Industry associations advise on post-trade risk reduction services
10 April 2018 London
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The International Securities Lending Association (ISLA), The International Swaps and Derivatives Association (ISDA), the European Banking Federation (EBF) and the International Capital Market Association (ICMA) have published a joint whitepaper on the benefits of post-trade risk reduction services as a crucial risk management tool.
In the paper, ISDA, the EBF, ICMA and ISLA recommend that European Market Infrastructure Regulation (EMIR) be amended as part of the Regulatory Fitness and Performance Program, to exempt transactions resulting from post-trade risk reduction services from the clearing obligation.
It said an alternative of this could be to empower the European Securities and Markets Authority (ESMA) to be able to exempt such transactions. In the white paper, associations gave recommendations on conditions for satisfying any exemption.
The associations stated that post-trade risk reduction services should be market risk neutral, in that they are designed to not change the directional market risk of the portfolios concerned, but rather reduce counterparty, operational and systemic risk in respect of existing derivatives transactions.
The white paper also said that the risk reduction services should be non-price forming. It said: “While they may involve a new legal transaction (rather than a trading transaction) in order to achieve the identified risk reduction result, participants are not able to post bids or offers, no price negotiation takes place and market risk neutrality means transactions are recorded away from market prices on stale curves.”
The associations also commented that risk reduction services should address second order portfolio risks.
It stated: “They do not offer a vehicle for taking market positions or enter into trading transactions. Their purpose is the reduction of operational, counterparty and systemic risk.”
Another recommendation was that, in terms of single multilateral compound transactions, the risk reduction cycles are binding on an all or nothing basis across all cycle participants.
ISLA said: “Post-trade risk reduction services like compression and counterparty rebalancing play an increasingly important role in reducing risks in derivatives markets.”
It added: “Compression, for example, results in offsetting trades between multiple parties being torn up, which reduces the size of gross derivatives exposures, in turn reducing systemic risk.”
These risk-mitigating benefits are recognised in the EU under the revised Markets in Financial Instruments Directive as well as the second Markets in Financial Instruments Directive and regulation, which exempt post-trade risk reduction administrative transactions from the trading obligation.
However, the associations also noted that there is “currently no exemption from the clearing obligation in the EU for these transactions”.
All associated agreed that “failure to recognise these strictly non-trading and market risk neutral administrative transactions within EMIR’s regulatory framework limits systemic risk reduction in derivatives markets”.
Roger Cogan, head of European public policy at ISDA, said: “Post-trade risk reduction has become an essential risk-management tool for the derivatives market, resulting in hundreds of trillions of euros in derivatives risks being removed.”
Mark Hutchings, COO at ISLA, commented: “Collateral in the form of margin is an essential risk management tool, but rather than over rely on this mechanism, it makes sense to better facilitate post-trade risk reduction and so reduce aggregate exposure levels.”
He added: “Recognising the risk reduction benefits of compression—for example, reducing counterparty risk and therefore systemic risk—is critical when considering amendments to EMIR.”
“For securities lending, post-trade risk reduction like compression will bring with it efficiencies such as less collateral being called, which will ultimately improve collateral liquidity and reduce collateral costs.”
In the paper, ISDA, the EBF, ICMA and ISLA recommend that European Market Infrastructure Regulation (EMIR) be amended as part of the Regulatory Fitness and Performance Program, to exempt transactions resulting from post-trade risk reduction services from the clearing obligation.
It said an alternative of this could be to empower the European Securities and Markets Authority (ESMA) to be able to exempt such transactions. In the white paper, associations gave recommendations on conditions for satisfying any exemption.
The associations stated that post-trade risk reduction services should be market risk neutral, in that they are designed to not change the directional market risk of the portfolios concerned, but rather reduce counterparty, operational and systemic risk in respect of existing derivatives transactions.
The white paper also said that the risk reduction services should be non-price forming. It said: “While they may involve a new legal transaction (rather than a trading transaction) in order to achieve the identified risk reduction result, participants are not able to post bids or offers, no price negotiation takes place and market risk neutrality means transactions are recorded away from market prices on stale curves.”
The associations also commented that risk reduction services should address second order portfolio risks.
It stated: “They do not offer a vehicle for taking market positions or enter into trading transactions. Their purpose is the reduction of operational, counterparty and systemic risk.”
Another recommendation was that, in terms of single multilateral compound transactions, the risk reduction cycles are binding on an all or nothing basis across all cycle participants.
ISLA said: “Post-trade risk reduction services like compression and counterparty rebalancing play an increasingly important role in reducing risks in derivatives markets.”
It added: “Compression, for example, results in offsetting trades between multiple parties being torn up, which reduces the size of gross derivatives exposures, in turn reducing systemic risk.”
These risk-mitigating benefits are recognised in the EU under the revised Markets in Financial Instruments Directive as well as the second Markets in Financial Instruments Directive and regulation, which exempt post-trade risk reduction administrative transactions from the trading obligation.
However, the associations also noted that there is “currently no exemption from the clearing obligation in the EU for these transactions”.
All associated agreed that “failure to recognise these strictly non-trading and market risk neutral administrative transactions within EMIR’s regulatory framework limits systemic risk reduction in derivatives markets”.
Roger Cogan, head of European public policy at ISDA, said: “Post-trade risk reduction has become an essential risk-management tool for the derivatives market, resulting in hundreds of trillions of euros in derivatives risks being removed.”
Mark Hutchings, COO at ISLA, commented: “Collateral in the form of margin is an essential risk management tool, but rather than over rely on this mechanism, it makes sense to better facilitate post-trade risk reduction and so reduce aggregate exposure levels.”
He added: “Recognising the risk reduction benefits of compression—for example, reducing counterparty risk and therefore systemic risk—is critical when considering amendments to EMIR.”
“For securities lending, post-trade risk reduction like compression will bring with it efficiencies such as less collateral being called, which will ultimately improve collateral liquidity and reduce collateral costs.”
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