ISDA publishes new derivatives principles calling for changes to SEFs

O’Malia: more flexibility is needed on SEF models

The International Swaps and Derivatives Association has published a set of derivatives trading principles, as part of an effort to get regulators around the world to harmonise their efforts at derivatives market standardisation. The principles include a call for greater flexibility on US swap execution facilities.

ISDA’s paper, Path Forward for Centralized Execution of Swaps, accepts that the execution of standardised derivatives on an exchange or electronic trading platform was a key objective from the Group of 20 summit in 2009, and regulations have either been implemented or are being developed in several key jurisdictions. However, ISDA and its members are concerned about the potential for divergences in how these rules are applied in each jurisdiction, which could lead to market fragmentation, low trading liquidity, duplicative compliance requirements and increased risk.

ISDA research has shown that fragmentation of global liquidity pools has already emerged since the US swap execution facility rules came into force in October 2013. European dealers are opting to trade euro interest rate swaps with other European dealers rather than be subject to US rules. By December last year, 85% of euro IRS transactions were traded between European dealers, up from 71% in September 2013.

One of ISDA’s major concerns is that this market fragmentation will continue and broaden as US, European and other regulators fail to reconcile their rule sets. This could prompt difficult and intractable arguments about which rule set should prevail.

“ISDA believes it is critical that trade execution regimes work on a cross-border basis to ensure regulatory consistency across jurisdictions, proper oversight, transparency and continued competition,” said Scott O’Malia, chief executive at ISDA. “ISDA and its members believe that targeted regulatory corrections in the US can improve the utilisation of SEFs and enhance the likelihood of coordination with European transaction rules currently under development.”

The ISDA paper says that the trading liquidity of a derivatives contract (and consequently the regulatory obligations to which the contract is subject) should be determined by reference to specific objective criteria. The process should be based on ‘concrete, transparent and objective standards’ so that market participants have a clear understanding of when swaps will be required to move from the bilateral market to centralised trading venues.

ISDA also recommends that derivatives contracts that are subject to the trading obligation should be able to trade on a number of different types of centralised venues across borders, so that market participants are not subject to costly compliance obligations and regulatory arbitrage. Trading venues must offer ‘flexible execution mechanisms’ that take into account the trading liquidity and unique characteristics of a particular category of swap.

The Association is also not entirely happy with the US SEF rules, adding that changes need to be made to these rules to comply with ISDA’s principles if the market is to achieve a harmonised international regulatory regime. The necessary regulatory adjustments would include changing the process for making mandatory trade execution determinations to ensure it is based on objective criteria and supported by data, and to allow greater flexibility in swap execution mechanisms.