OTC derivatives market concentration: Evidence from the ISDA Market Survey
A recent edition of ISDA Research Notes presented an analysis of concentration of notional amounts outstanding among the largest over-the-counter derivatives dealers. The analysis, which was based on data reported by ISDA Primary Member firms to the Mid-Year 2010 ISDA Market Survey, found that market concentration is low according to standard economic criteria. The following analysis will present data from previous versions of the ISDA Market Survey to show that market concentration has been low and has risen only mildly over the last five years.

There are two types of market concentration measures in common use. One measure is the concentration ratio, which is a cumulative market share of the largest competitors, usually of the largest four or eight firms. Under one criterion, a four-firm concentration ratio above 80 percent is evidence of a “tight oligopoly,” which facilitates collusion between the dominant firms; a ratio below 40 percent, in contrast, is evidence of “loose oligopoly,” in which effective collusion is effectively impossible.1

The other, more commonly used measure is the Herfindahl-Hirschman Index (HHI), which is the sum of squared percentage market shares of all firms in a market. According to the United States Department of Justice Merger Guidelines, a market is considered unconcentrated if its HHI is below 1,500, moderately concentrated if its HHI is between 1,500 and 2,500, and highly concentrated if its HHI is above 2,500.

In order to calculate either a concentration ratio or an HHI, one needs a measure of activity and a definition of the relevant market. The customary measure of OTC derivatives activity is notional amount outstanding. Despite the measurement problems associated with using notional amounts, there are no readily available alternative measures. With regard to the relevant market, the definition must recognize the cross-border nature of OTC derivatives activity, in which there are few barriers to competition in a given national market between domestic and foreign firms. As discussed separately in the sidebar “Domestic versus international market definitions,” the ISDA Market Survey covers international activity, so that total notional amount takes account of cross-border competition by global dealers.

Table 1 shows three measures of concentration - four-firm concentration ratios (CR4), eight-firm concentration ratios (CR8), and Herfindahl-Hirschman Indexes (HHI)—for the total notional amount of OTC interest rate, credit, and equity derivatives from June 2003 to June 2010.The table shows that concentration has been and remains well below the threshold level for unconcentrated markets, although it has trended gradually upward over time. Given the reduction in the ranks of major OTC derivatives dealers over the past decade, some increase in concentration is to be expected. But the data show that, measured by market share of the largest dealers, market concentration remains well below levels that could cause competitive concerns.

Contact: David Mengle -

Domestic versus international market definitions
An example of the problems associated with market definitions that are restricted to domestic activity is the Office of the Comptroller of the Currency report that the five largest US bank holding companies hold 95 percent of the notional amount outstanding at all US bank holding companies.

By not taking account of the cross-border nature of derivatives activity, this number overstates concentration in two ways. First, the numerator, which is notional amount outstanding at the five largest US dealers, includes US dealer transactions with both US and non-US counterparties. Second, the denominator, which is total notional amount at all US bank holding companies, excludes transactions between non-US dealers and US counterparties. Because the numerator is overstated and the denominator understated, the resulting ratio is significantly higher than a more inclusive measure.

The ISDA Market Survey, which is based on responses from derivatives dealers globally, provides such an inclusive measure. As reported in the ISDA Research Note cited in the text, as of mid-2010 the five largest US dealers held 37 percent of total global notional amount.

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Elections bring changes to key committees
The November 2 elections will bring some changes to the key committees with jurisdiction over the financial services and derivatives industry. Most notably, the Republican takeover of the House means that House Financial Services Chairman Frank (D-Mass.) will become the ranking member beginning in January and a Republican — most likely Rep. Bachus (R-Ala.) — will assume the Chairmanship. On the Senate side, Agriculture Committee Chairman Lincoln (D-Ark.) lost her re-election bid, while Sen. Bennet (D-Colo.), a member of both the Banking and Agriculture Committees, squeaked through in a tight race.

Contact: Mary Johannes -

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China: Guidelines introduce two types of credit derivatives to domestic market
On October 29, the National Association of Financial Markets Institutional Investors (NAFMII) published the Guidelines for a Pilot Credit Risk Mitigation Business in the Inter-bank Market (Guidelines). The Guidelines introduce two types of credit derivatives to China’s domestic market, Credit Risk Mitigation Agreements (CRMA) and Credit Risk Mitigation Warrants (CRMW).

A CRMA is very similar to a single-name CDS contract except that the protection bought under a CRMA is limited to a specific bond, loan or other debt instrument whereas the protection under CDS typically covers a wide range of obligations of the reference entity. A CRMW is a transferable instrument similar to a credit-linked note, however under a CRMW the issuer of the warrant is the protection seller and the warrant holders are protection buyers. A CRMW would be registered for trading in the Chinese inter-bank market.

The Guidelines categorize the participants of the credit derivatives market into three types, core dealers, dealers and non-dealers, according to the participant’s registered capital, relevant trading qualifications, risk control systems. Pursuant to the Guidelines, a core dealer may trade credit derivatives with all market participants, a dealer may trade with any other dealer according to its own needs and a non-dealer can only trade with a core dealer for hedging purposes. It is unclear from the Guidelines what the difference is between trades entered into according to its own needs and trades entered into for the purpose of hedging. As to the settlement method, the Guidelines state that parties may choose cash settlement, physical settlement or auction settlement. The auction settlement rules will be drafted separately by a NAFMII committee.

The Guidelines also include various rules about issuance of CRMW. For example, only dealers and core dealers which satisfy certain requirements can issue CRMW and each issuance will be subject to review by an expert committee established by NAFMII. There is a prohibition against self-referencing credit derivatives and certain restrictions on leverage. According to article 42 of the Guidelines, a dealer’s net position in respect of a reference obligation (regardless as a buyer or seller) cannot exceed 100% of the outstanding amount of that obligation; the total amount of credit protection a dealer can sell is capped at 500% of its net or registered capital; and the outstanding CRMW issued over a reference obligation is capped at 500% of the outstanding amount of that obligation. The Guidelines do not mandate central clearing of credit derivatives.

It remains unclear how China’s nascent credit derivatives market will evolve after the issuance of the Guidelines. Under revised derivatives rules which are currently being drafted by the banking regulator, CBRC, banks may only conduct credit derivatives transactions for client-driven trades. The net effect of this is to prohibit banks from keeping open CDS positions on their books and would appear to restrict the ability of banks to issue CRMW or make markets for either end clients or other dealers.

Contact: Keith Noyes - / Jing Gu -

India: Dispute Resolution mechanism under PSS Act
The Reserve Bank of India (RBI) has put in place a formal dispute resolution framework under the Payment and Settlement Systems Act (PSS Act) to resolve disputes between system participants, between system participants and the system provider, and between system providers. Disputes between system participants are to be resolved by a Panel for Resolution of Disputes (PRD) consisting of 5 members with a right of appeal to the Appellate Authority at the RBI. Disputes between system participants and the system provider, or between system providers, are to be referred to the RBI. The PRD and the RBI are required to dispose of the dispute within 15 working days.

ISDA submission on Foreign Investment in India
ISDA made a submission on October 8 to the Ministry of Finance (MOF) on the report by the MOF Working Group on Foreign Investment in India. ISDA supported the recommendations made by the working group, in particular that the current different avenues for portfolio investment (the Foreign Institutional Investor, Foreign Venture Capital Funds and Non-Resident Indian schemes) be rationalized into one plan, the Qualified Foreign Investor scheme.

Contact: Keith Noyes - / Jacqueline Low -

Hong Kong: HKMA deliberating on trade repositories; FSTB on CCPs
On October 26, ISDA met with the Hong Kong Monetary Authority (HKMA) and Hong Kong Interbank Clearing Limited. HKMA is considering whether Hong Kong needs a trade repository to give regulators easy access to OTC derivatives exposures across all asset classes. The priority would be setting up a repository for interest rate and foreign exchange derivatives, including FX swaps and forwards. ISDA explained the differences between repositories on Transaction Reporting and Position Reporting, and the use of FpML to facilitate electronic trade processing and trade reporting.

On October 26, ISDA and LCH Clearnet visited the Undersecretary of Financial Services and Treasury Bureau (FSTB) of the HK government. FSTB chairs the task force that is examining CCP options for Hong Kong. FSTB has stated that Hong Kong intends to align itself with G20 commitments with regard to CCPs and is open to various possible linkage models with international CCPs.

Contact: Keith Noyes - / Jeffrey Kan -

On October 20, ISDA visited the Reserve Bank of Australia (RBA), the Australian Securities & Investments Commission (ASIC) and the Australian Prudential Regulation Authority (APRA). ISDA provided an update on industry-wide portfolio compression exercises, including within clearing houses, and described the current progress on the drafting of OTC derivative regulations under the Dodd-Frank legislation. ISDA also described the likely proliferation of national champion CCPs in Asia to meet G20 commitments. Australian regulators are supportive of moving more OTC business to a cleared environment, but are concerned about the possible cost of having too many CCPs with mandatory participation requirements.

ISDA also reiterated the importance of legislation to remove any concerns that amendments to the Banking and Insurance Acts in 2008 had "trumped" the Payment Systems and Netting Act. ISDA explained that in the past couple of years, members have continued to treat close-out netting as valid against Australian banks, based on the expectation that clarifying legislation would be passed. The next review cycle will be at the end of the year when the Australian netting opinion update will be published. In the absence of any positive indication about clarifying legislation, some members may be constrained against changing their current position on close-out netting enforceability against Australian banks.

Contact: Jacqueline Low - / Keith Noyes -

Singapore: MAS response on investment products
On October 21, the Monetary Authority of Singapore (MAS) issued its response to the feedback it received on its January 2010 consultation paper on the regulatory regime for listed and unlisted investment products. MAS has clarified that the new regime will only apply where the products are sold to customers who are natural persons, excluding accredited, institutional and expert investors, high net worth individuals who are clients of private banks, and persons outside Singapore who are not, and are not dependent on, citizens or permanent residents of Singapore. Products that are prescribed by MAS as Excluded Investment Products (EIPs) are not subject to the new regime. Non- Excluded Investment Products (NEIPs) are subject to the new regime.

The new regime requires (a) financial advisers to put in place formal policies and procedures on the sale process for NEIPs; (b) the conduct of a Customer Knowledge Assessment (in the case of unlisted NEIPs) and Customer Account Review (in the case of listed NEIPs) prior to a sale to assess whether the customer has the relevant knowledge or experience to understand the risks and features of the product; (c) a Product Highlight Sheet complying with specific prescribed requirements to be lodged together with the Prospectus with effect from March 1, 2011; (d) representatives to pass additional examination modules and undergo training on a new product prior to sale; (e) ongoing disclosure requirements to be made for unlisted debentures; and (f) mandatory cooling-off period of 7 days for unlisted debentures with tenures longer than 3 months.

Contact: Jacqueline Low - / Keith Noyes -

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Waiver of mandatory clearing requirements for certain OTC derivatives would reduce risk
Conrad Voldstad ISDA CEOThe waiver of mandatory clearing requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act for certain OTC derivatives transactions would reduce risk in the financial system and help to achieve the risk-reduction goals of the Act. ISDA believes that the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) should grant such waivers in limited circumstances where bilateral and/or systemic risk would be reduced.

A swap that is required to be cleared may hedge the market and counterparty risk of a swap that is not able or required to be cleared. In such circumstances, managing both transactions on a bilateral basis reduces risk. The alternative -- clearing one swap through a central counterparty clearing facility (CCP) and managing the other on a bilateral basis -- increases risk between the two counterparties as well as in the CCP and the financial system more broadly. Waiving mandatory clearing for swaps in these specific circumstances would have the effect of reducing risk.

ISDA is committed to working with policymakers in the US to implement the provisions of the Dodd-Frank Act that pertain to OTC derivatives and to make our markets safer and more efficient. This specific provision of the Act has unintended consequences that could be damaging to the marketplace and the level of risk in the marketplace. We believe the CFTC and SEC should exercise flexibility in interpreting the Act through rulemaking to achieve its objectives.

The Association estimates that addressing swaptions, caps and floors would be the biggest reason for waivers. Over $40 trillion of these transactions are currently reported in the TriOptima Rates Repository, indicating that splitting the risk management of the trades would increase counterparty risk by a significant amount. These products should become eligible for clearing in the relatively near future and once they are, the waivers need not be granted for them. In addition, the Commissions could put in place reporting requirements and waiver limits to ensure the use of the waivers is not designed to avoid clearing.

An example
The simplest example of a paired trade where one leg is eligible for clearing and the other is not involves a swaption (an option on a swap). A swaption user often buys or sells options to take positions on volatility. In these cases, the swaption user also needs an interest rate swap to hedge the market risk inherent in the swaption. The interest rate swap used to hedge the swaption would be for a notional amount equal to a percentage of the swaption. The maturity and coupon would mirror those of the swap that underlies the swaption but the user would pay fixed on the swap if the user purchased a receiver option and would receive fixed on the swap if he purchased a payer option. If the swap is cleared and the swaption is executed bilaterally, the daily exchange of collateral between the two parties will be greater than what would be needed if the swap was kept with the swaption. In other words, counterparty risk is increased. Similarly, adding an extra swap to the CCP might increase its risk to one or both of the parties.

Conrad Voldstad
Chief Executive Officer

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Settlements and interest claims best practices
On October 26, ISDA published two best practice documents: The OTC Derivatives Settlements Best Practice (Settlements BP) and the OTC Derivatives Interest Compensation Claims Best Practice (Claims BP). The documents are the result of the collaborative efforts of firms represented on the ISDA Settlements Implementation Group (SIG), which takes direction from the ISDA Operations Steering Committee.

The Settlements BP provides cross-asset class guidance to the industry on common settlement risk management issues as identified by the SIG, covering both pre- and post-settlement issues. The Claims BP has been published to outline the guidelines for the submission and processing of interest claims arising from payments relating to transactions confirmed under the terms of the ISDA Master Agreement.

Contact: Catherine Brady -

Strategic restructuring event processing for credit
On October 1, The Warehouse Trust Company released Phase I of its new Strategic Restructuring Event Processing functionality, which will provide a central electronic solution for restructuring credit events. The new functionality provides a more robust operational approach, with increased automation, in regard to ISDA’s Small Bang Protocol and 2009 ISDA Credit Derivatives Determinations Committees, Auction Settlement and Restructuring Supplement. Key features include automated delivery of notices, enhanced transparency reporting and a new environment dedicated specifically to the processing of restructuring events. All functionality will be supported via the Trade Information Warehouse.

Contact: Nichole Framularo - / Andrew Kayiira -

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World Legal Forum discusses dispute resolution on complex transactions
On October 25, ISDA participated in the World Legal Forum’s (WLF) inaugural meeting on the establishment of an international dispute resolution facility for complex financial transactions, especially derivatives. Sixty experts from more than a dozen countries in Europe, North America, Middle East, Asia and Australia-New Zealand discussed the feasibility of this plan as well as the possible form of the proposed facility.

The suggestions range from establishing a global pool of experts to provide advice on complex financial transactions, to courts and arbitration worldwide, to the establishment of a tribunal to hear disputes between the various types of market participants. The WLF intends to make specific proposals to market participants in the first half of 2011.

Contact: Peter Werner -

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CESR survey of financial statements for IFRS filers
On October 26, the Committee of European Securities Regulators (CESR) issued a Statement about the financial instruments disclosures for IFRS filers. CESR analysed the 2008 and 2009 financial statements of 96 European listed banks and insurers to assess compliance with the disclosure requirements of IFRS 7. The results highlighted that improved compliance could enhance transparency. However, the report emphasized that there was no infringement requiring a public corrective note with regard to the 22 companies in the sample belonging to the FTSE Eurotop 100. Most of the corrective actions were concentrated on non-financial-institutions. In 2009, the analysis performed was conducted on the same sample of entities to maximize comparability and results showed a marked improvement for all companies.

Standards Boards request views on effective dates
On October 20, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) published documents requesting views on when new reporting standards should become effective. The new standards result from the effort to converge IFRS and US GAAP. With a number of major projects planned to be completed in 2011, the IASB and FASB want to schedule effective dates to manage the pace and cost of change for affected parties. ISDA will review these two consultations during the next European Accounting Committee meeting on November 10, and plans an appropriate response.

Contact: Antonio Corbi -

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Meeting with AIBIM on Tahawwut Master Agreement
At the end of October, ISDA met with the Association of Islamic Banks in Malaysia (AIBIM) to discuss the uptake of the ISDA/IIFM Tahawwut Master Agreement, and AIBIM’s input to the forthcoming draft confirmation templates for profit rate and currency swaps.

Contact: Peter Werner -

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Romania: ISDA addresses insolvency and business rescue amendments
ISDA has written to the National Bank of Romania as well as the Ministries of Justice and Public Finances regarding the need for legislative reform. Recent amendments to local insolvency proceedings as well as the introduction of certain business rescue procedures have had a considerable impact on the previously slightly clearer legal analysis for netting and collateral arrangements. In order to clarify the various issues, ISDA suggests using the forthcoming implementation of the EU Directive Amending the Settlement Finality and Collateral Directives for amending to the current legislation.

contact: Peter Werner -

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AFME, ISLA and ISDA publish joint briefing note on short selling
On October 15, ISDA along with the Association for Financial Markets in Europe (AFME) and the International Securities Lending Association (ISLA) published a joint briefing note on the EU Commission’s proposal for a regulation on short selling, which was published in September. It states that, while AFME, ISLA and ISDA support the move to establish a harmonized framework for short selling in the EU, they also believe that some of the specific proposals are disproportionate to the actual risks being addressed and will have negative consequences for the financial markets and its users.

In particular, the groups support the proposals for private disclosure of net short positions in shares to enable regulators to effectively monitor market activity. The associations underline, however, that with the reporting of net short positions in CDS it is important to take into account their role in proxy hedges. CDS that hedge an economic interest of a bank should not be considered uncovered.

Contact: Roger Cogan -

Joint response submitted to CEBS consultation
On October 1, ISDA along with the Association for Financial Markets in Europe (AFME) and British Bankers’ Association (BBA) submitted their joint response to the Committee of European Banking Supervisors’ (CEBS) Consultation Paper (CP40) on Guidelines to Article 122a of the Capital Requirements Directive. Article 122a creates new requirements for credit institutions when acting as an originator, sponsor or original lender, and when investing in securitizations.

In the response document, the associations expressed their appreciation of the flexible and practical approach that CEBS has taken in many areas. However, there is a high degree of concern among members that investors would be dissuaded from returning to the asset-backed securities markets as a result of the regulation’s potentially wide-ranging effects. AFME, BBA and ISDA highlighted areas that need increased flexibility, and urged CEBS to use as much leeway as inherent in the provision to address these matters.

Contact: David Murphy -

IOSCO publishes report on commodity futures markets
On November 2, IOSCO’s Task Force on Commodity Futures Markets published its November 2010 Report to the G-20. Among other items, the report provides recommendations on OTC commodity derivatives market transparency, price discovery in financial commodity markets and reduction of volatility in oil prices. The Task Force also commits to collaborating with the CMD and ISDA Commodities Steering Committee to work towards the utilization of a commodities trade repository. For more details please refer to the ISDA note on the topic.

Contact: Roger Cogan -

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EC reaches out to ISDA on netting project
The European Commission has assigned a team leader for the EU netting instrument project, and has reached out to ISDA to initiate discussions. The Commission intends to present an official work product by July 2011.

In this context, ISDA has already worked on the ISDA/European Financial Markets Lawyers Group proposal for a netting instrument in 2010, in parallel with the ISDA proposal to UNIDROIT for a global convention on close-out netting. Since making the first proposal in 2004, ISDA has also provided the Commission with legal analysis of non-netting EU member states as well as of differences in netting in various netting-friendly EU member states.

Contact: Peter Werner -

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Central Clearing discussed with FSA
On November 2, representatives from the Japan Credit CCP Working Group met with the Financial Services Agency (FSA) and shared the results of the survey on default management process in which 14 firms participated. The survey results showed mixed views, especially on compensation for central clearing losses caused by a default of a clearing member. The FSA commented that unlimited liability issues would not be resolved (or the unlimited liability requirement would not be excluded from the provision) unless a more specific loss compensation mechanism is presented that will not trigger systemic risk. The next steps will be discussed in the upcoming working group meeting.

Financial Instrument and Exchange Act exposure draft
The Financial Services Agency (FSA) published the exposure draft of the revised Cabinet Office Orders to the Financial Instrument and Exchange Act (FIEA) on October 15. The revisions detail rules on clearing houses for OTC derivatives, such as the financial or licensing requirements for inter-operation between CCPs. The revisions also cover regulations such as cold calling for OTC derivatives, hedge funds and new rules for property derivatives. ISDA plans to submit comments by the November 19 deadline.

Contact: Tomoko Morita -

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BNY Corporate Trustee Services Ltd v. Lehman Brothers Special Financing, Inc.
On November 1, ISDA filed an amicus brief with the Southern District of New York in connection with BNY’s appeal of the bankruptcy court decision in the matter of BNY Corporate Trustee Services Limited v. Lehman Brothers Special Financing, Inc. The ISDA brief addresses, among other things, the bankruptcy court’s construction of the Bankruptcy Code definition of swap agreement to mean only terms and conditions that are literally stated within the four corners of a swap agreement, rather than those that are incorporated by reference. Also addressed was the bankruptcy court’s conclusion that the protected right to terminate and liquidate a swap agreement under Section 560 does not include the right to enforce those contractual provisions by which the counterparty determines how much will actually be paid to whom in a final settlement of the terminated transactions.

Contact: Rosario Chiarenza –

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FpML Version 4.9, Second Working Draft ISDA published the second working draft for FpML Version 4.9 last week. This version is synchronized with Version 5.1. It contains support for the following:

  • the “Fixed Settlement” provision for the new CDS Matrix Recovery Lock Matrix Confirmation;
  • the Fair Value Share Swap European Interdealer;
  • the new Supplement 23 to the 2006 ISDA Definitions, which describes a new method for calculating the cash settlement amount for cross-currency swaps in the event of early termination.

The Recommendation is expected by year-end.

Contact: Karel Engelen -

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