CDS index daily notional were traded in the first half of this year.

3. With regard to reporting, all swaps transactions involving a US person are required to be reported to a US trade repository according to the CFTC rules, that’s been going on for two years. The reporting rules give regulators the ability to drill down to the individual trade or counterparty level and, in theory, regulators should be able to aggregate this, in order to observe broader trends and concentrations in the market that might pose systemic risk.

4. In regard to the margin of uncleared products, there is a global margin framework that was proposed in September 2013. That is the good news because major jurisdictions have worked together to establish a consistent OTC margin framework. Both the US and Europe are in the final stages on implementing a final national margin requirements. 

5. The Basel Committee has also developed the capital rules in the international level. Reforms include higher and better quality capital, new liquidity requirements and leverage ratios. The Basel Committee has set up a tight schedule between 2013 and 2019 that means that some of the capital rules are in place today and some of them are still coming into place.

After the GFC, the US was the first mover while other jurisdictions moved in a different pace. Undoubtedly, that  posed some challenges, legislation was drawn up and not much time was given to coordination among supervisors. The differences in the content of different national rules are now beginning to emerge and see the results of that. The immediate effect is that rather to be subject to multiple and inconsistent requirements, derivatives users are increasingly choosing to trade with counterparties within its own jurisdiction.  The result is a fragmentation of liquidity along geographic lines. Therefore, greater harmonisation of the national rules is required, and more transparent process of determining the equivalence would be useful.

The Contribution of ISDA 

ISDA has a global footprint, and that why it has been attacking these issues kind of individually and establishing broader principles to help to solve the different challenges with the each of the rule making.

1) Reporting: Currently regulators are not able to see the global picture of the global risk exposures and possible concentrations due to the differences in reporting requirements in each jurisdiction and across borders. ISDA published principles for reporting that underline the path forward to resolve this issue. 

Regulators across the globe need to identify and agree the trade data they need to fulfil their supervisory responsibilities, and then to tackle the issue of consistent reporting requirements within and across jurisdictions. In the US, for example, there are differences between the CFTC implemented rules and CFTC proposed rules. In addition there are also differences between the US rules and European Rules. The industry would like to see all those rules harmonised in a global framework probably through IOSCO, which would be the best venue for that.

There are also challenges at the legislative level. The Dodd-Frank passed by the US congress includes a provision that requires SDR to indemnify other parties in receiving data, that has preventing the US swap trade repositories from sharing data with anybody other than the CFTC, and has slowed down the process of doing a critical analysis and sharing the data globally. The industry is in a key position to work with regulators to develop and adopt standard products and transaction identifiers as well as clear reporting formats. ISDA has played leading role in this area by creating unique identifying services to give universal market identifiers to market participants.

2) In the Trade execution space ISDA has also played a role looking into the future. It has identified some of the problems that will occur with the differences between the US and the European trading rules to be implemented in early 2017, in addition to future rule making that might be come out of Asia. ISDA has targeted some of the US rules and has helped to harmonise with other jurisdictions rules to have a better cross-border trading. 

For instance, ISDA argues that there is a need to allow more flexible execution rules. The CFTC is taking a very restrictive approach in comparison to the interpretation of the European regulators. Particularly, for the imposition of mandatory trading requirements, ISDA advises that the CFTC should conduct a public consultation where members of the industry can have a voice.

3) Clearing: the main issue is that the European Regulators have not recognized the equivalence of US CCPs, and that fractures liquidity. CCPs have become systemically important and more work is needed to ensure that they are resilient. Moreover the attention should be on increasing transparency in the market, working on margin methodologies, and establishing minimum standards for stress tests. Regulators have done phenomenal works in terms of harmonising the global standards around CCPs but more work can be done. 

ISDA is tackling the issue of recovery of Central Counterparts CCPs, it is focused on making them resilient, robust, capitalised and protected entities, rather than resolvable institutions.  ISDA has published principles on the recovery of CCPs including some ideas around stress testing and transparency in the margin methodology. 

4) In regard to margin ISDA appreciates the efforts by regulators to harmonise these rules in a global basis and the recognition that the more time is needed to implement this effort by extending the compliance date to September 2016 from December 2015. The margin requirement will involve substantial efforts to all the documentation, technology and best practices. 

ISDA has been leading the industry implementation effort for example through the development of the Standard Initial Margin Model, which is a common calculation for computing initial margin requirements for all market participants, this will reduce the potential for disputes. However, in order to progress in that effort the industry needs to know the final rules of initial margin calculation. 

Despite the regulators work to harmonise these rules, there are some differences. For example a proposal from US prudential regulators to subject transactions between affiliates in financial groups to additional margin requirements, is putting the US financial institutions in a competitive disadvantage internationally.

5) With regard to capital a lot of work has been done to implement the capital rules, this should be globally consistent to prevent financial and non-financial institutions being put in a competitive disadvantage. 

There are some differences in the approach of national prudential regulators. ISDA calls for a coherent regulation that is appropriate for the risk of the given activity. It recognises the difficulties faced by regulators who are implementing all these rules at the same time, and trying to understand the ramifications of them. These rules need to be consistent,  work together and operate across both cleared and uncleared markets.  The interplay between the various regulatory components should be comprehensively assessed to ensure that the cumulative impact is fully understood, to avoid excessively high financial costs for borrowers and increasing the cost for end users. At the end of the expectation is to ensure that these markets are viable, that people can continue to use them in a very transparent and open way, and prudently manage their risk. If these rules are too expensive people will not hedge their risk, will not utilise these services and end up holding more risk in their balance sheet.

The market has been adjusting to the new regulatory framework and many of these important technologies and new service providers swap trade repositories, swap dealers, major swap participants have been in limbo for the entire time as to what the standard is.


ISDA

DerivatiViews: Dodd-Frank: The Five-Year Appraisal. July 22, 2015

Dodd-Frank Five Years On: Significant Progress and Outstanding Challenges