In a letter dated June 2, 2009, to the Federal Reserve Bank of New York (the “NY Fed”) and eleven other regulators, a group of dealers and buy-side participants comprising the Operations Management Group (the “OMG”) set forth a renewed commitment to implement additional changes to improve risk management and market structure for OTC derivatives (the “OMG Letter”). The OMG Letter is consistent with many of the proposals set forth by the US Department of Treasury in a letter from Treasury Secretary Geithner dated May 13, 2009, to Congressional leaders and various international regulators (the “Geithner Letter.”) 1 The NY Fed, in a press release issued shortly after the OMG Letter’s publication, confirmed that it welcomed the OMG Letter and the expressed commitment to changes in market design and risk management for OTC derivatives.
The principal elements of the proposal in the OMG Letter are as follows:
- Recording of non-cleared OTC derivatives in trade repositories beginning with the recording of all credit derivatives (“CDS”) by July 17, 2009;
- Central clearing for an expanding list of “standardized” OTC derivatives, beginning with single-name CDS and Overnight Indexed Swaps in 2009;
- Buy-side access to OTC clearinghouses either through direct membership or indirect customer clearing by December 15, 2009;
- Enhanced OTC collateral management, emphasizing expanded inter-dealer portfolio reconciliation by June 30, 2009, and a new dispute resolution protocol targeted for September 30, 2009;
- Inclusive industry governance based on both buy and sell side participation; and
- Key operational improvements, including trade confirmation matching, electronic processing, standardization and the reduction of aged confirmations.
These elements are described in more detail below.
Establish Data Repositories for Non-cleared Transactions
The OMG Letter (consistent with the Geithner Letter) differentiates between “standardized” OTC derivatives capable of being cleared through a central counterparty (a “CCP”) and customized noncleared trades for which there is a commitment to record in a trade repository. In furtherance of this proposal, the members of the OMG have committed to record all of their non-cleared (i) CDS by July 17, 2009; (ii) interest rate derivatives (“IRS”) by December 31, 2009; and (iii) equity derivatives (“EDS”) by July 31, 2010.
Recording of transactions in a trade repository is designed to increase market transparency by providing access to relevant data to the “supervisory community,” as well as “appropriate access to relevant aggregate data” to the public. This is largely consistent with the Geithner Letter’s proposal for trade repositories to collect aggregate position and volume data on customized OTC derivatives and making such data available to the public, the Securities and Exchange Commission, the Commodity Futures Trading Commission and the particular counterparty’s primary regulator. The OMG Letter, however, makes no reference to particular regulators.
For CDS, the OMG Letter commits to use the Depository Trust & Clearing Corp. (“DTCC”) Trade Information Warehouse (the “Warehouse”) as the appropriate trade repository (DTCC has filed applications to establish Warehouse as The Warehouse Trust Company LLC and for membership in the Federal Reserve system). Whereas major dealers previously had committed to record “eligible” products in the Warehouse by November 30, 2009, the OMG Letter now commits to record all CDS trades by June 30, 2009. The OMG Letter does not identify repositories for IRS or EDS transactions.
Central Clearing for Standardized OTC Derivatives and Enable Buy-side Access to Clearing
According to the OMG Letter, despite published news reports of disagreements between dealers and the buy-side community, there is now a commitment to work with CCPs to provide buy-side participants access to CDS clearing (either through direct CCP membership or customer clearing) with segregation of customer initial margin and portability of customer transactions to occur no later than December 31, 2009. The legal and regulatory analysis necessary to achieve this goal is to be delivered to regulators by June 30, 2009. The OMG Letter states that if it is determined that regulatory and/or legislative changes are necessary to implement buy-side access, the OMG will seek the assistance of the regulators.
This is a significant development and is consistent with the overall tone of the OMG Letter, which emphasizes a strong commitment to increase collaboration between the dealer and buy-side communities.
In terms of the types of transactions which will be subject to central clearing, the OMG Letter expresses a commitment to clear “liquid single name CDS and Overnight Indexed Swaps” in 2009, with “tranche CDS” to be added in 2010. The OMG further commits to work with regulators to develop performance targets by August 31, 2009, for CCP usage and an expanded list of products.
In specifically naming product types, the OMG Letter has provided greater detail than the Geithner Letter’s reference to the clearing of “standardized” trades. By identifying trade types for which CCPs are capable of clearing, the OMG Letter’s approach is largely consistent with the Geithner Letter’s criteria for treating OTC derivatives as “standardized” if they are “accepted for clearing by one or more fully regulated CCPs.” Of course, identifying the criteria for determining “standardized” trades for which clearing is required is a critical issue in revamping the regulatory framework for OTC derivatives and will likely be subject to further debate.
Notwithstanding the commitment to provide buy-side access to CDS clearing, it is unclear whether one or all of the new clearinghouses will be used, specifically International Exchange Inc.’s ICE Trust or the CME Group Inc.’s CMDX.
Develop Robust Risk Management Policies
The development of more robust and efficient collateral management practices, including enhanced portfolio reconciliation and margin dispute resolution rules, is expected to reduce or eliminate perceived systemic risk. Through the regular reconciliation of trade portfolios the potential for margin disputes should be significantly reduced. In this spirit, the OMG Letter expands on previous dealer commitments for weekly reconciliations of inter-dealer portfolios in excess of 5,000 trades. By June 30, 2009, the new commitment is to reconcile inter-dealer portfolios in excess of 500 trades on a daily basis.
Furthermore, under the auspices of the International Swaps and Derivatives Association, Inc.’s (“ISDA”) Collateral Committee, the OMG Letter commits to publish a study by October 31, 2009, on the feasibility of extending regular portfolio reconciliations beyond the current OMG dealers to include smaller banks, buy-side participants and OTC derivatives end-users.
The dispute resolution process specified in the ISDA Credit Support Annex (“ISDA CSA”) has long been viewed with skepticism in terms of quickly and efficiently addressing disputes involving a large portfolio across a broad list of trade types. While possibly adequate to address the more limited market size and scope in existence at the time of its publication in 1994, both market participants and regulators have recognized the ISDA CSA’s cumbersome dispute resolution provisions as creating the potential for delay in the efficient movement of risk-reducing collateral.
By June 2, 2009, the OMG Letter commits to publish for comment a new mechanism for resolving disputes, focusing on more efficiently moving collateral associated with undisputed trades, identifying quickly the cause of a dispute, and providing more timely valuations - all leading to a prompt resolution. A second phase of the proposed approach, focusing on the use of third party vendors to provide valuations, is also committed for publication for comment by June 30, 2009. Additionally, the OMG has committed to publish by September 20, 2009, a market-wide dispute resolution protocol incorporating the new mechanism and thereby resolving a significant source of concern regarding the efficient movement of risk-reducing margin.
Include Buy-side Participation in the Relevant Derivative Market Committees
While historically dealers have largely driven industry initiatives related to OTC derivatives issues, over the past decade the buy-side has sought to become more involved in the development of the market’s infrastructure. The OMG Letter commits to an important systematic reform in the governance structure of the relevant industry committees to improve transparency, coordination and to facilitate a decision-making process that incorporates the views of both the dealers and buy-side participants.
Improve Operational Performance
The OMG Letter also identifies four operational areas for improvement: (i) matching trades on the applicable trade date; (ii) automation across asset classes; (iii) standardization of confirmation documentation; and (iv) continued reduction of trade confirmation backlogs. Many of these initiatives have been ongoing, but there is a renewed emphasis on expediting improvements in these operational areas. In this regard, the OMG Letter sets aggressive targets for a number of initiatives across the CDS, IRS and EDS markets. Such improvements are also consistent with the Geithner Letter’s goal to achieve greater transparency and reduce systemic risk.
Open Issues and Conclusion
Of the OMG Letter’s proposal, the overall commitment by both the buy and sell-sides to work together to resolve significant issues represents a dramatic development. This proposal reflects strong efforts by both the buy and sell-side communities to arrive at mutually acceptable compromises on a range of difficult issues, and such level of collaboration will be necessary to move forward on issues of this magnitude.
The objectives are largely consistent with those specified in the Geithner Letter, but the deadlines outlined in the OMG Letter underscore the amount of work to be done. The NY Fed’s positive response to the OMG Letter is encouraging, and it will be interesting to see how the Obama administration’s reported upcoming plans for an overhaul of regulation of the financial markets will mesh with the OMG’s approach.