Measure Twice, Cut Once

ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

Last week, I was fortunate enough to be invited once again to testify before the House Committee on Agriculture’s Subcommittee on Commodity Exchanges, Energy, and Credit on the impact of new capital and margin rules. This came at an extremely opportune time. Margining requirements for non-cleared derivatives will be rolled out for the largest banks from September, while core elements of the Basel reforms are still evolving.

The problem is that no one has a clear idea of how these various rules will interact and what the ultimate impact will be.

As I said in my testimony, the old tailor’s saying holds true – measure twice, cut once. At the moment, we’re cutting our cloth in the dark.

What we do know for sure is that policy-makers such as the Group of 20 and the Financial Stability Board think further refinements to Basel III should be made without significantly increasing capital across the banking sector. Major improvements have already been made to ensure the financial system is more robust. As I pointed out last week, common equity capital at the largest eight US banks has more than doubled since 2008, while their stock of high-quality liquid assets has increased by approximately two thirds.

Unfortunately, recent studies by ISDA on those parts of the capital framework that have not been fully implemented show further increases in capital or funding requirements for banks, on top of current levels. This will increase costs for banks, and may negatively impact the liquidity of derivatives markets and the ability of banks to lend and provide crucial hedging products to corporate end users, pension funds and asset managers.

Given this, ISDA believes regulators should undertake a comprehensive impact assessment covering capital, liquidity and margin rules. Given continuing concerns about economic growth and job creation, legislators, supervisors and market participants need to understand the cumulative effect of the regulatory changes before they are fully implemented.

The margin rules are equally important – and we’re rapidly approaching the September effective date for the large, phase-one banks. ISDA has worked hard to prepare for implementation, by drawing up revised margin documentation that is compliant with collateral and segregation rules and developing a standard initial margin model called the ISDA SIMM.

But despite these efforts, challenges remain. For one thing, regulators need to send a clear signal that the ISDA SIMM is appropriate, giving banks the confidence to implement the model ahead of the start date.

For another, the Commodity Futures Trading Commission needs to finalise cross-border margin rules to ensure substituted compliance determinations can be made for overseas rules that achieve similar outcomes. These determinations need to be made quickly. Another three-year wait, as happened with the US/EU central counterparty equivalency standoff, will hobble cross-border trading and further contribute to the fragmentation of global derivatives markets.

I would just like to take this opportunity to thank the House Committee on Agriculture for its interest in these topics, and for holding this important hearing.

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