New York — One of 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 we suspect there are many more:

• 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 we move into this new cleared world, we 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 uncleared 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.
• Extraterritoriality. 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. We 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? First, we remain focused on spreading the gospel of the benefits of netting, as evidenced by legislation in ­­­38 jurisdictions, and the 55 opinions that provide the backbone of the ISDA Master Agreement (Members can see all those opinions by logging in to the ISDA Members Portal). In this regard, we continue to urge European regulators to take up the cause of a netting directive. Second, we help regulators understand the exposures of derivatives market participants as they face a more fragmented and less efficient netting environment. Third, we pursue ways, through documentation, regulation or otherwise, to facilitate netting across entities and platforms.

Netting remains a key part of ISDA’s mandate. We believe, in short, that if you undermine netting, you undermine the safety and efficiency of markets.

We encourage members to email us at derivatiViews@isda.org with their reactions to each View and to suggest new issues that might benefit from analysis and comment.