It’s All About the Risk

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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.

If you want proof that big changes have occurred in the derivatives market, look no further than our regular SwapsInfo trading statistics. The latest figures show that 88% of interest rate derivatives trading volume reported to US swap data repositories was cleared in 2018. Of course, this comprehensive shift to clearing means it is imperative that central counterparties (CCPs) conform to the very highest standards of risk management – and this has become all too clear following the recent member default at Nasdaq Europe.

That default ended up eating into the CCP’s mutualized resources, spreading losses to other members – the second such event in five years following another member default at Korea Exchange in 2013. This has prompted industry participants – members, clients and CCPs – to take a long, hard look at CCP risk management practices, and to ask what needs to be done to prevent this happening for anything other than an extreme stress event in future.

Now, it’s important to stress that we at ISDA and our members support clearing. For those products suitable to be cleared, it’s an incredibly effective means of mitigating counterparty credit risk. But we also recognize there has been too much divergence in CCP risk management practices across the globe, based in part on regulatory differences, but also on how the Principles for Financial Market Infrastructures have been interpreted and implemented.

That’s why ISDA and its members have published a set of best practice recommendations, aimed at ensuring greater consistency in risk practices at CCPs.

Central to these recommendations is the principle that CCP risk management decisions should be based on the risk profile of the product, rather than on whether it is an exchange-traded or over-the-counter (OTC) derivative.

There has been an assumption that listed products are always more liquid and therefore easier to close out than OTC products, which has shaped the regulatory treatment of these products. While many CCPs already go beyond regulatory minimums where warranted by an analysis of the risk, the fact that both recent clearing member defaults to have hit mutualized resources have occurred in the listed segment emphasizes the importance of this risk-based approach.

Other best practice recommendations include ensuring CCPs have risk controls and margin requirements that adapt to concentration, liquidity, member credit quality and wrong-way risk. CCPs should also have effective and transparent default management processes and robust membership criteria. Importantly, the products cleared by a CCP must be sufficiently standardized and liquid – it must be recognized that not every product can be cleared.

The derivatives industry and regulators can be very proud of the progress that has been made in shifting a large proportion of the derivatives market to central clearing. It’s critical that risk management practices keep pace. We believe consistent application of these recommendations is a big step in that direction.

We encourage regulators to give this report a careful review, and to consult with market participants on maintaining high standards for CCP risk management. ISDA and its members are ready to engage.

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