ISDA concerned about Netting in OTC markets

ISDA a global association working to increase efficiency in OTC derivatives markets highlights the need for greater efficiency in Netting.

by Adil Siddiqui, Independent Financial Services professional.

ISDA a global association working to increase efficiency in OTC derivatives markets highlights the need for greater efficiency in Netting. Netting is a risk management tool used to reduce settlement and credit risk in OTC FX trading between counter-parties.

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Since the turn of the millennium regulators and industry bodies have been putting emphasis on netting as an active solution in dealing with the many risks off exchange products like FX, swaps and options pose. Foreign Exchange trading has continually been on the rise (BIS Survey) with increased volumes across the board. More participants means enhanced credit risk, the industry at large does not want a repeat of AIG’s FX prime brokerage division and new tools and solutions are strongly welcomed.

Traiana a post trade solutions provider has been working closely with interbank participants with its Netlink product, Netlink is a pre and post trade matching engine that gives brokers and banks greater transparency in checking orders and credit limits and increasing processing efficiency of orders.

ISDA’s core beliefs is in the power of close-out netting, which enables counterparties to reduce their credit risk exposure to each other. No single tool is more effective in delivering safe, efficient OTC derivative markets.

That’s why the Association is concerned about the effect of legislative provisions contained in the Dodd-Frank Act. These provisions could have serious adverse effects on the efficiency of netting. And less efficient derivative markets could have the effect of exacerbating system risk. No one has done the analysis of the extent to which the benefits of clearing are offset by less efficient bilateral netting. Where is netting inefficiency being introduced?

The following are a few examples, and ISDA suspects there are many more:

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DFA Section 716. The so-called “push-out” provision forces banks active across product areas to create a new company for equity, commodity and certain credit derivatives.

Clearinghouse proliferation. By all accounts, clearinghouses will abound—by product type and by geographic area. Clearing has huge potential for risk reduction through multilateral netting, but a proliferation of clearinghouses will make it harder to achieve that potential as transactions are moved from bilateral arrangements to a multitude of clearinghouses. ISDA is fully supportive of the greater use of clearinghouses, particularly when netting and compression can be aggressively pursued for cleared trades. But as they move into this new cleared world, they must be attuned not just to its promise, but to its limitations.

Breaking up hedged sets. A potentially risk increasing effect of trades moving to clearing is where the trade to be cleared provides a hedge for a trade that cannot be cleared. The bilateral trade that remains and the cleared trade that is moved to the clearing house are no longer netted under an ISDA Master Agreement.

Legacy trades vs. new trades. ISDA has generally taken the view that new regulations should only apply to new trades, and that legacy trades should reflect the terms and regulatory environment at the time the trade was done. But proposals regarding margin for un-cleared trades could create a dilemma: apply the new rules to all transactions (both existing and new) under one master or create two masters, one for the old, uncollateralized trades and one for the new, collateralized ones.

Then, there is the issue that has reared its head in issue after issue—the applicability of national rules to global participants in global markets. ISDA will address the many facets of this issue in an upcoming ‘Views’, but depending on how these issues are addressed, strong incentives may be created for booking business in a multitude of entities, a sure recipe for netting inefficiency.

How does ISDA work to maximize netting efficiency in this new world? Firstly, they remain focused on spreading the gospel of the benefits of netting, as evidenced by, and that provides the backbone of the ISDA Master Agreement. In this regard, they continue to urge European regulators to take up the cause of a netting directive. Second, they help regulators understand the exposures of derivatives market participants as they face a more fragmented and less efficient netting environment. And finally ISDA pursues ways, through documentation, regulation or otherwise, to facilitate netting across entities and platforms.

Netting will continue to be a key area the industry will address, the market is continuing to rise and there has been a shift towards more tickets with the ‘algo’ and ‘high frequency traders’. With the size of each transaction reducing there will be continued strain on settlement risk, credit risk and back office.

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