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.

The checklist of post-crisis reforms now has neat ticks alongside each item. Clearing of standardized derivatives – tick. Reporting, trading on regulated venues where appropriate, margin requirements for non-cleared derivatives – tick, tick, tick. Revised capital rules – tick. With these requirements in place, our focus is now on two key issues: making sure the entire rule set is appropriate and reflects risk, and we achieve a globally convergent regulatory framework.

When it comes to the capital rules, the rubber is really about to hit the road. The Basel Committee on Banking Supervision published its final Basel III package in December 2017, and it now falls to national authorities to implement those rules.

The question is whether those national regulations will be consistent, appropriate and risk sensitive – something we’ll be discussing with a group of high-level European Union (EU) and US regulators at an event in Brussels today. Dialogue like this is important. When it comes to the global capital framework, coordination, cooperation and alignment are paramount. Divergence on the core components of the capital rules would create significant hurdles for internationally active firms, reducing the efficiency of markets and increasing compliance costs. Those costs would likely be passed onto end users – and that’s in no one’s interests.

National authorities are currently at different stages of implementation. In the EU, the European Commission (EC) first proposed its revised capital rules back in November 2016 – about a year before the final Basel agreement – and the Council of the European Union and the European Parliament have recently agreed their respective texts. In some areas, the EU package takes a more risk appropriate line than the Basel measures.

For example, the EU recognizes the exposure-reducing effect of client initial margin within the leverage ratio, which will make a big difference to the economic viability of client clearing businesses. The US Treasury also recommended taking a similar approach in its first report on financial regulation last year. This stands in contrast to the approach taken by the Basel Committee, which has only agreed to monitor the impact of the leverage ratio on client clearing for two years.

Elsewhere, the EU package sets the bar on the net stable funding ratio. The council and the European Parliament have both called for a 5% add-on for gross derivatives liabilities in their negotiating positions. This follows a Basel announcement last October that gave national regulators the discretion to set the add-on at between 5% and 20%.

A 20% add-on would have had an extremely punitive impact on derivatives, so we welcome that the EU has recognized the original calibration was overly restrictive. We hope other regulators will also adopt this approach to ensure appropriateness and consistency.

While the Basel III package is complete, the final shape of the Fundamental Review of the Trading Book (FRTB) is more uncertain after the Basel Committee earlier this year launched a consultation on certain technical elements, including the P&L attribution test, the treatment of non-modellable risk factors and the calibration of the sensitivity based approach.

These details really matter. The market risk framework as it stood would have hit bank intermediation activities hard, restricting their ability to provide the financing and hedging services that are so important to a vibrant economy. We just submitted our response to this consultation, which is available here.

Given the fact the final FRTB rules probably won’t emerge until the end of the year, there is a possibility that new legislation will be required at the EU level to incorporate those changes. Both the council and the parliament have suggested that the EC should issue a new legislative proposal by the end of June 2020. But with the European Parliament elections next year, and a new commission to bed down, there’s a lot to do by the FRTB start date of January 2022.

In the US, meanwhile, we are just beginning to understand how their rules will be implemented. In a report published last year, the US Treasury recommended that the FRTB should be delayed until it is appropriately calibrated. It’s not yet clear whether the changes proposed in the current Basel consultation will deliver an appropriately calibrated FRTB.

On all these issues, our view at ISDA is very clear: we believe the capital framework should be appropriate, risk sensitive and – importantly – consistent. We’ll look to achieve that by continuing to feed into consultations at both the Basel and national levels, and by providing industry impact analysis to regulators. Getting this right is important. A robust but appropriate capital framework will further improve the resiliency of the financial system, while continuing to ensure it functions efficiently.



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