Yesterday, key over-the-counter (OTC) derivatives market participants and industry associations, including the International Swaps and Derivatives Association, Inc. (ISDA), the Managed Funds Association and the Asset Management Group of the Securities Industry and Financial Markets Association , in an effort to "significantly reduce systemic risk and increase transparency,” submitted a letter to the Federal Reserve Bank of New York (FRBNY) and other banking regulators. The letter addresses the issues discussed at a meeting held April 1, 2009, between key stakeholders in the OTC derivatives market and regulators, and “continues supervisory efforts to reduce systemic risks in the OTC derivatives market.”

The letter issued today outlines several additional commitments on the part of its signatories, which include representatives of both the sell side and the buy side, regarding “changes in the market design and risk management for over-the-counter (OTC) derivatives.” Since 2005, the FRBNY has worked in conjunction OTC market participants to formulate industry standards designed to reduce inherent market risks. This work has been memorialized in a series of letters containing commitments by industry participants. However, the financial crisis has intensified the need for reform in the OTC derivatives market. William C. Dudley, President of the FRBNY, noted that “the OTC derivatives market has been exposed as a source of excessive risk. Achieving these commitments is an important step toward managing that risk, making the financial system more resilient and robust."

The letter's main objectives “include expanding use of central counterparties, strengthening risk management and operations, significantly improving transparency and ensuring strong coordination within the regulatory community.” “Key elements of the letter include establishing, for the first time, deadlines for recording all credit, interest rate and equity derivatives transactions in trade repositories and expanding credit default swap (CDS) central clearing to buy-side firms.” Commitments supporting the letter’s objectives include the following:

  • Reporting of all OTC derivatives transactions in centralized repositories. In efforts to “further increase market transparency” and “improve the ability of regulators to monitor the OTC derivatives market” the industry has “committed to record all of their credit derivatives trades by mid-July and to establish centralized reporting infrastructures for interest rate and equity derivatives.”
  • Expanding CDS central clearing by year end. The signatories noted that a “key regulatory priority is to extend the risk reduction benefits of CDS Central Counterparties (CCPs) to all market participants.” To meet this objective, dealer clearinghouse participants will “provide their clients with access to any viable CDS CCP solutions” no later than December 15, 2009.
  • Expanding customer access to CDS central clearing solutions. Market participants have made commitments to “set near-term targets to expand central clearing support for credit and interest rate derivative products,” which will increase “the credit risk reduction and operational efficiency benefits provided through use of prudently managed, financially strong and regulated CCPs” for standardized OTC derivatives instruments.
  • Enhancing counterparty risk management. By June 30, 2009, major dealers have made commitments to “implement daily reconciliation of portfolios, a requisite practice for robust counterparty credit risk management,” and by September 30, 2009, market participants “will publish a standard mechanism for timely and fair resolution of valuation disputes.”
  • Improving industry governance. The industry will adopt measures to “enhance its newly-established governance structure to ensure that a broad range of market participants will be included in open, transparent decision-making processes that fairly balance the interests of dealers and their customers.”
  • Maintaining operational performance improvements. Market participants have specifically made commitments "to improve operations in four key areas: matching trades on trade date, increased automation, increased standardization and continued reduction of trade confirmation backlogs.”

ISDA is working to create a more “inclusive industry governance structure for the derivatives post-trade space, comprising an array of business-led Steering Committees and more tactical implementation groups.” Robert Pickel, Executive Director and Chief Officer of ISDA stated that, “[a]s our letter demonstrates, ISDA and the industry remain committed to increasing operational efficiency and reducing the sources of risk in the privately negotiated derivatives business.” He further stated that collectively, ISDA and the industry “have made substantial progress in a short period of time and intend to maintain this strong positive momentum as we move forward.”

In a press release regarding the industry letter, the FRBNY noted that it would "continue to work with domestic and international banking supervisors to monitor market progress on these objectives and encourage rapid action to improve the OTC derivatives infrastructure further.”