The Market Review of OTC Bilateral Collateralization Practices and the Isda Independent Amount Whitepaper were both developed by the Isda Collateral Steering Committee. The Managed Funds Association (MFA) and Securities Industry and Financial Markets Association (Sifma) both helped with the white paper.
Isda hopes the documents will shed light on how the OTC markets work, at a time when regulatory reforms are being prepared in the US, Europe and Asia.
OTC markets’ perceived opacity and susceptibility to systemic risk have been widely attacked since the financial crisis and even blamed for causing it. A strong current of regulatory and political opinion wants to push more OTC derivatives into centrally cleared or exchange-traded structures.
But some derivative specialists believe this is a kneejerk response that would be difficult to implement, and that it ignores the already considerable risk protection measures used in the OTC market.
“The motivation for putting the Market Review together crystallised last autumn,” said Julian Day, head of trading infrastructure at Isda in London. “Clearing was beginning to play a more important part in the business, affecting more asset classes, and we wanted to show what happens for the parts of portfolios that are still, and probably will remain, bilateral. It’s intended to be a declaratory and explanatory document that we can use with regulators, commentators and so on, to give assurance as to the robustness of the arrangements in place for collateralisation in the bilateral market.”
The Market Review surveys the bilateral collateralisation practices for OTC derivatives, aiming to enlighten readers about how the practice works – including some of the motivations, capabilities, limitations and typical practices of market participants.
The 57 page document makes 12 recommendations, the first of which is that, subject to relevant capital standards and supervisory oversight, OTC derivative players should be allowed to make their own decisions about what credit risk they assume and what mitigations they adopt.
Other recommendations deal with making netting and collateral provisions enforceable in all jurisdictions; trying to achieve a level regulatory playing field; and working towards standard provisions for third party custodian and tri-party collateral agent agreements.
Isda wants to continue the drive towards standardisation and electronic trading, and will nominate a working group to develop with clearing houses a “set of guiding principles and practical recommendations for common Straight Through Processing to be adopted by all entities that interact with the bilateral collateralisation process (including central clearing houses)”.
Isda warns participants to beware when using credit-based thresholds that can be triggered by credit rating downgrades.
The Independent Amount Whitepaper is more detailed and technical. It examines the risks from over- or under-collateralisation associated with ‘independent amounts’ under Isda Credit Support Annexes, and considers potential alternatives that might be developed.
“The Whitepaper deals with the arrangements around initial margin,” said Day. “It explains what the different holding structures are, and in the second part gives a whole array of different ways margin can be held.”
Jon Hay +44 207 779 8372 jhay@fow.com