Isda chair on twin threats facing OTC market

Capital a “sword of Damocles”, says Litvack; cleaner CSAs will fix valuation woes

Eric Litvack: Prudential reforms risk endangering capital markets

A sword, suspended over a throne by a single horse's hair: as legend has it, this is how the Greek tyrant Dionysius showed a courtier that life as a ruler was haunted by fragility and fear. Derivatives dealers know the feeling, says Eric Litvack, chairman of the International Swaps and Derivatives Association.

"Prudential reforms are a sword of Damocles hanging over the derivatives market and the capital markets in general," he says.

It's a doomy way to go into the association's thirty-first annual meeting – which starts on April 13 in Tokyo – but sums up the mood of the banks that until recently were the swaps market's sole intermediaries. A combination of higher capital and liquidity requirements is making that role more costly, and at some point, Litvack argues, the thread keeping the business alive might snap.

"Banks continue to have an important role to play in intermediation, particularly in the derivatives market. The fuel that enables a bank to perform that function is the capital and liquidity calibration. If you get that wrong, then you incite banks to allocate capital and other resources elsewhere. At the end of the day, very few banks are currently generating a return on equity that is commensurate with the cost of equity. Increasing the cost of capital against these activities is only going to act as a disincentive to allocate capital," says Litvack, who also serves as head of regulatory strategy for Societe Generale Corporate & Investment Banking.

I'm hearing the words; I would just like to see the actions line up with those words
Eric Litvack, International Swaps and Derivatives Association

It's a familiar argument, and prudential policy is a big focus for Isda's legion of working groups. The question is whether regulators buy it – some have argued that banks should simply pass increased costs to clients – and whether they are willing to act.

There are some encouraging signs for the industry. On March 31, speaking in his role as chairman of the Financial Stability Board (FSB), Mark Carney – the governor of the Bank of England – said "where there are material unintended consequences arising from the implementation of reforms, the FSB stands ready to make appropriate policy adjustments."

Litvack has heard similar pledges – about the need for capital stability, for example – but has yet to see any actions backing them up.

"That's the high-level message, and it's been communicated a number of times recently. It just doesn't seem to be feeding through in terms of what is coming out of the different working groups," he says.

As examples, he points to the Fundamental review of the trading book – which regulators estimate will produce a 40% weighted average increase in market risk capital – as well as plans to kill off the modelling of operational risk capital and to rein in credit risk capital models: "It's hard to see how any of those individually will do anything other than add capital into the system and how the sum of all those will not be a significant increase in capital requirements. So, I'm hearing the words; I would just like to see the actions line up with those words."

It could be, of course, that regulators want markets businesses at the banks to be smaller and more constrained, and are waiting to see what impact, if any, this has on other market participants.

For that reason, the sword of Damocles is a good metaphor; whether and when the horse's hair breaks is largely out of the industry's control. But there are other threats facing the market, over which Isda and its members have more power.

Simpler CSAs

End-users complain they increasingly face unexpected costs when trying to unwind a trade – often a result of differences in the accompanying legal documentation. Swaps valuation rests in part on the type of collateral posted by a counterparty, so the eligible collateral specified in a credit support annex (CSA) can have a big effect, as can any agreement about how to treat negative interest rates on the collateral in question.

If a hedge fund, for example, wanted to collapse two offsetting trades and leave its dealers facing each other, it might find that the change of counterparty for the banks would leave one of them worse off than if it continued facing the fund. That can produce exit costs running into the millions of dollars and trigger bitter disputes.

In most cases, collateral and negative rates agreements use templates issued by Isda, so should the association be directing more of its firepower here?

These problems have been discussed by Isda's board, Litvack says. He notes that the incoming bilateral margining regime – which will start to be phased in from September – will require CSA changes for all in-scope firms, creating an opportunity to standardise the agreements. Standardisation is something Isda encourages where there is no pressing need for non-standard terms, he adds.

Three years ago, the association went further, crafting a standard CSA that removed some of the scope for bilateral tailoring. Published with a fanfare, the new contract quickly found its first two signatories – Deutsche Bank and Goldman Sachs – but word in the industry is that no other firms followed suit.

People are going to recognise that keeping non-standard terms will potentially be more costly. Standardisation will come, but it will be a gradual process
Eric Litvack, International Swaps and Derivatives Association

Litvack says he does not know which firms signed the standard CSA, but notes the contract "may have been a little bit ahead of its time ... There were different incentives to sign or not for a wide range of actors, and the absence of a hard deadline and a hard mandate meant that while it would certainly add value for some to move, there was no snowball effect around it."

The same outcome can be achieved without a new contract, he argues: "Historically, most end-users have considered the specificities in their contracts were free of charge, and did not come with any hidden cost. Now, as standardisation becomes the way to drive residual cost out of the process, people are going to recognise that keeping non-standard terms will potentially be more costly. Standardisation will come, but it will be a gradual process."

In the meantime, does Litvack worry that a combination of capital, liquidity and valuation pressures could strangle the non-cleared swaps market?

"In some way it's my job to worry about it. There are a number of associations out there that speak for specific parts of the market, but Isda speaks for the entirety of the derivatives market – including the non-cleared end of the spectrum," he says.

"The real world we're addressing is made up of idiosyncratic risks. It's important that we are still able to provide an effective, efficient, safe market for the transfer of those idiosyncratic risks, because it oils the wheels of the economy; it oils the wheels of investment. If that part of the market disappears there will be potentially less investment, and potentially more fragility."