Paris, 9 September 2009 Response of the AFTI Association Française des Professionnels des Titres On European Commission consultation Possible initiatives to enhance the resilience of OTC Derivatives Markets Response to be sent by email: markt-g2@ec.europa.eu 1
1 PRESENTATION OF THE AFTI AFTI (Association Française des Professionnels des Titres) has more than 100 members and is the voice in France and EU of the Post-trade industry and back-office businesses: credit institutions, investment firms, market infrastructures, issuers. 2 COMMENTS PROMOTING FURTHER STANDARDISATION (1) What would be a valid reason not to use electronic means as a tool for contracts standardisation? AFTI fully supports initiatives that standardise electronic processes and lead to STP across the trade cycle. However, AFTI recognizes that there will be some exceptions where according to the types of trades/products and/or counterparties, building the requisite infrastructure would be costly, burdensome and inappropriate. Regarding products, we can distinguish three categories: The first one is the most standardized; to the point of being fungible. These products should be treated electronically without exception by all sophisticated users of derivatives such as financial institutions and hedge funds. An example of product falling in this category is the exchange of "look-alike" vanilla equity option. The second type of product is standardized to a lesser extent because they cater to the tailored needs of clients. For these products, there exists a commonly accepted and shared economic and legal description which is fully described in electronic format. The necessary step for these products is to have both the contract and the contractual "master" well defined. Those products include interest rate swaps whose dates must be customized to client needs or equity swaps on bespoke baskets of underliers. For these products, the efforts of ISDA to standardize the legal framework must be robustly promoted. Regulators could help in setting firm targets for the production of standardised ISDA contracts. The third class of products is not standard by definition since it covers bespoke solutions such as, for example, the hedging of an Equity Share Option Plan or the investment in an interest rate spread curve package to benefit from a market inefficiency. For these products standardization is anathema; it contradicts the underlying economic purpose of the trade. Regarding counterparties, AFTI supports initiatives that standardise electronic processes for institutional derivatives users, such as the inter-bank dealer community. However, for less frequent users of derivatives, such as Corporates and unsophisticated users, AFTI does not consider as mandatory the use of electronic means as a tool for contract standardisation. For example, Corporates in foreign exchange and interest markets do not do sufficient number of trades individually to warrant the investment required to support this technology. In general, all counterparties should invest in electronic technology if they have sufficient volumes of trades. FED commitments use for example a threshold of 20 trades per month in a product range such as interest rates to determine the sufficient level. 2
AFTI would like to stress that the majority of business (by volume) is already largely standardised as it is linked to type 1 products concluded between financial institutions which have the technological capacity. (2) Should contracts standardisation be measured by the level of process automation? What other indicators can be used? Contracts standardisation can be measured by the level of process automation. However, automation is not the sole measure of standardisation. There are two aspects that need to be distinguished: - the negotiation process of an OTC derivatives - the processing of events during the lifecycle of the contract. Contract standardisation is well advanced on all products to allow automation of trade negotiation and the level of automation can be indeed considered as a good measure for that part of the contract. However, there are also specific processes for handling special events that need to be put in place. The degree of standardization of terms and conditions used in confirmations is key. The life cycle of a contract is potentially affected by a series of events which lack proper standardization and common agreement. The best known example is the "credit event" which triggers the payment of CDS contracts. The credit events have been recently developed in procedures, which is a very useful step to reduce financial uncertainty pertaining to the treatment of OTC derivatives. The equivalent in the equity derivatives world is the "Market Disruption Event" and "Corporate Actions". However, even when the occurrence of a market disruption event is agreed upon, the impact of this event depends on the specific bilateral Master Agreement between the two parties involved in the transaction. When contracts are deemed "automated" because they are confirmed using a "short form" confirmation, they are still not standardized for the handling of these types of events. This point is particularly important when considering the transition of those contracts to a CCP. A transition can be organized only when the Master Agreements have converged and when the industry has agreed on a way to define and manage such events with a consensus applicable to all (equivalent to "market adjustments" for listed derivatives). The standardisation for those elements is more complex and takes generally at least a year of discussion by product to obtain full standardisation. This process is already ongoing through ISDA initiatives but is far from being finalised. This concern will affect mainly products and trades belonging to type 2. (3) Should non-standardised contracts face higher capital charges for operational risk? AFTI believes there is no need to impose higher capital charges for operational risk given that a robust regime already exists. Moreover, new capital requirements are already restrictive so reduced capital for use of CCPs or electronic confirmation would be a preferred option. Contracts that are standardized and automated and eventually cleared will generate less operational risk and therefore less capital. The internal models of banks rely on the actual operational risk events witnessed internally and in the industry at large. These models charge operationally inefficient processes and differentiate the institutions with more or less efficient setups. 3
(4) What other incentives toward standardisation could be used, especially for non-credit institutions? At this stage, AFTI estimates that the current incentives are sufficient and that there is no need to take additional regulatory measures for non-bank firms. STRENGTHENING BILATERAL COLLATERAL MANAGEMENT FOR NON-CCP ELIGIBLE OTC DERIVATIVES (5) How could the coverage of collateralised credit exposures be improved? The Basle II capital treatment already provides the right incentives as it differentiates between collateralized and non-collateralized credit exposures. It is therefore essential that the actual transposition and implementation of this regulation are adequate and consistent at worldwide level. (6) Are there markets where daily valuation, exchange of collateral and portfolio reconciliation cannot be the goal? Please justify. Daily valuation with exchange of collateral and portofolio reconciliation should be a target to reach as it allows to drastically reduce the risk exposure.nevertheless, some counterparties (like enterprises) are not equipped to run such reconciliations on a daily basis and it would be not appropriate to ask them to fill immediately this objective.. (7) How frequently should multilateral netting be used? There are various facilities now available in the rates and CDS markets to perform multi-lateral netting and thus trade compression. The major dealers via the FED letter have committed to participate in these cycles as much as possible. Most end users of significant size already reduce their portfolio size directly with the dealers and so they do not need to use the industry tools. The use of CCPs will also have a similar effect. (8) Should bilateral collateral management be left to self-regulatory initiatives or does it need to be incentivised by appropriate legislative instruments? Since the default of Lehman the need to carefully monitor credit exposures and the need to collateralize has been at the forefront of institutional thinking generally. For this reason, the need to legislate is low as the industry is pushing for bilateral collateral management with all clients and there is no need for additional legislative instruments. CENTRAL DATA REPOSITORIES (9) Are there market segments for which a central data repository is not necessary or desirable? AFTI considers that all market segments in the OTC derivatives world should benefit from a Central Data Repository (CDR). Ideally, to ensure full coverage for regulators and operational efficiency for users there should be one single global CDR for all products. In practice, we believe that the best solution is to have global CDRs by type of products as participants are specialised by type of products and some processes are already in place for given products. 4
Multiple repositories for the same product should be avoided. One size does not fit all principle should be kept in mind, emphasizing that not the same tool or the same functionalities should be used for all types of products. For example, it is most likely that Credit Derivatives that already have the Trade Information Warehouse (TIW) will populate with non standard products in that warehouse. The TIW already operates payment netting but this should not be necessarily required for all other products that will be entered in the repository. For foreign exchange, payment netting is done via CLS and should not be duplicated in TIW, while for rates the payment flows are not based on a quarterly roll like CDS so this functionality is of less benefit. Nevertheless, regulators should ensure that no products are left outside any CDR as the segmentation of the data between repositories potentially leaves gaps in the reporting system. The aim of the regulator should be to have ALL OTC contracts with a small number of characteristics in one place and declared frequently (daily reporting being the target for financial institutions). To respond to regulators request, we fully support that all relevant regulators and supervisors should have access to CDR regardless of their location, and that the CDR is responsible to provide them the adequate reporting. We also call for a balance between EU and US in terms of location of CDRs. Although AFTI strongly supports a single global repository per product, if no agreement is found and separate repositories are envisaged in the US and Europe for the same products, regulators should agree on the same scope and format of data to be provided by counterparts on both sides of the Atlantic in order to have in the end the equivalent of one global repository per product. (10) Which regulatory requirements should central data repositories be subject to? Regulators should push for a common standard in terms of data and confidentiality among the various data repositories that will be launched. Moreover, as mentioned in the previous answer, there should be at most one global repository per product so access for all appropriate regulators is permitted. Because of the sensitivity of the data collected by the repositories, the governance of these entities needs to be addressed. More specifically, the function of a Central Data Repositories (CDR) must be limited to maintaining the reported data and disclosing to parties who strictly need it, i.e. the parties to the derivative and to public authorities for cases to be defined. They should be regulated in particular for operational risk and business continuity due to their systemic importance. CDR should not be banks. Given their central role as an infrastructure, they should not be allowed to cumulate risk. The Cash Settlement of derivatives should not be done by the CDR and must always be done in Central Bank Money only. Currently, information related to specific contracts (whether trade information or position information) is undisclosed. The introduction of the CDR, can improve transparency but information should be disclosed only to regulators and supervisors. The level of granularity of the information provided should be dependant of their role and status. For instance, only the home supervisor of an institution should have access to the position of that institution. (11) What information should be disclosed to the public? AFTI estimates that the information housed in a trade repository is foremost for the regulators of the dealers. No additional information should be required for dissemination to the public at large; 5
industry aggregate data in the format of BIS and ISDA declaration, mentioning the nominal, product type, currency..., are already disclosed but it could be on a more frequent basis. MOVE CLEARING OF STANDARDIZED OTC DERIVATIVES TO CCPS (12) Do you agree that the eligibility of contracts should be left to CCPs? Which governance arrangements might be necessary for this decision to be left to the CCPs' risk committees? The responsibility for determining which types of contracts to accept must be left to CCPs. They should equip themselves with efficient risk management systems and appropriate systems of governance, in close collaboration with users and regulators. (13) What additional benefits should the CCP provide to secure a broader use of its services? The following benefits should be considered: Definition of market disruption events and corporate transactions in a unique fashion in Europe Tri party repo arrangements for the collateral posted at the CCP. Currently, the wider adoption of CCPs is slowed by the economic inefficiency of the collateral posted there. Ensuring better pricing and more operational efficiency would help incentivize market participants to move more of their transactions to CCPs. Collateral management and client protection (where positions are reflected in the CCP and collateral is protected via a security or trust structure); Trade compression through account segregation and trade portability for clients when a Clearing Member defaults (14) Is the zero-risk weighting a sufficiently effective incentive for using CCPs across different market segments? Zero-risk weighting could be a sufficient effective incentive for banks but reduced clearing costs and more effective cross-product netting would also be powerful incentives. Regarding Corporates and less frequent users, as mentioned earlier, they will not have the required infrastructure and technology but still CCP would require the matching of both counterparts to clear a trade. (15) Should additional requirements, such as appropriate account segregation, be introduced to apply the zero-risk weighting to indirect participants? We do not believe that account segregation at the CCP level should be mandatory. The level of protection of clients using CCP services is already well ensured as clients have the choice between multiple Global Clearing Members (GCMs) operating in competition. Indeed, GCMs cover the risk that CCPs take by clearing transactions only because certain qualified entities may be GCM. Through the GCM, less secured entities, Non Clearing Members (NCM) or indirect participants (IP), have access to the CCP. It is therefore of the utmost importance that the risk of default of a GCM is limited. This is done inter alia: by the GCM selecting its NCMs; duplication of margin requirements that the CCP addresses to the GCM, ideally even by duplication of the very algorithms that the CCP uses; proper and adapted risk management. 6
A GCM must retain control over its risk management and the margin it receives and deposits. Moreover, the currently used default mechanisms proved to be efficient (cf. LCH.Clearnet closing out the positions of Lehman Brothers) and thus, we believe that no additional risk reduction would result from the segregation of collateral at the level of the CCP. However, if account segregation at the CCP level is request by a client, GCMs could integrate this possibility in their offers, knowing that this feature will likely increase the cost for the client. It should then remain the client decision to balance counterparty risk and cost. GCM could offer different commercial arrangements to clients depending on their credit risk appetite and the fee levels they wish to pay. For example, client could choose between posting all their margin to a segregated account at the CCP, holding the net balance of margin in a segregated account with their GCM or no segregation at all. Each option will be offered at a different price as the infrastructure needed would differ for each. (16) Should bilateral clearing of CCP-eligible CDS be penalised and, if so, to what extent? Is there a need to extend regulatory incentives to clear through a CCP to other derivatives products? As mentioned in question 1, we believe that the vast majority of business (type 1 products between financial institutions) will naturally if not already be cleared by a CCP. We believe that incentives are the best approach to favour CCP clearing and Basel II already provides sufficient penalty. The goal should be to make the CCP effective and value added as described in Question 20. In particular, the capital charge for non CCP "clearing" would remain higher than the cost of going to the CCP. Decreasing the cost of the CCP should thus be the goal, rather than increasing the cost of non CCP "clearing". There is also no need to extend the regulatory incentives to other derivatives products than CDS. The transition to CCPs should occur naturally as they become more cost effective. Moreover, clearing already exists for example in the inter-dealer market for swaps and will extend to clients soon. Foreign exchange products will likely parallel cross currency rates products which are planned for later system releases. Further regulatory initiatives should not be needed at present. Not to forget that there are also real reasons why certain trades can not be cleared. It may relate to client types (see previous answers) but also to the external credit exposure the dealer has to the counterpart external to the CCP. (17) Under which conditions should exemptions be granted and by whom? For the reasons provided in the previous answers, we believe that bilateral clearing should remain possible and accordingly not penalised. CCP clearing will naturally develop if not already implemented for type 1 products traded between two financial institutions, which represent the majority of business. In that case, no exemptions are then necessary. Moreover, another reason is that clearing transactions may in certain circumstances add risk to the system. For example, a client may trade multiple products under a CSA with a dealer. Removing certain products from under the CSA into a CCP may add risk and therefore increases the cost for the client both under the CSA and the CCP. The impact of clearing only a portion of a client portfolio needs to be carefully considered. 7
From a dealer perspective, clearing standard products in a CCP but leaving non standard as bilateral may add risk to the bilateral process that is not sustainable. It would then be preferable in that case to rely solely on a bilateral process that could not be characterised as an exemption. (18) What is the minimum acceptable ratio of CCP cleared/eligible contract? What is the maximum acceptable number of non-eligible contracts? As explained in question 1, there can not be a simple ratio as CCP clearing will depend on the type of products and the type of counterparties to the trade. The goal should be to clear all eligible transactions but there will be exceptions. And as it takes two to clear a trade, the dealer may not have total control of the clearing percentage. (19) What statistics need to be provided to regulators to make sure they have all the information necessary to perform their duties? Statistics about number of cleared and not cleared trades per counterparty and total nominal involved for each type could be useful to assess the business activity and size of the market. This proposal does not preclude any other information that regulators would feel necessary to assess the level of risk. (20) How could European legislation help ensuring safety, soundness and a level playing field between CCPs? CCPs should be focused on 5 points: (1) Efficiency of the collateral management, (2) Competitiveness of trading costs associated with the CCP, (3) Interoperability with other CCPs and, (4) Solid risk management, (5) Ensure a common system of default rules and procedures for the various CCPs European legislation, if any, should be focused around these points. It is important that competition between CCP does not touch upon risk aspects of multilateral clearing (but only on services, costs, etc). Therefore, the risk aspects must be precisely regulated and harmonised throughout the EU. Concerning the status of CCPs, it is important that CCPs are credit institutions. Precise EU rules must determine the following risks Legal risk of CCP (e.g.: extension of the conflict of law rule of the SFD to CCPs); Operational risk (including operating hours, functioning of CCP and GCMs systems and supervision and control of internal procedures); Credit risk on participants (including the fact that participants must require their clients to pay margin on the same conditions as GCMs pay to the CCP); Principal risk; Financial risk of the CCP (through minimal capital requirements, margin requirements, default funds); Market risk through appropriate market exposure (mark-to-market); Custody risk of margin that a CCP deposits or invests. 8
Concerning liquidity risk it is important that in any case only central bank money may be used by the CCP for the cash settlement of premiums, margin and payment of derivatives. The CCP must have access to central bank liquidity. Concerning interoperability of CCPs clearing OTC derivatives, since their practical functioning is currently unknown, we think that their interoperability should not yet be envisaged. The CESR recommendations for Central Counterparties in the European Union (CESR/09-446) are a first step in the right direction although the recommendations are not precise enough on many important aspects, while others are not treated. Finally, consistency of regulation is key so regulators and law makers need to work together to ensure soundness in the system but more importantly consistency of legislation within Europe and across the US. INCREASE TRANSPARENCY OF PRICES, TRANSACTIONS AND POSITIONS (21) Should MiFID-type pre- and post-trade transparency rules be extended to non-equities products? Are there other means to ensure transparency? One of the goal of the MiFID is the protection of non-professional/retail investors. This investor type does not participate in the OTC derivatives markets, which are by nature wholesale markets. For this reason, we do not believe that MiFID transparency rules should be extended to non equities products. Transparency should rather be enhanced by the use of central data repositories, CCP information and is already available via electronic systems such as Bloomberg and Reuters. (22) How should transaction reporting of OTC derivatives to competent authorities be envisaged? Should it be extended to all contracts or to certain categories? If so, which ones? Are there other means to ensure that the competent authorities receive the relevant information on OTC derivatives transactions? Providing relevant information to the competent authorities is the role dedicated to central data repositories where all OTC transactions can be reported. Regulators should have access to theses repositories as to CCP information in order to be able to monitor efficiently market activity in terms of products, clients and the size of positions. The information will be sufficient to provide regulators an overview of all eligible OTC derivatives that are traded. Relying on these processes should be efficient and prevent from building expensive trade reporting capabilities that will not bring additional transparency but that will most likely slow the implementation of other initiatives. (23) How should position reporting of derivatives to competent authorities be envisaged? Should it be extended to all contracts or to certain categories? If so, which ones? Are there other means to ensure that the competent authorities receive the relevant information on the exposures to particular contracts? As developed in the previous answer, reporting to authorities will be ensured by central data repositories and all CCP available information. MOVE TRADING TO MORE PUBLIC TRADING VENUES 9
(24) How can further trade flow be channelled through transparent and efficient trading venues? What would be the appropriate level of transparency (price, transaction, position) for the different derivatives markets? Cost efficiencies concerning collateral, operational risk and capital are the main driver to channel trade flow to public trading venues. The transition occurs naturally as products become more cost effective. Competition between the dealers plus the electronic service providers will provide price transparency and the appropriate level of balance between electronic trading and traditional OTC trading venues. -ooooo- 10