EQUITY DERIVATIVES STANDARDISATION A Critical Element in Curbing Systemic Risk Author: Nick Fry Director, Global Markets
TABLE OF CONTENTS Introduction 2 Standardisation and the Challenges for Equity Derivatives 3 An Industry Moving Toward Standardisation 5 The Challenges Ahead 6 Standardisation: A Step in the Right Direction 7
INTRODUCTION STANDARDISATION AND THE CHALLENGES FOR EQUITY DERIVATIVES ATION Standardisation is at the heart of the G20 declaration on financial reform of the OTC derivatives market and is driving the development of a host of industry initiatives. Standardisation is the pre-requisite to meaningful preand post-trade transparency within the OTC industry and is the primary enabler for automation and the facilitator for the use of clearing a key component of systemic risk reduction. In the drive for increased automation and greater efficiency, the OTC industry continues to target standardisation within two keys areas: Product standardisation, which involves commoditising the trade mechanics and legal terms of a particular OTC product across the industry to such an extent that it can be processed via electronic confirmation matching platforms and eventually via CCPs. Process standardisation, which involves the marketwide standardisation of aspects of the front-toback trade life cycle to facilitate transparency and eradicate systemic risk and market abuse. Examples include: - Increasing automation for trade execution, trade confirmation and settlement processing - Reducing/eliminating confirmation and settlement exceptions - Facilitating real-time reporting for regulatory purposes - Facilitating central counterparty clearing We reaffirm our commitment to trade all standardized OTC derivatives contracts on exchanges or electronic trading platforms, where appropriate, and clear through central counterparties (CCPs) by end-2012 at the latest. The G-20 Toronto Summit Declaration June 26 27, 2010 TECHNOLOGY 1 Standardising trade documentation to such an extent that it can be electronically matched via a vendor platform has been instrumental across the OTC market in enabling product standardisation and, in turn, increasing process efficiency and reducing associated risks. Using data from the world s largest investment banks, Markit published the G14 metrics at the end of 2010. They demonstrate how far behind the OTC equity derivatives market is with regard to the percentage of total trade confirmation volume that is electronically eligible versus credit and interest rate derivatives. The reasons for this include the legal model used, the type of business and technicalities which combine to somewhat amplify the gravity of the situation. For the past seven years, Master Confirmation Agreements (MCAs) have been produced to rectify issues around the 2002 ISDA Equity Derivatives Definitions, which prevented standardisation and electronic trade confirmation matching because they contained a high number of legal terms open to unilateral election. MCAs facilitate the electronic matching of equity derivatives by ensuring that these terms are agreed upon in advance by both parties, thus reducing the trade confirmations to around twenty confirmable fields specific to each trade. However, although there are now MCAs for many products and processing by electronic matching platforms is possible, the current MCA model has hindered the adoption of these standardised terms and electronic matching as much as it has helped. The reasons for this are threefold. First, as MCAs are executed bilaterally and the parties need an agreed upon MCA in place before using matching platforms with each other, there is a heavy reliance on getting these forms signed. Since the equity derivatives market has a greater number of smaller players than other asset classes, such as credit derivatives, it has been difficult for banks to find the time and resources to sign an MCA with each client, resulting in a significant missed opportunity percentage. Second, as MCAs are bilateral documents, banks will, depending on the type of counterparty they are Historically, the OTC equity derivatives market has lagged behind the credit and interest rate derivatives market in terms of both process and product standardisation. This paper outlines why this has been the case, discusses the steps the industry is taking to increase standardisation and presents the challenges that must be overcome before it can be achieved. 2 3
AN INDUSTRY MOVING TOWARD STANDARDISATION facing, insert additional provisions into the ISDA standard forms. This has slowed down the process considerably. Buy-side clients have become wary of executing MCAs because many do not match the ISDA-published version and, therefore, have to be rigorously reviewed and negotiated by legal counsel. Third, MCAs have grown organically on a regional basis. While this has the advantage of addressing specific regional concerns and trends, it has also multiplied the number of MCAs requiring execution for each product by a factor of at least four (e.g., Europe, North America, Asia (excluding Japan) and Japan). Therefore, the amount of effort required to execute all current MCAs for one product with a single counterparty is significantly increased. In addition, elements of the OTC equity derivatives business are very much client driven. As a result, many of the products are highly bespoke, and this custom-built nature does not lend itself naturally to a high level of standardisation. Despite these challenges, some of this volume has been standardised by banks on a per-client basis using their own document forms to the extent that some of the more vanilla products can even be processed via MarkitSERV. However, this clientspecific electronic volume is not currently included in the electronically eligible statistics since they are not based on industry standards despite the assertion that these transactions are as controlled as the products covered under ISDA-published documents. Another contributing factor to the low percentage of electronically eligible trades in equity derivatives lies in the fact that contracts for difference (CFDs) and portfolio swaps are treated legally as nonconfirmable events. Consequently, this volume is not included in the numbers quoted in widely published industry metrics (e.g., ISDA and Markit). These products constitute approximately 50% of the total trade volume in this asset class. As such, a large proportion of the vanilla business is excluded from benchmarking metrics and, therefore, the remaining non-electronically eligible trade population contains a sizable (and disproportionate) amount of structured business. Finally, the percentage of the overall derivatives volume that is exchange-traded via futures and listed options is far greater in equities than it is in credit and interest rate derivatives. To some extent, this explains the lower OTC trade volumes in equities versus the other asset classes. Therefore when measuring asset class performance, one must be aware that another factor contributing to the low electronically eligible population in OTC equity derivatives is that a large number of vanilla transactions are already traded on exchange via a central counterparty. As a result, the percentage of non-vanilla OTCs comprising the total OTC trade population is greater in equities than in credit or interest rate derivatives. Notwithstanding the above, it is clear that more needs to be done to increase standardisation and the market is taking progressive steps in that direction. The key delivery this year is the publication of the 2011 ISDA Equity Derivatives Definitions. These Definitions represent the single largest overhaul of OTC trade documentation methodology since definition booklets were first introduced. Their goal is to create a flexible documentation structure fit for the 21st century and built to facilitate electronic processing across the full range of equity derivative products. The new modular approach enables complex exotic combinations to be built within the existing structure and language of the Definitions, with taxonomy built on the basis that change and additions will occur to the terminology over time. As such, the terms should be adaptable enough to incorporate these enhancements within the existing framework something all sets of ISDA definitional booklets have struggled to cope with to date. The 2011 ISDA Equity Derivatives Definitions are the first terms to be published in a machinereadable format via FpML upon inception, having been specifically engineered to facilitate electronic processing for both confirmation matching and reporting purposes. The Definitions incorporate distinct sections. The core booklet (known as the Main Book) is a data dictionary of each defined term. Attached to it is the Appendix, which contains default information related to product terms and underlying assets, among other things. Default product elections will then be listed in a matrix contained in the Appendix. This will be updated periodically, allowing flexibility in the event of subsequent changes in direction, which have been evident during the past five years of MCA negotiation. Replacing the old MCA model and replicating the method which proved successful in credit derivatives, this approach addresses the current issue in which trades that are electronically eligible are still processed via paper as banks will not need to bilaterally agree to a MCA with each client. This is a time- and resourceintensive process given the amount of smaller players in this market and the fact that matrix terms are merely adhered to by parties on ISDA s website. Finally, there is the flexibility to agree to bilateral terms if desired via the Matrix Support Agreement, although the hope is that this will be the exception and not the rule. The other key focus area for the new set of Definitions is increasing the low percentage of electronically eligible trades via the standardisation of new products (e.g., accumulators).the Definitions cater for a variety of additional products and features not currently found in either the old 2002 Definitions or any subsequent MCAs. Therefore, the market should have the tools to increase this beyond the current mark. In addition to the 2011 Definitions, the equity derivatives market is currently looking at the overall target architecture, including all life cycle event processing. Central counterparty clearing is a long-term aim and discussions are ongoing as to how the model should develop in order to promote transparency and control, whilst also retaining the flexibility essential to maintain the dynamism of the asset class. 4 5
THE CHALLENGES AHEAD The challenges the industry faces in this asset class to further standardise trade documentation are numerous and vary according to business type. Vanilla (or flow) businesses are generally split between equity financing and volatility trading. The equity financing business is all about customer facilitation. Standardisation in that market is more difficult as clients typically want a tailored service (e.g., customised schedules, customised payouts, etc.), and one of the key challenges is for the industry to agree to a flexible but resilient product taxonomy that will meet the demands of both regulators and clients. The majority of the vanilla volatility business has already been standardised (e.g., options in established markets and variance swaps) with the remainder targets for commoditisation. The aim is that the 2011 ISDA Equity Derivatives Definitions will enable the remainder to be standardised. Before the full potential of the Definitions can be realised, major hurdles will need to be overcome. The process to adhere to and implement these Definitions must still be finalized. If the new terms will not be actively used until a matrix is in place for that product, as has been suggested, there will be pressure to agree to and implement these in a timely fashion so that the extensive legal negotiation has not gone to waste. Conversely, if the expectation is that participants can utilise the Definitions without a matrix using any of the menu items, then concerns arise as to how matching platforms, such as MarkitSERV, will cope with electronic versions of bespoke documentation. Effectively, these platforms will need to be able to potentially process confirmations with any electable term from the new Definitions, increasing the number of fields from the current average of twenty or so to over fifty. The business (i.e., trading) needs to be engaged in the process to agree upon default elections from the list of menu options, creating the matrix for each product. This is not always an easy task given the firm s focus on revenue generation and may delay agreement. The approach that has been taken thus far by the legal community is to look at all hypothetical situations and devise language to cover these eventualities in the interest of providing as much protection for their firms as possible. However, the proliferation of elections under the new definitions creates a headache for a market that is trying to agree upon default elections for these terms for each product matrix. The hope is that the bilateral Matrix Support Agreements will not be widely used; however, history tells us that participants do like to agree to bilateral terms. If there is a proliferation of bilateral terms being agreed upon under the new Definitions, this may well slow progress towards greater electronic processing. It will also test the new FpML-friendly structure, since the methodology for catering to bilateral terms has yet to be determined. The process, from agreement of each matrix to electronic eligibility, needs to be carefully managed. For a period of time, participants will be trading on the old 2002 terms, as well as the new Definitions, and this could cause considerable legal basis risk if it is not coordinated across the market. In addition, the impact of these terms goes beyond the OTC market since there will be a requirement internally within participants to update legal prospectuses for retail and securitised products to mirror the new Definitions and avoid any legal basis risk. All participants will have to complete their own internal analysis and determine how they are going to deliver this change within the required timeframes. The book of work is considerable and will impact the front-to-back trade life cycle from trade capture GUI enhancements to automated template management projects. Lastly, there is the matter of resourcing all this change, particularly with the amount of competition from other market initiatives (e.g., clearing, reporting). It is difficult to see how parties will not be constrained and, therefore, delays are to be expected. Within a structured business are many different types of trades that are often individually tailored to the specific needs of the client. The primary driver for many clients using equity derivatives is to hedge a specific risk or gain exposure to a particular opportunity. The customisation of the OTC product empowers them to realise this goal. Many key players believe that if these bespoke products were standardised too much, they may eliminate their value and, as a result, their standardisation may foster systemic risk rather than reduce it. In order for these transactions to survive, firms will need to stop negotiating additional bespoke language after trading and parties will have to agree upon templates for these products prior to trading. As the market discusses the long-term target operating model, the key challenge will be determining how to have a robust solution that promotes service choice but not at the cost of efficiency or control. The move towards central counterparty clearing will raise new issues, particularly around documentation. The current ISDA model will be amended and/or replaced with documentation that fits the new legal relationships in the post-clearing world. Trading relationship documentation should standardise, given the need for the CCP to enter into the same documentation with each of its clearing members. Standardisation of documentation on a per-ccp basis, and not across CCPs, will result in standardisation with increasingly unmanageable complexity, particularly when one considers the need for CCP interoperability. STANDARDISATION: A Step in the Right Direction The OTC equity derivatives market is unique in many respects. While, there are valid reasons for the low percentage of electronically eligible transactions, it is clear the market should strive to deliver greater standardisation across its products and processes. The 2011 Definitions will hopefully provide the platform the industry needs to rectify past problems, standardise new products and establish a sound framework for processing OTC equity derivatives well into the 21st century. The publication of these terms is the start of a long and potentially rocky road towards a more secure marketplace. 6 7
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