Risk - International Swaps and Derivatives Association, Inc.

Risk - International Swaps and Derivatives Association, Inc.
Matthew Crabbe
Editorial director, Risk
Risk magazine is delighted to have been invited by the International Swaps and Derivatives
Association to produce this special report as part of the Association’s 20th anniversary celebrations. There are strong historical links between ISDA and Risk. ISDA was already two
years old when Risk was born, and from the very first issue of our magazine, which was
launched in December 1987, we have recognised the critical importance of the
International Swap Dealers Association (as it then was) to the risk management industry.
We reported on how ISDA came about; how the Association’s founding members joined
together to break a documentation log-jam in the swaps market in the 1980s, and how
ISDA went on to create a common legal language for derivatives dealers around the world.
We can only guess what the financial system would look like today without that effort.
Without ISDA, Risk would be a very different magazine. And I like to think that, over
the years, Risk has played an important part in communicating the news about ISDA and
its many achievements to the markets. I think we can claim to have balanced our high
standards of impartial reporting with the close relationship we have forged with the people who have made ISDA what it is today.
Many of the original founding member firms of ISDA that
came together to talk about their shared problems in documenting swaps trades have changed beyond recognition; their names
have been swallowed up in mergers. Bankers Trust, Salomon
Brothers, Kleinwort Benson, Morgan Guaranty and Shearson
Lehman Brothers; they are now part of history.
What is heartening, though, is how so many of the individuals who contributed to ISDA in those early days, have stayed
the pace and prospered, moving on to new ventures to take
advantage of the constant innovation in our markets. You’ll
find many of those people in this report, reflecting on the history of ISDA and its role today.
It’s traditional in an anniversary publication to say something along the lines of: “the
Association has never been more relevant than it is today”. In ISDA’s case that is no
mere lip-service.
The derivatives business had grown into a truly global business and one that touches
more and more people. Individual retail investors are now taking views on interest rate rises
with cumulative reverse floating-rate note structures. They’re taking views on stock market
volatility with double no-touch options. More importantly, perhaps, ideas about how portfolio risks can be hedged with derivatives are also reaching the mass markets.
This activity springs from the innovation and liquidity that your markets have generated
during the past 20 years. And we can only imagine how your businesses will change as an
even greater mass of affluent financial consumers in significant new markets such as China
come to terms with free markets and financial products.
What I think we can agree on is the importance of standards of conduct, documentation
and education to the development of orderly markets. ISDA was needed when the derivatives business was in its infancy. But even today, it’s a business that is still growing up – witness the remarkable 40%-plus growth rate in credit derivatives outstandings.
Only a glance at the ISDA website tells you that this growth brings with it a huge concomitant demand for new trading protocols and for liaison with regulators and market
supervisors. The staffs of ISDA and the many dealers that have invested their time on ISDA
committees and subcommittees have to be congratulated and thanked.
We at Risk magazine wish ISDA’s members a happy anniversary and a successful
AGM in Barcelona. ■
Letter from
Editor Christopher Jeffery
Email: cjeffery@riskwaters.com
Contributing Writers
Sarfraz Thind, John Ferry
Managing Editor Clare Beesley
Chief Subeditor Jonathan Lloyd
Subeditor Gary Fox
Head of Design Simon Bogle
Advertising Director Natt Knight
Advertising Sales Nick Wakefield
email: advert@riskwaters.com
Editorial Director Mathew Crabbe
Publishing Director
Tony Gibson
© Incisive Media Investments Limited, 2005. All
rights reserved. No part of this publication may be
reproduced, stored in or introduced into any
retrieval system, or transmitted, in any form or by
any means, electronic, mechanical, photocopying,
recording or otherwise, without the prior written
permission of the copyright owners. RISK is
registered as a trade mark at the US Patent Office
ISDA 20th Anniversary
4 Foreword
Around the world in 20 years
By Bob Pickel
ISDA executive director and chief executive Bob Pickel
reviews the Association’s key achievements during the
past 20 years.
6 Timeline
A snapshot of the global events, strategic challenges and industry milestones that have shaped the modern financial world.
8 Chairmen’s roundtable
Looking back
By Peter Field
Risk founder Peter Field speaks with nine of ISDA’s chairmen
about the foundation of the Association and how the derivatives
industry emerged through its many challenges.
Personal accounts
Risk invited individuals that have engaged actively with ISDA
during the past 20 years to submit a personal account about
their involvement with the Association. While we understand a
shortage of space means it is impossible to offer everyone the
opportunity to comment, we hope this selection of personal
accounts sums up much of the spirit of ISDA and its members
throughout the years.
20 Documentation
Lawyers in agreement
By Dan Cunningham, Jeff Golden and John Berry
The desire to standardise swap documentation was the very reason for ISDA’s foundation. But the development and maintenance of a vast and highly innovative library of documentation
has perhaps been the Association’s greatest achievement, argue
the article’s authors from Allen & Overy.
22 Financial engineering
The foundations of modern finance
By Marek Musiela
The world of finance has been completely revolutionised by
mathematics. Leading quant, Marek Musiela, traces the development of options pricing models from 1973 to the present, and
looks at the challenges ahead.
24 Regulatory threat
Zero to $200 trillion
By Mark Brickell
At the rapid pace of the derivatives business, 20 years in the
financial markets are like an evening gone. So how did all these
boxes of news clips and draft regulations pile up in my office?
26 Risk management
Finding a true accord
By Christopher Jeffery
Working on one of ISDA’s regulatory capital committees might
not seem as much fun as attending its late-night AGM parties.
But it leaves the industry with much less of a collective
Risk March 2005
30 Self-regulation
The genesis of G-30
By Mark Brickell, David Brunner and Patrick de Saint Aignan
Some sharp words from the right regulators sparked an
industry-wide initiative to establish a template for managing
risks associated with derivatives. It’s known now, simply as
the ‘G-30 Report’.
32 Japan
Forging a
derivatives code
By Sarfraz Thind
The historical development of Japan’s derivatives market has closely
followed that of the US
and Europe. But the evolution of legislation has
been more idiosyncratic.
34 Global reach
Expanding legal certainty worldwide
By Sarfraz Thind
ISDA has worked tirelessly to spread legal certainty for
derivatives transactions, and the lawful enforceability of
collateral and netting agreements. It has made
major breakthroughs in central and eastern Europe, the Middle
East, Latin America, and the Asia-Pacific region.
p50 Board roundtable
42 Collateral
The International Swaps and Derivatives Association
(ISDA) plays an extremely important role in today’s global
financial environment. ISDA provides a forum for exploring
ways of creating a level playing field for all participants in the
markets for privately negotiated derivatives. Along with other
central banks and, indeed, the global financial community,
the European Central Bank (ECB) has a strong interest in the
smooth functioning of financial markets, not least the complex markets for swaps, options and other derivatives. The
ECB and the Eurosystem are grateful for the contribution of
ISDA to this end. I wish ISDA continued success in its endeavours in the years to come.
Jean-Claude Trichet, President, European Central Bank
Mass market appeal
By John Ferry
ISDA began standardising collateral documentation in the
1990s, producing its first ‘credit support annex’ in 1994. Its
work resulted in $1 trillion of collateral used last year.
46 Processing
The steady drive to STP
By John Ferry
ISDA has played a vital role in co-ordinating efforts to improve
the efficiency of OTC derivatives trading. It is a critical issue for
dealers and is attracting more end-user attention.
50 Board roundtable
Looking ahead
By Christopher Jeffery
Risk‘s deputy editor Christopher Jeffery questions six ISDA directors about the future challenges for the Association.
ISDA played a major role in the development and maturation of the OTC derivatives markets and continues to make
important contributions through coordinating efforts to mitigate the legal risks, counterparty credit risks, and operational
risks that use of these instruments entails.
Alan Greenspan, Chairman, Federal Reserve
I would like to congratulate ISDA on its 20th
Anniversary. As the global OTC derivatives market has grown
exponentially over the years, ISDA has played a key role in
the development of sound and robust markets globally as
well as in Japan, through its work in areas such as documentation and risk management.
Toshihiko Fukui, Governor, Bank of Japan
ISDA 20th Anniversary
world in
By Bob Pickel,
executive director and chief
executive of the
International Swaps and
Derivatives Association
20 years
It’s a little ironic that in the early days of the industry, interest
rate dealers disagreed on the spelling of the tools of their
trade: were they ‘swaps’ or ‘swops’? But this was just one of many
issues of culture, custom and practice that the budding world of privately negotiated derivatives debated and deliberated. Then agreed
to compromise.
It’s now 20 years since a group of swap dealers set aside their differences – and competitive concerns – to try to create some common standards for the novel financial instruments they saw as a useful part of their firms’ customer-driven activity.
The date was May 23, 1985. The location: New York. The occasion was the formal incorporation of the International Swap Dealers
Association. Membership: 10 firms. Their first document, the Code
of Standard Wording, Assumptions, and Provisions for Swaps – or
Code of SWAPS – helped settle the spelling debate.
Today, the International Swaps and Derivatives Association represents participants from all parts of the world of derivatives and risk
management, with more than 625 members in almost 50 countries.
The activity it supports accounts for around $200 trillion in notional principal of underlying assets.
Twenty years on, we thought it was time to review how the
industry has developed. It would be impossible to highlight in these
pages all the achievements of ISDA, its board of directors, committee chairs, membership and staff throughout the years. But we hope
this special publication, prepared by Risk magazine, will serve as a
reminder of some of those challenges and successes, and inspire us
as we contemplate future projects. In particular, two roundtable
discussions, one featuring chairmen of ISDA through the years, the
other its current board, will offer many insights.
The main use of swaps back in those very early days was to reduce
end-user borrowing rates on new bond deals. Widely acknowledged
to be the first ‘material’ swap was the IBM/World Bank swap of
1981 arranged by Salomon Brothers. In those days, firms were able
Risk March 2005
to charge sizeable spreads for arranging swaps between corporate
and government borrowers, and banks. No surprise, then, that they
wanted to do more of this business.
Although it had all the trappings of potential growth for individual
dealers, all of those firms had their own standard contracts, proprietary procedures and terms of reference. Early tensions between commercial and investment banks also had to be overcome. There was no
glue to bind these disparate approaches into a cohesive industry.
To assume the market was always going to become the major
force it is today would not do justice to the foresight and careful
execution exhibited by those first 10 members, who put their trust
in each other (and the lawyers they hired) for the furtherance of the
industry. They sacrificed the partisan and parochial
for the greater good.
The flexibility of the industry architecture they created should be heavily credited for facilitating the growth of the
industry. Alongside individual product
definitions, the ISDA Master
Agreement structure has the capacity to bring all bilaterally
negotiated derivative (and
indeed other) instruments under the sheltering-umbrella terms
of a central, legally
enforceable relationship. Its
architecture is
open-ended and able to incorporate new products as they evolve. It
is a document for the ages.
Netting, as facilitated under the terms of an ISDA Master
Agreement, offers significant counterparty credit mitigation.
Furthermore, the netting opinions ISDA commissions from counsel
in an ever-increasing number of jurisdictions are a critical part of the
value of ISDA membership, and an important factor in ISDA’s
growth. A large part of ISDA’s work in the early 1990s was to seek
recognition of netting for capital relief purposes by the Bank for
International Settlements. In 1994, those efforts paid off. The
change was a catalyst for increased dramatic growth in privately
negotiated derivatives.
We also like to credit the ISDA documentation and the dedicated
work of the membership for the continuing strong growth in use of
collateral. It’s sometimes hard to quantify directly how ISDA’s
efforts pay off, but we were gratified last year to find that interdealer counterparty credit exposures are reduced to less than 10% of
their original exposures after giving effect to netting and collateral.
These results came from a poll of the largest dealers in the
Association’s first survey of exposures in April 2004.
The derivatives business has had many tests: Hammersmith &
Fulham, Procter & Gamble, Long-Term Capital Management, the
Russian and Asian debt crises, and Enron. All have grabbed headlines
and attention. Not all resolved to the satisfaction of all counterparties. But the legal and documentation foundations have universally
helped to resolve these situations in an orderly fashion.
Other tests came. Tests that meant a lot of ISDA’s attention
focused on the views of regulators. In 1992, Gerald Corrigan, then
president of the Federal Reserve Bank of New York, fired a cautionary salvo at privately negotiated derivatives, famously adding: “I
hope this sounds like a warning, because it is.” Very soon thereafter,
the G-30 report ‘Derivatives: Practices and Principles’ was published
with significant input from the ISDA board of the time.
The tenets of this report set a lot of the groundwork for ISDA’s
risk management committee, which was formalised in 1994. Its work
became such a key part of ISDA’s mandate that in 1996, the
Association changed its mission statement to incorporate risk management. The predominant focus of the committee’s work has been
in the consultation process with the Basel Committee on Banking
Supervision in the review of its 1988 Capital Accord. In 2004, the
revised Accord, widely known as Basel II, rewarded many of these
efforts. The approach taken to credit risk in particular is considerably
more risk-sensitive and better aligned with firms’ internal risk management practices than the original Accord. ISDA’s work continues
to review specific counterparty credit risk management issues,
notably credit derivatives, and on implementation of the new Accord.
Relationships with government, regulators and supervisors around
the world have become a laser point of ISDA’s focus in its 20-year
history. Fostering those relations and working to ensure understanding of the issues and each other is about as important as any of the
work that ISDA does. Not least of these is the accounting arena,
where the Association and its members persist in seeking appropriate
and harmonious treatment for derivatives on an international basis.
Tightening timeframes for transaction processing is something
industry and regulators alike have identified as requiring work.
Through ISDA, firms have worked hard to minimise processing, settlement and operational risk. At the start of the twenty-first century, a
large part of ISDA’s work has come to focus on technological infrastructure. In 2001, ISDA announced the integration into its organisational structure of Financial products Mark-up Language. This lingua
franca for derivatives messaging plays an important part in the posttrade environment, and may do so on the trade execution side.
I am pleased to be able to congratulate ISDA on reaching
its 20th anniversary. Over the two decades of its existence,
ISDA has made a major contribution to the creation of a
sound infrastructure for the derivatives markets. Some trade
associations tend to focus their efforts on lobbying regulators for action, then complain about the result. Others take
matters into their own hands and work to resolve the problems. ISDA has been, and remains in the latter category. I
hope it will continue to prosper in the decades to come.
Sir Howard Davies, former chairman of the
Financial Services Authority
Back in the 1980s, ISDA was operated solely by its board of directors
in hands-on fashion. Each piece of the Association’s work was done
directly under the supervision of one or more board members. Even
as the Association took on staff, a board member had to sign off on
almost every item, including conference agendas.
In the past decade, the expansion of ISDA’s activities and the
establishment of a huge range of committees to address the different products and disciplines necessitated the work to migrate to a
different model; one where the broader membership performs
much of the Association’s work through a committee process
steered by committee chairs and staff. The board still lends a guiding hand to almost everything the Association undertakes – albeit
through these layers of execution – making ISDA a unique association in the financial industry.
The growth of the Association’s membership has been another
cornerstone of its development. At the outset, it was confined to
dealers only. With the growth of the industry and the obvious need
to represent the wishes and views of all participants, the association
opened its doors in 1987 to end-users of derivatives and service
providers to the industry, such as law and accounting firms, software
vendors and consultants. Reflecting this shift, ISDA changed its
name from the International Swap Dealers Association in 1993,
retaining the now-familiar acronym. During the term of my predecessor, Richard Grove, the Association made growth of its membership a priority. This continues today, as we welcome members representing products, markets and regions, many of which are new to
the world of derivatives.
Adding to the professional staff in the past decade has created inhouse expertise for many products and disciplines, tracing the geographic reach of ISDA across the globe. ISDA’s European office in
London was opened in 1996. In spring 2000, ISDA opened its
Tokyo office and, later that year, Singapore. They are complemented
by dedicated government advocacy offices in Brussels and
Washington, DC.
Those who ask are usually surprised when I tell them ISDA has
fewer than 50 staff across the globe. Of course, ISDA is able to
limit this number because of the incredible efforts of its members.
I’d like to take this opportunity to thank all of them for their hard
work and support over the past 20 years.
Although ISDA’s roots are in the documentation of derivatives, it
has grown and reached out to touch many issues. The groundwork
ISDA laid in those early years made possible the prolific expansion
privately negotiated derivatives have enjoyed since the 1980s. In my
view, it is highly doubtful that the industry would be what it is
today but for this finely crafted and well-tended foundation.
We wouldn’t swap it for the world. ■
ISDA 20th Anniversary
Twenty year snapshot
■ ISDA Interest Rate and
Currency Exchange Agreement
and Definitions (prototype of
ISDA Master Agreement)
■ Modern equity derivatives
market is born with the creation
of an OTC market for put
options on Nikkei 225 Index
OCC allows Chase Manhattan to
introduce commodity swaps
■ 'Black Monday' stock market
■ First Boston loses $100m
trading options on US Treasuries
Merrill Lynch loses £377m
trading mortgage-backed
■ Patrick de Saint-Aignan
■ ISDA is chartered
First ISDA Market Survey is
■ Swaptions emerge
Trading in IR caps emerges when
banks begin to strip interest rate
guarantees from floating-rate
notes to sell to the market
■ Rampant hyper-inflation in
Bolivia prompts 'shock therapy'
market liberalisation
■ Tom Jasper and Artur Walther
■ Revised SWAPS Code
■ Tom Jasper and
Ken McCormick
■ Basel Committee on Banking
Supervision issues first Basel
Accord. This forms the first
supervisory proposals for
applying capital charges to
banks' credit risk
■ Japan's economic 'miracle'
■ Patrick de Saint-Aignan/
Mark Brickell
■ ISDA 20th Anniversary
ISDA 2005 Commodity Definitions
ISDA 2005 Collateral Guidelines
ISDA 2005 Inflation Definitions
■ Kyoto protocol to control
greenhouse gas emissions
■ Jonathan Moulds
■ Isda milestones
■ Industry/product milestones
■ Key global developments
■ ISDA chairman/chairmen
Risk March 2005
■ Addendum to Schedule to
Interest Rate and Currency
Exchange Agreement
■ Bankers Trust introduces
equity swaps
Index Amortization Swaps
CFTC says swaps contracts do
not constitute futures contracts
Passage of Financial Institutions
Reform, Recovery and
Enforcement Act in US confirms
netting provisions' enforceability
in transactions involving
insolvent US banks
■ 'Collapse of Berlin Wall
Fall of communism in Poland
Eastern Europe finds democracy
■ Mark Brickell
■ ISDA shows that netting reduces interdealer exposures to single percentage figures
■ China Banking Regulatory Commission
issues Interim Rules on Derivatives Business of
Financial Institutions
Basel II capital Accord finalised
■ Madrid railway station bombed by
'Al-Qaeda' group
■ Fraudulent forex options traders at National
Australia Bank cause losses of $282 million
■ Keith Bailey/Jonathan Moulds
■ 1991 Definitions published
■ Merrill Lynch forms first
separately capitalised derivatives
products company with a
continuation structure. Non triple-A
rated banks use them to trade with
sovereigns and supranationals
■ Disintegration of USSR into 15
independent countries
India prime minister Narasimha Rao
confronts balance of payments
crisis with major liberalisation
reform of 'Permit Raj'
■ UK's House of Lords rules in its
Hammersmith & Fulham decision
that all swaps entered into by all
local authorities were ultra vires
and therefore legally unenforceable
contracts. Ruling illustrates need for
legal certainty
■ Mark Brickell
■ ISDA obtains legal opinions on the enforceability
of netting in nine of the 11 BIS countries
■ Differential swaps (quanto swaps) developed to
aid customers with strong views on the spread
between interest rates in different countries
BIS issues report from G-10 supporting crossborder and multi-currency netting systems
■ Reunification of Germany
'Shock therapy' market reforms introduced in
■ Mark Brickell
■ ISDA survey reveals that 92% of global
Fortune 500 companies use derivatives to
effectively manage and hedge their risks.
ISDA Master Agreement Protocol launched
2003 ISDA Credit Derivatives Definitions
ISDA opens dedicated government advocacy
office in Washington, DC
■ Iraq invaded by US and British forces.
■ Warren Buffet declares derivatives as latent
"financial weapons of mass destruction"
■ Keith Bailey
■ Name changed from
International Swap Dealers
Association to the International
Swaps and Derivatives Association.
1993 Commodity Derivatives
Definitions published
■ Basel Committee unveils
preliminary details of supervisory
proposals for applying capital
charges to market risk of banks.
The G-30 publishes Derivatives:
Practices and Principles
■ MG Corp, the US subsidiary of
Germany's Metallgescellschaft, loses
$1.3bn in losses related to oil
■ Malcolm Basing/Joe Bauman
■ 1992 ISDA Master Agreement published
First ISDA FX and Currency Option Definitions
■ Credit derivatives emerge.
■ UK pulls out of ERM, despite spending £10
billion defending pound against speculators.
China president Den Xiaoping ensures
continued economic reform with 'Southern
Journey' speech
■ Gerald Corrigan, president of New York
Federal Reserve, warns banks that swaps are
distorting the market-place and possibly
balance sheets
■ Mark Brickell/Malcolm Basing
■ 2002 ISDA Master Agreement published.
2002 ISDA Equity Derivatives Definitions
■ Introduction of euro notes and coins
■ FSA chairman Howard Davies voices
concerns about CDOs, saying one investment
banker described them as 'the most toxic
element of the financial markets'
John Rusnak loses Allied Irish Banks $691m via
fraudulent trades related to yen-dollar
currency forwards and fake options
■ Keith Bailey
■ ISDA Credit Support Documentation under English and
Japanese Law
■ The Federal Reserve discusses pre-commitment approach to
determining regulatory capital
Basel Committee on Banking Supervision with the Technical
Committee of the International Organisation of Securities
Commissions issues framework for supervisory information
about derivatives activities of banks and securities firms
■ Earthquake hits Kobe
■ Nick Leeson's rogue derivatives trades lead to the collapse of
Barings Bank.
State of Wisconsin Investment Board reports a $95m loss from
investments in derivatives
■ Gay Evans
■ First weather derivatives transaction executed by
Aquila Energy
■ Speculators force collapse of Thai baht
Contagion throughout Southeast Asia
End of the 'Asian miracle'
■ NatWest Markets loses £90m on mispriced interest
rate options. Propels the use of the phrase 'model risk'
UBS reports losses of $420m in its global equities
division run by Ramy Goldstein. His group had losses in
Japanese convertibles and long-dated European options,
plus losses on a structured index product it had
■ Gay Evans
■ ISDA Long-form Equity Derivatives Confirmation
ISDA Credit Support Documentation under New York Law
■ Bank for International Settlements recognises effects of netting in
determining capital levels needed to support derivatives transactions
US Accounting Standards Board says it is to alter the way US firms
account for derivatives
■ Apartheid ends in South Africa. Nelson Mandela inaugurated as country's first
democratically elected president
Mexican peso crisis
■ A Fed rate hike in part leads to the bankruptcy of Orange County, CA. Its
investment pool had sustained a $1.7bn loss on leveraged inverse floating-rate
notes financed by reverse repo transactions
Procter & Gamble declares a $157m pre-tax loss on two leveraged swaps
Gibson Greetings and Mead Corporation also unveil major derivatives losses
Bankers Trust faces lawsuits to disclose 'misrepresented' risks associated with
■ Joe Bauman/Gay Evans
■ ISDA announces integration of FpML into its
organisational structure
■ Basel Committee issues second consultative
paper for a new risk-based capital Accord,
Basel II
■ China officially joins WTO, commits to
Hijacked airliners crash into the World Trade
Center in New York and Pentagon in
Argentina defaults on £132 billion in debt
held by foreign investors
■ American Express announces a $370m loss
on a $1.4bn CDO
Enron collapses and prompts calls for
additional regulation of derivatives
Host of other power trading companies
dragged into spotlight
Death knell for bandwidth trading
■ Keith Bailey
■ ISDA Long-form Credit Derivatives
ISDA EMU Protocol launched
■ Report by Basel Committee on Banking
Supervision advises banks to tighten their
collateral policies and leverage to hedge
fund clients
■ Russia defaults on international loan
Rouble devalued. Determines OTC derivatives
contracts as legally unenforceable
■ LTCM implodes. The Federal Reserve
organises a $3.6bn bailout
■ Gay Evans/Mark Harding
■ ISDA opens office in London
1996 Equity Derivatives Definitions published
■ EU's Capital Adequacy Directive becomes law. CAD
requires banks to separate trading book risk from
banking book risk
Eonia swaps become popular in Europe after BIS begins
publishing overnight settlement rate for ecu money
■ Yasuo Hamanaka, a copper trader at Sumitomo, loses
$2.6bn in the London metals markets
■ Gay Evans
■ ISDA opens offices in Tokyo and
2000 Definitions published
■ The US Financial Accounting
Standards Board's new derivatives
accounting rule, FAS 133, goes into
US Commodity Futures Modernization
Act becomes law
■ Mark Harding/Keith Bailey
■ 1999 ISDA Credit Derivatives
Definitions published
■ US Congress approves
Gramm-Leach-Bliley, Glass-Steagall
Act repealed
■ Euro starts trading between
wholesale counterparties
US and China sign agreement on
its accession to WTO
■ Goldman Sachs and Credit
Suisse First Boston, among other
dealers, suffer large losses in
sterling swaptions
■ Mark Harding
ISDA 20th Anniversary
over 20 years
Peter Field
Last month, the ISDA staff assembled a formidable group of people for a
round-table discussion on their organisation’s eventful first 20 years: all the
former chairmen of ISDA, bar two, plus the current chairman. Sitting round
the table in New York were Tom Jasper, co-chair in 1985 and 1986, Patrick de
Saint-Aignan, 1987–88, Mark Brickell, 1988–92, Joe Bauman 1993–94 and
Keith Bailey 2000–04. Also present was ISDA executive director and chief
executive Robert Pickel. Linked on a conference call from London were
Malcolm Basing, chairman, 1992–93, Gay Huey Evans, 1994–98, Mark
Harding, 1999–2000, and Jonathan Moulds, current ISDA chairman.
The chairmen looked back over the highlights and low points of ISDA since it
was formed in March 1985. They talked about the first ISDA Master
Agreement in 1987 and the way it evolved as new products came out. They
talked about the battle for legal certainty for swaps in the US, locking horns
with the futures industry in the process. They recalled the early legal blow from
the case of the London council, Hammersmith & Fulham, in the UK, and the
string of so-called ‘derivatives disasters’ (involving Procter & Gamble and
Orange County among others) in 1993–95 that rocked the industry and
tarnished its image for a time. The ISDA luminaries also pointed to how well
the markets had weathered more recent tests, for example, the collapse of
Enron, and how well they’d built their bridges to the regulators. Finally, they
expatiated on ISDA’s capacity to grapple with new challenges such as the Basel
II Accord, the breakneck expansion of credit derivatives, and new accounting
and disclosure rules.
Peter Field, who founded and launched Risk in 1987, chaired the round-table.
Patrick de Saint-Aignan
Tom Jasper (then Salomon
Joe Bauman (then Bank of
Jonathan Moulds
Mark Brickell (then JP Morgan,
(Morgan Stanley)
Brothers, now Primus)
America, now WestLB)
(Bank of America)
now Blackbird Holdings)
Risk March 2005
Chairmen’s roundtable
Gay Huey Evans
Malcolm Basing
Keith Bailey (then Merrill Lynch
Mark Harding
Bob Pickel,
(then Bankers Trust, now UK
(then Swiss Bank Corporation, now
Capital Services, now Merrill Lynch
(then Warburg Dillon Read, now
ISDA chief executive
Financial Services Authority)
City Disputes Panel)
Global Commodities)
Barclays Bank)
Photography: Alex Towle
■ Risk: Did you ever think in the early days that the industry
would grow to be as massive and as global as it is today?
■ De Saint-Aignan: Even in 1985 there were visible reasons for
the activity to grow significantly and for a long time. Initially swaps
were used, generally speaking, as a way to reduce borrowing costs.
A new set of participants came in when investors started to use
swaps to enhance yield. Then swaps were also looked on as hedging
instruments, and more broadly one could already see the beginnings
of swaps and derivatives as tools for risk management, and that
again had marvellous potential.
■ Jasper: I remember at the time when ISDA started coming out
with its first shot of estimates on the size of the market and sitting
there thinking, “Oh come on, this just can’t keep growing like
this!” But lo and behold it has! And lo and behold it keeps growing, and it’s really phenomenal.
■ De Saint-Aignan: Frankly, we may have made a mistake by measuring the growth of the business by the growth of notionals, which
initially was to get attention from the market-place. This was really
useful for perhaps the first 10 years but after that the sheer size of
those statistics caused people perhaps undue concern. Then we had
to make people understand that the notional amount of derivatives
did not equate with the amount of risk being taken.
■ Bauman: I think everybody who was active in the market realised it
was something different from just another trading desk on the floor.
But I didn’t anticipate the breadth of the market, the way that the
products would expand over the years. The template ISDA set up early
on has facilitated the growth of this industry more than anything else.
■ Risk: What you’re saying is that the industry wouldn’t have
developed so fast without ISDA?
■ Jasper: I think that’s absolutely right. It was a very small, negotiated-deal type market at the time and I think that we saw an opportunity to make something happen. We were all faced with this issue
of a tremendous backlog of documentation, and traders – that’s
probably a glorified term, relative to traders today – could certainly
transact a lot quicker than we could document the deals. So the
whole push for standardisation of contract terms and for better communication between the firms in the market was very important.
■ De Saint-Aignan: There were good practical reasons why the
market might never have taken off. Firms competed on being able to
provide customised terms to their customers, including customised
documentation, which meant that customers had to use a different
form when they were dealing with Citibank than when they were
dealing with Morgan Stanley, and so on. This was not particularly
user-friendly. At the same time, as Tom [Jasper] mentioned, there
was the developing backlog of documentation. Transactions were
done without master agreements, based on a confirmation that was
not standardised, and there was certainly doubt about the validity of
this confirmation. Documentation was not signed for months, sometimes even a year or more. If issues such as standardisation had not
been resolved, the product would not have grown the way it did,
and I think that ISDA deserves a lot of credit for that.
■ Risk: You needed standardised documentation but did you need
a separate organisation?
■ Jasper: We had to have a way to talk about issues that were critical to the growth of this industry. A lot of people said we should go
to the Bond Market Association or one of the other associations at
the time. But we recognised that we were so unique as an industry
and as a group of individuals that we needed a way to address the
issues that were important to this industry, and not get involved in
the bureaucracy and the various other issues at other associations.
■ Moulds: In the early and mid-1990s the swap curve became the
benchmark. The work ISDA has done has given
tremendous impetus to growth in the market –
from the rate markets in the 1980s and the
early 1990s, then the credit market and now
the energy markets.
■ Bailey: I agree. It is also very important
that we recognise that we’re nowhere near
the full potential of this product at this time.
■ Risk: When you were having
your preliminary discussions in
1984–85, did any of the participants have worries about
confidentiality, about sharing proprietary
■ Jasper: Oh,
There was a
great deal of
ISDA 20th Anniversary
Chairmen’s roundtable
between the commercial banks and investment banks to begin with,
and then everybody had their own document and was convinced it was
a good document. We had to work to develop a level of trust among
the participants in these meetings in order to have anything happen.
■ De Saint-Aignan: We were very wise in all of our meetings to
have our counsel Dan Cunningham [formerly of Cravath, Swaine &
Moore, now with Allen & Overy].
■ Risk: When did you realise that, having started off as swap dealers, you might need to widen your coverage to other instruments?
■ Brickell: We had a big debate about what architecture to use
for the Master Agreement back in 1989–90. I can remember
debating whether to put interest rate options under the same
agreement with interest-rate swaps. We made a very useful decision to make this master with the ability to expand, even beyond
the boundaries of the products and risks that we knew about at
the time.
■ De Saint-Aignan: The original 1985 code covered only interestrate swaps. The 1986 code added definitions that could apply to
currency swaps. I know in 1987 there was a proposal to do a separate interest-rate cap agreement but this was not done, because we
then moved to the master approach, and at the time there were tax
issues with respect to the treatment of the premium, which precluded us from going forward on the interest rate cap document.
■ Risk: ISDA issued addenda to the schedules of the Master
Agreement for caps, collars and floors in May 1989, I think?
■ Bauman: Right, and by 1993 we had recognised the commodities
product set and started on the process of drafting the definitional
addenda to fit within the basic structure of the master. Commodities
were the first non-interest rate and currency option product.
■ Risk: And that year, 1993, was when ISDA appropriately
changed its name from International Swap Dealers Association to
International Swaps and Derivatives Association?
■ Bauman: Yes.
■ Risk: Of course there were a lot of legal issues to contend with
early on that cast a shadow over the longer-term future of swaps.
■ Huey Evans: There was the threat from the futures exchanges,
particularly in the US. As the OTC derivatives business was growing
exponentially, it appeared to the exchanges that the OTC market
was challenging their turf significantly. Now we can look back and
say they have benefited from the derivatives growth,
but many couldn’t see that at the time. That
was a major threat to the OTC business,
because the futures market wanted the
OTC derivatives market to be regulated
the same way they were.
■ Brickell: I think that we were telling
them at the time that they were benefiting
but they didn’t want to listen to us.
■ Basing: My recollection was that it was
the CBOT [Chicago Board of Trade]
that we had the problems with and that
CME [Chicago Mercantile
Exchange] was more progressive.
■ Risk: And of
course you had the
Risk March 2005
[Commodity Futures Trading Commission] for many years campaigning to be allowed to regulate swaps.
■ Moulds: Which is why you have to say that the CFMA
[Commodity Futures Modernization Act of December 2000, providing legal certainty to the OTC derivatives markets], which
involved significant work by many people in the industry to get
across the finishing line, is a highlight in ISDA’s life.
■ Brickell: To be precise, it was 12 years of negotiation and two
pieces of legislation and policy statements and regulations.
■ Various: And many visits to many commissioners…
■ Brickell: The comparative advantage that the industry has is our
use of technology, our Master Agreement architecture and the regulatory framework that exists for swaps as a result of what we’ve done
– swaps aren’t futures, swaps aren’t securities for the most part, and
it’s easier for us to innovate.
■ Risk: So there is absolute legal certainty now about swaps?
■ Bailey: No, not in every respect. In 2002, as we faced some of the
consequences of Enron, we were obliged to revisit that topic and fortunately we prevailed in reaffirming the legal integrity for the product.
But there are still some open issues.
■ Risk: Overall, would you say that ISDA has been a driver of the
business or a facilitator?
■ Bauman: Maybe in the early days ISDA was a facilitator but in
many ways it’s been the driver because it’s been an organisation that
has always had its ear to the ground and has been pushed by its
members to listen to what’s going on in the market-place.
■ Huey Evans: I think ISDA is much more of a facilitator. ISDA
did drive through issues, but it was the industry itself, the participants that encouraged ISDA on particular issues that needed to be
done. ISDA did not get dragged down into bureaucracy or politics,
we were all in it together to make the market-place of derivatives
more efficient and risk-reducing.
■ Harding: I think that’s true. One of the reasons that ISDA’s been
a success in comparison with a number of other associations is
because it’s actually always allowed its members to have a say. We
allow participation in a committee by any member who wants to sign
up. That is unique and I think has generated membership involvement in a way no other mainstream association has managed to do.
■ Jasper: You’ve got to have people that are willing to take on the
responsibility of getting things done, and ISDA has always had people that are willing to roll up their sleeves, set an agenda, and get
something done. A lot of organisations end up being basically social
clubs and never getting anything done.
■ Basing: One thing that impressed me when I joined the organisation was that ISDA was ahead of my own organisation in being
aware of the regulatory issues that were coming our way and moving very quickly to establish our position before the regulator and
everyone else had formed a fixed opinion. That made us able to
influence the debate effectively, and ensured that regulation didn’t
kill us off early in the day.
■ Risk: Has the organisation changed very much over the years?
■ Jasper: In the early days, ISDA was very much a board-dominated
organisation but Gay [Huey Evans] as chairman in the mid-1990s
recognised that ISDA needed to develop a much more significant staff.
So now I believe there is a strong interplay between the staff and the
board in terms of what the goals and objectives for the organisation
should be. This is extremely important in relation to continuing to be
a driving force for change and evolution in the market-place.
■ Moulds: ISDA has also developed more conferences and made sig-
Page 1
Over the past 20 years, ISDA has helped to define the derivatives market, and BNP Paribas is proud to have played an
important role. Our quantitative and trading skills put us at the forefront of this market soon after its birth in the 1980s
and have kept us there ever since. By offering our clients innovative investment and liability management solutions,
BNP Paribas leads the way in the derivatives industry. We thank ISDA for its contribution to making the industry a success.
BNP Paribas London Branch is authorised by CECEI and AMF, and is regulated by the Financial Services Authority for the conduct of
its investment business in the United Kingdom.
Chairmen’s roundtable
The birth of ISDA
When Tom Jasper and Dan Cunningham (then of
Salomon Brothers and Cravath, Swaine & Moore)
flew to London in 1983 to negotiate one of many
early swap transactions with a major Japanese
bank, they found themselves locked in intense
negotiations for two whole days. The sticking point
was a formula determining what the damages
might be in the improbable occurrence of a counterparty default.
Salomon Brothers was not alone. At the time, a
US market in interest rate swaps had mushroomed
swiftly, so most of the pioneering swap dealers had
backlogs of undocumented deals. At least 10 firms
were booking deals on their trading desks in
1983–84 faster than they could be confirmed
through the back office.
On Jasper’s recommendation, Salomon Brothers
and nine other major swaps dealers agreed to
devise a solution. Included were Bankers Trust
(Jonathan Berg), Citicorp (Yves de Balmann), First
Boston Corporation (Leon Kalvaria), Goldman
Sachs (Artur Walther), Kleinwort Benson (Ken
McCormick), Merrill Lynch (Rick Sterne), Morgan
Guaranty (Peter Bernard), Morgan Stanley (Patrick
de Saint-Aignan), Salomon Brothers (Tom Jasper,
first Isda chairman) and Shearson Lehman
Brothers (David Swansen). Jasper suggested they
meet in Palm Beach, Florida, to discuss the documentation backlog.
The group of commercial, investment and merchant banks discussed documentation problems
and what they might do to resolve them. “The
problem was that there was no common language.
The words ‘payer’ and ‘receiver’ seemed to be used
interchangeably among dealers. What did it mean
to pay fixed or pay floating? The first interest rate
The above are excerpts from an article
by William Falloon, Risk, December 1997
nificant strides in the past three or four years on the educational front.
Plus look at the growth of the organisation, with ISDA offices in
Tokyo, Singapore, Brussels and Washington, as well as London.
was that there’s no distinction made in the Master Agreement
between one party as a dealer and a counterparty as an end-user.
Everybody stands toe-to-toe as equals.
■ Risk: How has the membership evolved over the years?
■ De Saint-Aignan: I would say that ISDA is one of the organisations that has most successfully achieved global representation. We
worked very hard from the outset to make sure that ISDA, based in
New York, was not a US-centric organisation. We worked very hard
to make sure that we had members and associate members in
Europe, the Continent as well as the UK, and Asia, not simply Japan.
■ Huey Evans: We looked too much like a derivatives dealer shop
early on, so it was necessary to open up the association to a variety
of participants in the market-place that hadn’t been included before,
and this has continued to evolve.
■ Brickell: The day the organisation was formed, we had an international membership with Kleinwort Benson numbered among 10
founding firms and it was not always an easy thing to handle. I can still
remember Tom Jasper, at a meeting in Bermuda, trying to teach an
international group to play golf, when several had probably never even
held a club before!
■ Bauman: ISDA is a broader organisation than 20 years ago.
Initially it was a dealer-oriented group that grew to include endusers but with the dominance of membership still on the dealer side.
Now, the membership is a third dealers, a third end-users around
the world and a third service-providers.
■ Moulds: Also, because of the way the markets have evolved, the
board for a period of time had a stronger background in the rate
derivatives space. We’ve made tremendous progress in balancing the
board by product specialisation and by geography. We now have
credit derivatives experience on the board, as well as commodity
derivatives and equity derivatives expertise.
■ Risk: That’s a good point. I noticed that IBM was represented at
the first ISDA AGM in 1986. What are the other key differences
between the organisation in 1985 and now?
■ Moulds: The use of technology in the execution process is becoming much more important. ISDA’s merger with the FpML
Organisation a couple of years back will help streamline operations
and will be a very important step. [FpML (Financial products Markup
Language) is the industry-standard protocol for complex financial
products, based on XML (Extensible Markup Language), the standard meta-language for describing data shared between applications].
■ Bailey: I think in five years’ time we will look back and say that the
decision to merge with FpML was something
that we had to do from a strategic point
of view.
■ Brickell: Traditionally in our
business we’ve been innovators
and changers but there are some
signs of hesitation I see in the
way we do things in the business
now. I think we’ll get past that, I
think we’ll get back to being innovators.
■ De Saint-Aignan: Maybe
ISDA should recognise
the fundamental contribution
■ Risk: Do you think ISDA should have involved end-users more
in the early days?
■ Brickell: Our relationships with end-users have been very good
from the start. I remember the team at McDonald’s participating
with us and being eager to do it within the ISDA context and within the G-30 context. Part of the reason for the close relationship
swap manual was an attempt to codify a language,” says Jasper.
By March 1985, this group of 10 firms had
formed the first interest rate swaps industry association, known as the International Swap Dealers
Association (ISDA). On June 24, almost two years
after beginning work on the documentation
problem, they released a code of standard
terminology, known as the ‘Code of Standard
Wording, Assumptions and Provisions for Swaps
(1985 edition)’.
“The market would never have developed to the
degree it has without standardised documentation,” says Jasper. “Credit officers at some point
would have shut down the business without it.”
Risk March 2005
Risk Management-ISDA.qxd
4:05 pm
Page 1
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Chairmen’s roundtable
derivatives to risk management by changing its name to the
International Risk Management Association.
■ Risk: Dan Cunningham suggested just that in 1997
[Risk December 1997]. So overall, what would you say is
ISDA’s greatest achievement in the last 20 years? One single thing: is it the Master Agreement?
■ Various: The Master Agreement.
■ Huey Evans: Alongside the netting opinions, which
were achieved globally and which was sometimes an
uphill battle.
■ Brickell: And the netting legislation we had to pass to
earn those opinions.
■ Pickel: The recognition of close-out netting by the
Basel Committee in 1994 was significant. If you look at the
growth of the market and at the growth of ISDA’s membership,
both accelerated after that.
■ De Saint-Aignan: I would say the open architecture of the
Master Agreement, which has really been the key to its success.
■ Basing: And that’s also pulled in a wider range of products.
Because of the open architecture, we could add on and add on and
net all products against each other
■ Risk: What about the low points? There must have been some in
the 20 years?
■ De Saint-Aignan: It was Hammersmith & Fulham because that
went to the core of the legitimacy and efficacy of the Master
Agreement. Fortunately, the council’s illegality defence was not sustained for long and the issue went away, but that was a low moment
for the industry.
■ Risk: But surely the so-called derivatives disasters of 1993-95
were more a threat to the whole industry, given that legislation to
control derivatives appeared to be on the cards at that time?
■ Jasper: I think we became the victims of our own headlines. The
Risk March 2005
term ‘derivative’
itself became the one that started to attract attention.
■ Bauman: The difficulties faced by Orange County and all the rest
in 1994 maybe marked a lower point even than Hammersmith &
Fulham because that was a question about the viability of the transactions done by a particular subset of institutions. It affected everything we were doing and put in jeopardy the industry’s relationship
with those setting public policy.
■ Risk: Hammersmith & Fulham in the end was just was a stupid
legal decision, wasn’t it?
■ Brickell: Well, I’ll let you say that!
■ Harding: But if you could invent a catalyst for some of the changes
in the laws over the years to give us more legal certainty, it would be
difficult to invent a better one than Hammersmith & Fulham.
■ De Saint-Aignan: Early on, ISDA made a conscious decision not
to get into the code of conduct business, which I think was the
right decision, because it meant that ISDA could not be responsible
for monitoring actions taken by market participants.
■ Bauman: My mind still comes back to public-image issues in
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Chairmen’s roundtable
Personal account
Yves de Balmann, co-chairman, Bregal
ISDA board: 1985–1986
It is hard to believe that it has been 20 years
since 10 practitioners, each representing a different firm (a crosssection of commercial and investment banks – an antiquated notion
today) got together and decided to form ISDA.
We did not have any grand plan. The derivatives business itself
was very new (trading in over-the-counter derivatives was no more
than a year old) but most of us recognised instantly that it would
radically transform the financial markets as we knew them then. By
creating ISDA, we hoped to help shape the destiny of the derivatives business to make it better understood and accepted by our
customers and by regulators.
We have made enormous progress. There is not an asset class that
has not been affected, most often positively, by derivatives. What
began as a purely fixed-income linked business, moved to equities,
commodities, credit and even weather. The understanding of longterm options brought about by Black-Scholes opened avenues for
derivatives to include every customer category: corporates, financial
institutions, hedge funds and all types of asset managers.
It all happened so fast. I would say it was yesterday not 1985
that we first met as ISDA at The Breakers in Florida, except that now
when I look in the mirror my temples are grey!
1993–96. They might not have had the legal risks for the industry that
Hammersmith & Fulham brought, but they questioned whether what
was being built here of real financial benefit to the community at large.
I remember the cover of Fortune magazine with the mouth of the alligator open and some derivatives headline attached to it, and Adam
Smith’s Money World [a television programme on the Public
Broadcasting Service in the US] showing derivatives being possibly the
financial equivalent of a Challenger disaster. Those were the darker
sides of the time, not specifically related to ISDA but to the market.
■ Huey Evans: That’s where the foundations of ISDA were extremely
helpful because we were able to go to politicians and regulators to gain
support to resist attempts to regulate OTC derivatives the
way that some wanted to do.
■ Jasper: Also very important from the start was that
ISDA worked very hard to win the trust and confidence of the regulatory authorities in ISDA.
Obviously Mark [Brickell] and his work on the Hill
was very important to all of that. The ability of
ISDA to gain the trust of the regulatory authorities helped to educate them on the issues that they
could then transmit to the legislative authorities.
This was a momentous achievement for ISDA.
■ Moulds: To some extent a measure of how
influential ISDA became and how well those
relationships were built is the fact that Gay
[Huey Evans] has moved on to be a senior regulator in the UK [she is now
director of markets at the Financial
Services Authority].
■ Brickell: Yes, I think ISDA
Risk March 2005
arranged that, right? Talking about relationships with the regulators,
we’ve been active on the capital front from back in 1988 when the first
Basel Accord came out. Obviously, that work has expanded in terms of
the types of things that we focused on. Back then it was focused very
specifically on how swaps were treated under that structure. In the
more recent debates, we’ve really gone far beyond that to cover many
different product areas.
■ Risk: What else helped the industry get through the 1993–95
period relatively unscathed?
■ Bauman: I think ISDA decided to make risk management a
major objective and foundation for the market-place.
■ Pickel: Yes, we formed out risk management committee in 1994
and incorporated risk management into our charter in 1996.
■ Risk: The Group of Thirty report, which ISDA was involved
with, must have helped by publicising the basic principles of risk
■ Brickell: One of the high points was the writing of the Group of
Thirty’s Derivatives: Practices and Principles [published in July 1993].
That was an explicit recognition in text that the management principles
we were using on the swaps desk were applicable across the financial
system. I still remember former regulators testifying in Washington at
hearings to examine the problems of Procter & Gamble, Gibson
Greetings and other firms, brandishing the G-30 report that Patrick de
Saint-Aignan and David Brunner, then of Paribas, had written as an
example of how to manage risk.
■ De Saint-Aignan: I think the defining moment that probably got
the Group of Thirty thinking about making what was a very valuable
contribution to derivatives and risk management in general was the
speech by Gerry Corrigan in January 1992 where he told us all to
take a very, very hard look at off-balance-sheet activities and wound
up saying “I hope this sounds like a warning, because it is.” [Speech
of Gerald Corrigan, president of the Federal Reserve Bank of New
York, to New York State Bankers Association]. Because of his position, he had a lot of credibility. While ISDA was not directly involved,
I think all the participants in the Group of Thirty working group were
members of ISDA and the ability of this group to be mobilised owed
a lot to the fact that we’d all known each other within ISDA, so I
think in many ways ISDA facilitated the Group of Thirty report.
■ Risk: The top people at the Federal Reserve have changed their
tune a bit recently?
■ Harding Yes, some of the statements from the Federal Reserve,
including the chairman, have been very helpful.
■ Risk: Why do you think Greenspan has such a positive attitude
towards derivatives?
■ Bailey: The products that this market engages in have a material
effect on the growth of the economy in stabilising earnings. Their
importance is recognised by people in senior positions at the Federal
Reserve and in the other bodies around the world.
■ Brickell: I think it’s more than the team at the Federal Reserve
being smart enough to realise that derivatives help to manage systemic risk. A lot of time has been spent in cultivating relationships,
so that when there’s an issue there’s a trust with the regulatory
community that they can get an honest answer from ISDA, and will
look to ISDA as one of its main sources of input.
■ Risk: And some big tests have been passed, like Enron,
like Argentina?
■ Moulds: Yes, look at the resilience of the derivatives industry in
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Chairmen’s roundtable
the wake of Enron, a major name in the credit derivatives market.
The derivatives markets showed an amazing ability to bounce back
from disruption. Liquidity in the credit derivatives market has held
up better than in the bond market in a number of recent disruptions, including post-September 11.
■ Harding: I thought it was quite remarkable all through this period that people were beginning to say that perhaps the reason it hasn’t been worse is in fact because of the derivatives market, which has
the ability to manage great risk across a broad spectrum. That is
something that a few years ago you would just never have heard.
■ Risk: So major tests have been passed and regulators have
realised that the benefits of derivatives outweigh any disadvantages,
but we still have a few prominent business people who don’t accept
this, like Warren Buffett. Is that something you worry about?
■ Brickell: The attitudes that you’re talking about are like the setting sun at the end of the day.
■ Risk: But ISDA has been more pro-active recently in promoting
the benefits of derivatives, hasn’t it, for example issuing a report on
Enron’s collapse saying corporate governance failures, not derivatives were to blame and commissioning academic studies. Is that
part of a new strategy to promote the industry?
■ Bailey: Yes. We added ISDA staff in research in 2000. In some
cases those documents were still largely responsive to comments that
had been made, which we felt we had to respond to. And if we were
going to give a response, it had to be well considered and well
argued. We have tried to be a lot more proactive on that front.
■ Moulds: ISDA is continuing to invest significant resources on
the educational front. As an example, look at the recent work ISDA
has done in highlighting the effects of the broader use of collateralisation between the major dealers. A current priority for ISDA is
ensuring that the use of derivatives as a risk mitigant is fully understood by regulators and other policy makers
■ Bailey: We should never allow
ourselves to be complacent in
thinking that the community at
large generally understands
these products. There’s work
still to do on accounting and
on tax issues. We’re having to
deal now with certain issues
because the market has
reached the level of importance it now enjoys.
■ Moulds: You’ve got
to look at the
speed with which some of these markets have grown and continue
to grow – the credit derivatives markets, the inflation-linked markets and the energy markets. ISDA has got a pretty full agenda
ahead of it.
■ Risk: Does ISDA need to do more to help educate the general
public about the merits of derivatives?
■ Jasper: Obviously credit-default swaps are near and dear to my
heart these days, but the public market investor who invested in our
company [Primus, a company specialising in credit-default swaps],
really doesn’t understand the numbers. What does a market growing
at 40% every six months mean? This brings up the whole issue of trying to educate the broader universe of investors. Do those numbers
mean risk in the market, is this a lot of double-counting, what is it?
ISDA can be at the forefront of education in terms of what all this
means, in terms of the risk being transferred in the credit derivatives
market. They’ve taken up that challenge but there is still lots to do.
■ Brickell: The fact that we’ve developed traded markets for all
these kinds of risks has made risk more transparent to the managers
of the firms. That’s contributed to greater stability in the financial
system, perhaps to the economy more broadly, and the fact that
some people perceive the users of financial statements as receiving
more opaque information while the managers in the firms are getting
greater understanding of transparency is an interesting paradox.
■ Risk: So accounting issues will continue to occupy a lot of
ISDA’s time?
■ Jasper: The accounting issues associated with derivatives generally
are still a work in progress, and hopefully ISDA will, as they have
for many years, take up the challenge.
■ De Saint-Aignan: It’s not only a question of the accounting
standards that set the ground rules and the measurement practices.
There’s also a disclosure dimension because you can measure P&L
and other values, but that does not necessarily give you any information on the risk profile implicit in that balance sheet or income
statement. This other dimension is more difficult than the accounting dimension to address.
■ Moulds: If you look at the challenges of trying to create a global
accounting standard, a clear illustration is the lack of agreement
between the major European countries in terms of embracing IAS
39. In a number of ISDA board discussions recently, accounting has
been at the forefront and I’m sure it will continue to be.
■ Basing: People say, “we can’t report like this, because the
value of the balance sheet would certainly start changing and we
have to show some of these changes”, as if by not reporting them
it would be safer. The challenge is to say “no, you should make
it transparent”.
■ Bailey: We all know that we have clients who are not executing
transaction deals that economically they should be doing – because
of issues about the presentation of transactions in their accounts.
This is an urgent issue but it is not a simple one. Clients should be
doing transactions only for reasons of economics.
■ Risk: Any final comments?
■ Brickell: I’ve got one thing to say on a personal note.
When I walked into my first ISDA meeting, I was so
impressed to be with a group of people, each one of
whom was smarter and more articulate than the next.
It’s been a great source of personal enjoyment to me
to be connected to the organisation for all those
years, to be with that kind of group – it’s a special
group within the financial world. ■
Risk March 2005
Congratulations to ISDA on
20 years of innovative thinking.
In a world of constant change we work closely with our clients to
provide a source of new ideas. We value the role that ISDA has played
in this. For further information on how our innovative thinking can work
for you, please call Eraj Shirvani on +44 20 7888 5809.
This advertisement has been approved solely for the purposes of Section 21 of the Financial Services and Markets Act 2000 by Credit Suisse First Boston (Europe) Limited of One Cabot
Square, London E14 4QJ. © 2005 Credit Suisse First Boston LLC and/or its affiliate companies. All rights reserved.
in agreement
Setting standards in swap documentation
was the very reason for ISDA’s
foundation – and has been perhaps its
greatest achievement. By Dan
Cunningham, Jeff Golden and John
Berry of Allen & Overy
Dan Cunningham
Nowadays, ISDA documentation is taken for granted. Most
participants in the OTC derivatives markets have never
known a time when ISDA – and its documentation – has not been
there. When it comes to entering into a new trading relationship,
especially where there is an international element, most parties
automatically reach for an ISDA Master Agreement and, perhaps,
an ISDA credit support document. When documenting the commercial terms of transactions, they generally make use of shortform confirmations and at least one of ISDA’s definitional booklets. It is hard to imagine a time without ISDA documentation.
But there was such a time.
Many years ago, being a lawyer documenting swaps for clients
meant three things. First, it was glamorous. The few recognised
experts tended to be based in either New York or London and would
hop back and forth across the Atlantic, sometimes even on Concorde.
Advising on derivatives was also exciting. Back then, dealers tended
to trade a matched book. A swap was often linked to a specific bond
issuance, with the closing of each conditional on the simultaneous
closing of the other. Deadlines were immovable. For the experts who
held their nerve and took their clients over the finishing line, there
was often the excitement of a closing dinner, tombstones, fountain
pens and all the other things that make being a lawyer worthwhile.
Unfortunately, though, this work was also frustrating. Market participants fought about everything, even, for example, how to determine Libor and what to do if the primary source was not available.
And people fought not because their position was necessarily, or even
arguably, more correct, but because that position was more familiar.
Documentation experts had helped the leading houses develop a variety of proprietary standard form agreements. When those houses sent
out representatives to negotiate a deal, few of the negotiators understood the issues well enough to be able to take a view on what could
or could not be changed. The unfortunate result was what lawyers
call a ‘battle of the forms’.
Then there was another issue. Parties documented each individual
trade in a separate agreement. This meant at least two things: there
were a lot of repetitive, costly and often wasteful negotiations; and
there was no contractual basis for viewing a series of two-way exposures with the same counterparty on a net basis.
Everyone in the market was saying: “There has to be a better way.”
Finally, someone said “How about master agreements?” It was clearly
a good idea, but people could not agree on the form they should
take. The first breakthrough came in 1984, when a group of dealers
decided to meet in New York to set about establishing some standards for swap documentation. The seeds of ISDA were sown.
At first, it proved too ambitious to produce a standard form contract. Instead, the group resolved to focus on concepts and vocabulary to permit the market to negotiate in a common contractual language. Crucially, this approach enabled members of the group to step
back from the battle of the forms to focus on substance rather than
form. The result of these early efforts was the publication in 1985 of
ISDA’s Code of Standard Wording, Assumptions and Provisions for
Swaps (the Code of SWAPS). ISDA was formally chartered shortly
before the publication of the Code, primarily because the group needed an entity to hold the copyright in the document.
The Code was not a contract. It was more like a dictionary or a
collection of building blocks that parties could use as they saw fit.
Parties could adopt it in its entirety as the basis for their contract,
whether in a Master Agreement or for an individual transaction, or
they could incorporate some portions of the Code and not others.
The fruits of the process that began in 1984 were special, but so
was the process. The working group consisted of a mix of lawyers,
bankers and traders, offering a variety of experience and perspectives.
Drafts were prepared, circulated for comment and discussed at group
meetings. Draft terms were revised, reviewed and revised again. If,
ultimately, a consensus could not be reached, a provision was not
forced on the group. Either the issue involved would be put to one
side or, perhaps, a provision would be structured in such a way as to
offer parties the ability to choose between different approaches.
The group built on its success. In 1986, ISDA published an updated and expanded version of the Code. And then the next big step was
taken. With the benefit of the common concepts and vocabulary that
had been developed, as well as the proven ISDA process, in 1987
Risk March 2005
Jeff Golden
John Berry
ISDA published two forms of Master Agreements – the first complete
standard contracts for the OTC derivatives markets. The 1987 agreements have since been followed by the 1992 Master Agreement and,
most recently, the 2002 Master Agreement.
Each form was developed using the same basic process, although
the scale of the effort has grown. Literally hundreds of people contributed to the development of the 2002 Master Agreement.
The success of the ISDA Master Agreements cannot be understated. Collectively, they provide the contractual basis for the bulk of a
global OTC derivatives market estimated to have an outstanding
notional value of $220 trillion. They have also been the inspiration
behind a proliferation of different master agreements in other sectors
of the financial markets. But no other agreement enjoys the reputation earned by the ISDA Master Agreement – a contract that has
been described, in a petition to the House of Lords, as “the single
most important standard form contract on which business is done
internationally today”.
But ISDA documentation is about far more than the relationship
contracts. Over the years, ISDA has developed confirmation forms
and definitional booklets that provide standard provisions for use in
documenting the commercial terms of a wide variety of transactions.
Since 1994, documents have also been published to enable parties
to collateralise their relationships and so reduce credit risk, a practice
that has grown exponentially over recent years. Apart from the Master
Agreements themselves, however, perhaps ISDA’s most remarkable,
and certainly the most innovative, achievement in the area of documentation has been its development of ‘protocols’.
Pioneered in 1998 with the EMU Protocol, ISDA’s protocols have
offered market participants a convenient web-based mechanism for
reaching agreement with other parties on a multilateral basis, thereby
largely eliminating the need to enter into costly and time-consuming
bilateral negotiations. Indeed, without the EMU Protocol, many market participants at the time of the introduction of the third stage of
European economic and monetary union would have needed to conduct hundreds of bilateral negotiations in very short order.
Under each protocol, adhering parties were able to select from a
menu of standardised provisions and, to the extent that the selections
of any two adhering parties matched, the selected provisions applied
as between those parties. So helpful was the EMU Protocol that a
total of more than 1,100 market participants signed on to it, including entities as diverse as the European Commission, Harvard
University and McDonald’s Corporation.
ISDA’s Master Agreements have become important risk manage-
Personal account
Leslie Rahl, president, Capital Market
Risk Advisors.
ISDA board: 1986–1991.
As a derivatives pioneer, and ISDA board member for five of its formative years, I am proud to have participated
with ISDA in the creation of an industry. Although I trust we all rue
the day when we as a board decided to count notional principal as a
proxy for industry size, we did so with the best of intentions. In
those days, as strange as it seems, we were still a small band of
believers trying to get the rest of the world to recognise the importance of derivatives. Who would have ever thought that the business
would come so far that our size and importance is a source of concern and criticism?
I remember chairing the first ISDA Documentation Committee.
It is humbling to think of how many things we have all learned since
then - all the different products and risks that were not yet on our
radar screen despite the thousands of hours committed to the
process. It is even more humbling to know that we've not yet
scratched the surface in terms of our understanding of the way
derivatives have changed and will continue to change the world.
ment tools. Starting with discussions in 1987 about the risks of cherry-picking, the close-out netting provisions of the ISDA Master
Agreements have served to dramatically reduce credit risk between
counterparties on a bilateral basis. The enforceability of those closeout netting provisions is now supported by ISDA netting opinions
obtained from counsel in 44 jurisdictions. The combination of the
close-out netting provisions and the netting opinions has also resulted
in a material reduction in the capital required to support derivatives
activities under the Basel and other similar capital standards.
In an article written in 1994, one of us said that: “The creativity of
the market-place coupled with an interest in seeking further means of
risk reduction has ensured that the ISDA documentation story is by
no means finished.” Eleven years on, as we celebrate this special
anniversary of ISDA’s incorporation, that story is as open-ended, and
as exciting, as ever. ■
ISDA 20th Anniversary
Financial engineering
modern finance
The world of finance has been revolutionised by mathematics. Leading quant
Marek Musiela traces the development of options pricing models from 1973 to the
present, and looks at the challenges ahead
Before there was a swap dealers market, before the advent of
ISDA, the milestone year for anyone seeking to establish the
birth of the derivatives market is, inevitably, 1973. That is when
modern quantitative financial theory came of age – the year when
Fischer Black, Myron Scholes and Robert Merton developed a
model for option pricing based on the idea of perfect replication of
the option payout.
The timing of the creation of the Black-Scholes model was perfect
as it coincided with the introduction of exchange-traded options on
stocks in the US. But the real
strength of the Black-Scholes
model lay in its simplicity. In
Black-Scholes, the interest
rate is assumed constant as
well as the return and the
volatility of the stock. Because
it was easy to implement and
interpret, the model was very
rapidly accepted as a standard
for the pricing of vanilla
options. However, the BlackScholes method reduces the
pricing problem to solving a
partial differential equation
(PDE). And while the latter is
possible analytically for simple
payouts, it proves to be quite
difficult when dealing with exotic options such as barriers or Asians.
In 1979, Michael Harrison and David Kreps set down the next
important milestone in the development of arbitrage-free pricing theory. They provided a general framework to price very complex financial
instruments in a generic way and within a large class of models for the
prices of an arbitrary but finite number of financial assets. They created
the link between the arbitrage-based valuation and the general theory
of martingales. The arbitrage-free price was shown to correspond to
the expected value, calculated under the risk-neutral probability of the
discounted option payout. In 1981, Harrison and Stan Pliska presented this stochastic calculus-based valuation of options approach to a
large community of researchers from that field. Their seminal and
rather technical paper was published in a mathematics journal rather
than a finance journal.
Risk March 2005
This is how I personally got into the field of finance and derivatives. What attracted me, and many others that followed, was a
remarkable fit between the well-developed theory of stochastic calculus and the quantitative needs of the derivatives industry. It was
fascinating to discover that every major concept of stochastic calculus seemed as though it had been conceived for its application in
finance. The surprising, and to a certain extent disturbing, thing was
that these concepts were created years before the derivatives industry was born, but seemed to us as if they were simply made for it.
The superior power of mathematical language was evidently
speaking with a loud voice and
the concepts that were used to
describe the physical phenomena of the world were very
efficiently put to work in the
financial markets environment.
From then on, many mathematicians and other researchers
from quantitative fields were
exposed to challenging problems
coming from a rapidly expanding world of financial derivatives.
Over the years, courses specialising in financial mathematics
Marek Musiela, BNP Paribas
were set up at many universities
and their graduates started to
play an increasingly important role in quantitative research and derivatives trading.
The next major breakthrough occurred in 1992 with the introduction of a framework developed by David Heath, Robert Jarrow
and Andrew Morton (HJM) for contingent claim valuation under
stochastic interest rates. Before then, alternative ways of dealing
with stochastic interest rates had been developed, but the main contribution here was a paradigm change.
Rather than modelling the dynamics of the short rate, which is
the constant parameter of the Black-Scholes model, the focus had
shifted to the dynamics of the entire forward curve. The main mathematical difficulty was in dealing with an infinite dimensional object,
namely a curve representing the instantaneous continuously compounded forward rates of all maturities.
Financial engineering
At this stage, infinite dimensional analysis also started to play a
major role in finance. In a way, this should not be surprising, given
that, in many respects, the entire curve is traded. Therefore, to capture correctly the uncertainty about its future positions one should
diffuse it directly. And this is exactly what the HJM approach does.
One of the simplifying assumptions of the Black-Scholes model, that
is, constant interest rates, was thus removed.
Interestingly, the Black-Scholes formula remained valid for the
pricing of vanilla options in the Gaussian HJM framework. What
changed was the interpretation of the volatility parameter. It represented the volatility of the forward price to the option maturity.
Again, the practitioner’s intuition and the model-based interpretation of certain relevant quantities converged. Such observations
were very encouraging.
The second simplifying assumption of the Black-Scholes model
was the assumption of constant volatility. This was inconsistent with
the market practice of pricing options. Contracts with different
maturities and strikes trade at different implied volatility levels. This
phenomenon is known as the volatility smile.
The first attempt to understand and model it was proposed in 1993
by Bruno Dupire. The idea was to construct a martingale diffusion
that is consistent with the market smile. This was achieved by determining the diffusion coefficient, which is implicit in the prices of
options with different strikes and maturities.
While efforts continue in the direction of identifying a model that
generates the appropriate smile dynamics over time, the issue of
consistency with the smile had been resolved.
A considerable amount of effort has been put into dealing with
the shortcomings of the Black-Scholes model. This is because the
model was not only used in the context where its assumptions were
not satisfied, but was also applied in situations that self-contradicted
them. For example, it was used for the pricing of options on Libor
and swap rates while, at the same time, it assumed that the interest
rates were constant.
While the scientists looked upon such practices with a justifiable
degree of scepticism, the practitioners were less concerned with the
apparent internal inconsistencies. The latter were proved correct in
1997 in a series of papers written by Kristian Miltersen, Klaus
Sandmann, Dieter Sondermann; Alan Brace, Bruce Gatarek, Marek
Musiela, Marek Rutkowski and Farshid Jamshidian. The so-called market Libor and swap rate model framework, consistent with the market
practice of pricing caps and swaptions, was put in place.
The practical and operational success of this new way of thinking
about interest rate risk depended very strongly on the ability to
implement such complex models. One of the fundamental stumbling
blocks on the way was pricing American-style and Bermudan
options. Until that time, the HJM-like models with the state variables were used as they could be implemented using trees or PDEs.
Unfortunately such models could only be calibrated to a restricted
set of volatility inputs. As a consequence, different calibration sets are
used for different products. The ‘market models’, on the other hand,
allow for generic calibration. However, they are Markovian in high
dimension and require simulation-based implementation. Hence, they
present a difficulty when pricing such options. Coincidentally, in 1995
Francis Longstaff and Eduardo Schwartz published a simulation-based
algorithm for pricing American-style and Bermudan options. With it,
another major step was taken in pricing and risk managing complex
financial products.
The general concept of the arbitrage-free value hinges on our
ability to dynamically replicate the risk. While this idea works reasonably well in the equity, foreign exchange and interest rate markets, it fails miserably in the area of credit derivatives. The Black-
Scholes formula is still used in the credit context for pricing some
vanilla options, but its impact on the development of the credit
market has not been significant.
Is there anything quantitative that the credit markets embraced to
the same extent as the other markets accepted the Black-Scholes formula? There were many attempts to apply classical finance ideas, but
they have not changed the credit derivatives markets to the same
extent as the Black-Scholes formula changed the equity, forex and
interest rate markets. However, there is one particular development
that stands out above the rest. This is the concept of a copula function introduced to statistics by Abe Sklar in 1959. The idea is to
define the joint distribution of a collection of random variables when
the individual marginal distributions of each of them are known.
In financial modelling we often find implicit information about
distributions of individual financial variables but we might not know
how to define the joint distribution of all of them. For example, a
credit default swap provides information about the distribution of
the default time for the underlying name.
ISDA changed one-off contracts between two parties into
a standard form contract that revolutionised and spawned
the growth of the over-the-counter derivatives market. The
myriad uses of the ISDA contract must surpass the wildest
imagination of those involved at the start. It was not an
easy task and those involved in ISDA should pat themselves
on the back for not only co-ordinating this effort, but also
for continually explaining derivatives, a difficult concept to
understand to those peripherally involved in the industry.
Professor Myron Scholes, Stanford University
Unfortunately, the pricing of tranches of synthetic indexes
requires the knowledge of the joint distribution of all default
times. In 2000, David Li proposed using a copula to solve this
problem. Very rapidly, the one-factor Gaussian copula was accepted as a standard to quote prices for the tranches of synthetic
indexes in terms of flat correlation, in much the same way as the
Black-Scholes formula is used to quote the vanilla option prices in
terms of volatility. It seems that the fundamental reason for such a
rapid acceptance of this new methodology is its ability to provide
the sensitivity (hedge) of a credit derivative quickly and on a
name-by-name basis.
It is worth emphasising that the concepts of price and of the associated hedge in the context of credit derivatives are very different
from the classical one of the dynamic replication of risk. In particular, the copula-based default time model does not give the continuous time dynamics of the relevant stochastic variables. The price calculated by expectation defines simply a function of the various
parameters. The sensitivity refers to a classical differential description
of that function, local in the space of the variables. It can almost be
viewed as defining a tangent space to the surface given by the set of
marginal distributions and the chosen copula function.
In a sense, the credit derivatives area still lacks continuous time
models similar to the Black-Scholes that would be consistent with
the current practice of pricing. The scientists are again looking at
such practices with a legitimate degree of scepticism. Dealers are, of
course, concerned about this. But, having limited choice, they simply
do what they can. ■
Marek Musiela is global head of fixed-income research at BNP Paribas in
London. He is co-author of the BGM model for pricing interest rate swaps.
ISDA 20th Anniversary
Regulatory threat
Zero to
$200 trillion
Friends asked me to scour my archives for a video history of
ISDA’s 20 years. Now I know how much fun Heinrich
Schliemann had digging at Troy. From boxes of documents unfolds
the story of an epic struggle for swaps participants, as we worked with
government to build a sound regulatory framework for a new business. Orange County, Hammersmith & Fulham, Procter & Gamble;
proposed regulations from the Federal Register; comment letters;
reams of legislation; parliamentary hearings and congressional markups; new proposals for regulation as the cycle begins again. What
was achieved?
The papers in some files would make you think that we had been
there when Troy was sacked. “Financial Markets Working Group
Derivatives Report Eunuchs CFTC and Slashes Market-Integrity
Protections” says a 1999 press release from Commerce Committee
Democrats in the US House of Representatives. “Glee at plan to
exclude swaps from regulation” proclaims a Financial Times headline.
In fact, in 12 years of working with regulators and legislators, we
erected a framework on these foundation stones:
■ swaps aren’t futures;
■ swaps aren’t securities; and
■ swaps will be regulated best by a framework that gives market
forces the maximum opportunity to discipline swap participants.
When the questions about swaps regulation first arose, swappers
were so surprised that we did not recognise their significance immediately. It was in November of 1987 when the Commodity Futures
Trading Commission (CFTC) issued an Advanced Notice of
Proposed Rulemaking suggesting that perhaps swaps – and particularly swaps on commodity prices – were futures contracts. The Advance
Notice had been out for several months when the late Bob Schwartz
of Chase Manhattan called it to my attention. It turned out that
Chase Manhattan’s nascent business in bank deposits linked to the
price of gold or equities was a special focus of the CFTC. But the
same CFTC logic cast doubt on the budding energy swaps business at
JP Morgan, where I worked, and other banks. The stakes were high.
If swaps were futures contracts, the CFTC would be required to
assert exclusive jurisdiction over swap activity, making itself the
authoritative regulator of all swaps in the US. In the process, the
CFTC would drive the swap business on to the rocks of the
Commodity Exchange Act (CEA). The CEA contained a provision
requiring that every futures contract be traded on a CFTC-regulated futures exchange; otherwise, it was unenforceable. If swaps were
simply off-exchange futures, billions of dollars of swaps that banks
and their customers relied on to hedge the risks of their businesses
could be worthless. The resulting losses could threaten the solvency
of some large banks, and even weaken the banking system itself.
Swap dealers began to pull back from their new activities.
Perhaps because so much was at stake, official Washington quietly went to work. Federal Reserve chairman Alan Greenspan called
Risk March 2005
At the rapid pace of the derivatives
business, 20 years in the financial
markets are like an evening gone. So
how did all these boxes of news clips
and draft regulations pile up in
my office? By Mark Brickell
attention to the problem in private meetings
with the CFTC;
California congressman
Tom Campbell, of the
Banking Committee,
invited the CFTC
chairman to breakfast
on the Hill to discuss
it. Most importantly, a
new CFTC chairman,
appointed by President
Reagan, arrived to lead
the agency in a
thoughtful, deliberate
look at the issue.
Wendy Lee Gramm, a
PhD economist from
Hawaii, by way of
Texas, knew the work of leading scholars on the economics of regulation, such as George Stigler and Milton Friedman of the
University of Chicago. They had concluded that, sometimes, regulations were adopted to benefit particular business constituencies
by inhibiting innovation and competition. Chairman Gramm wanted to be sure that, if her agency regulated swaps, the benefits to
society of that regulation would outweigh its costs.
After 18 months of careful study, Gramm and her fellow commissioners decided that asserting jurisdiction would do more harm
than good. Like snowflakes, each swap contract was unique in
some way – the notional amount, interest or forex rates on the
deal, credit risk of the counterparties – but the CEA was designed
to regulate standardised futures contracts. You can’t make a
snowflake with a cookie cutter, and in May of 1989 the CFTC
adopted its Policy Statement on Swaps hammered out by chief of
staff Robert Mackay, and containing the sentiment statement that
“swaps, though similar in some ways to futures, are not appropriately regulated as such under the Act”.
The headline for the Wall Street Journal editorial written by
Holman Jenkins proclaimed: “Swaps Saved”. No single regulatory
decision was more important to the success of swaps; the Swaps
Policy Statement prevented the door from being slammed shut on
an innovative business. For Gramm and her team, the most farreaching decision of their careers was not the result of what they did
at the CFTC, but what they decided not to do. Within 16 years, the
notional amount of swaps outstanding had grown to $200 trillion.
Many other decisions flowed from this one. By 1992, Congress
had enacted the Futures Trading Practices Act, affirming the CFTC
position taken in the policy statement. Twice more, the CFTC reaffirmed its policy. It did so first in January 1996, when the CFTC
issued an enforcement order against Metallgesellschaft, then clarified
that it had no implications for swaps. “CFTC Promises Not to
Regulatory threat
Regulate Swaps Like Futures”, read the headline in Bond Buyer.
More vigorously the second time, regulators, Congress and the
White House weighed in again in 1997, when the US Securities and
Exchange Commission (SEC) invited securities firms in the swaps
business to opt-in to SEC regulation, under a more market-oriented
framework for broker-dealer regulation dubbed by some ‘brokerdealer lite’. Perhaps concerned that, within such a framework, swaps
might be construed as securities, the CFTC, chaired by Clintonappointee Brooksley Born, reopened the issue. “Official: Swaps
Certain to Be Regulated,” asserted a Bloomberg story quoting a
CFTC director. But Congress passed an unusual ‘appropriations
rider’, temporarily barring the CFTC from using federal funds to
change its policy. President Clinton’s Working Group on Financial
Markets swung the door closed in November 1999, telling Congress
that it should create “an exclusion from the Commodity Exchange
Act” for nearly all swaps, and Congress nailed it shut in 2000, with
the passage of the Commodity Futures Modernization Act. In fact,
that law even incorporated in futures regulation some of the best features of the swaps framework, including the ability to opt-in to institutional regulation, in some cases.
The CFTC Policy Statement on Swaps was critically important for
another reason: it set a precedent that the swap business would not
have a single market regulator with authority over all transactions.
In the US, both futures and securities have such regulators. Gramm
and her commissioners, though, had concluded that such regulation
by the CFTC was not needed for swaps. Other regulators went further, indicating that such regulation could be harmful. In March
1991, discussing legislative provisions that could have pulled swaps
or hybrid securities into the CFTC’s exclusive ambit, SEC chairman
Richard Breeden called the plan “an example of precisely the wrong
way to legislate”. He contended that “the worst policies happen
when special interests go to work in the middle of the night”,
according to the Wall Street Journal. The same article attributed to
Federal Reserve chairman Greenspan the concern that such a policy
“could hinder the development of new financial products”, and
quoted him as saying that the provision “falls well short of permitting full and open competition”.
A decade of policy-making debate with respect to the CFTC
alerted the regulators, the White House and Congress that making
one regulator responsible for all swap activity could hinder competition and innovation. When the opportunity arose, they also denied
that role to the SEC, by including critically important provisions to
ensure that most swaps would not be treated as securities (after all,
which counterparty would be the issuer?) in the 1999 GrammLeach-Bliley Act.
The result – in this business of custom-tailored transactions – is a
framework where regulation is custom-tailored, too. How your swaps
are regulated is a function of what kind of institution you are. Bank
participants are regulated by banking supervisors, securities firms by
securities regulators, insurers by the state insurance authorities, and so
on. And if your firm is not a regulated business, the fact that you shift
risk with swaps does not make it one. In this environment, even the
regulators are able to innovate and monitor the impact as each strives
to set the best swap policies for the firms it oversees.
To a great extent, the stateside debate informed the thinking of
policy-makers outside the US, too. Worldwide, today, the primary
regulators for swap activity are institutional regulators and market discipline. (The most notable slippage occurs in the European Union,
where the broker-dealer style regulation, including capital requirements, applies to dealers in an expanding range of derivatives.)
Within this regulatory framework, of course. Not every swaps participant makes flawless decisions. In 1994, several firms, including
Personal account
David Gelber, chief operating officer, Icap.
ISDA board: 1990–1993
Having served as a director of ISDA, I can think
of no other trade organisation that has done so
much to lobby for its industry, the high point being the 'safe harbour' provision, which saw off the threat of Commodity Futures
Trading Commission regulation. The work on enforceability of netting is another clear success, which, somewhat remarkably in my
view, actually led to some countries changing their laws on insolvency in order not to be disadvantaged as a jurisdiction in the
derivatives market.
I am proud to have been associated with ISDA and wish it
continued success.
Procter & Gamble and Gibson Greetings, took losing swap positions. In 1998, the hedge fund Long-Term Capital Management
sent a frisson through the financial system when it nearly collapsed.
In some cases, a couple of participants even pleaded guilty to fraud,
under laws that existed before swaps were invented.
In cases where discipline was needed, the harshest penalties were
meted out by the market-place. When one angry counterparty filed
suit, it discovered tapes of phone calls revealing that its bank had
been less than candid about the falling market value of swaps
between that firm and the bank. When transcripts were published,
that bank had a hard time finding new business. Its stock price fell
so far that it was sold by its shareholders to another bank, and its
name slipped into banking history. As the bank’s regulator said at
the time: “We couldn’t have fined them billions of dollars. But the
market did.”
The swap framework is a model of market discipline. Within it,
every participant scrutinises the reputation and credit quality of his
counterparties, and adjusts the flow of his business accordingly. As
each does a little less business with one, or more with others, our
epic is still being written – and a business valued in the trillions of
dollars has grown by more than 25% annually for two decades. It
has meant new earnings, capital, management techniques for
financial institutions, and their customers, and greater stability in
the growth rate of for the economy. Within this framework, the
business is likely to continue its good work. As Federal Reserve
Chairman Greenspan said in 1999, “I am quite confident that
market participants will continue to increase their reliance on
derivatives to unbundle risks and thereby enhance the process of
wealth creation.”
After 20 years, the result of this scheme of regulation is notable –
for its strengths more than weaknesses. It is worthy of study for
what it can teach about how to regulate other financial services.
And it is a critically important source of comparative advantage for
swap participants, who have the leeway to innovate and transact
more efficiently than many others in financial markets, to meet
important social needs. By making it possible to shift risks from parties who don’t want them, to others that do (if only because they
are better able to manage them), swap participants make it easier to
manage businesses, enhance economic growth and cut the cost of
everything from home mortgages to hamburgers. Life becomes a
little better for their fellow man as a result. ■
ISDA 20th Anniversary
Risk management
a true
Working on one of ISDA’s regulatory
capital committees might not seem as
much fun as attending its late-night
AGM parties. But it leaves the industry
with much less of a collective headache.
Christopher Jeffery reports
In the 1980s, ISDA’s main focus was on documentation and
bankruptcy code issues. While the Association always engaged
with regulators regarding their treatment of derivatives, ISDA only
started building real momentum when it established its Risk
Management Committee in 1994.
The first Risk Management Committee chairman in Europe was
Mark Wallace, at the time a risk officer at Swiss Bank Corporation,
who is now chief operating officer at UBS Asset Management based
in London and Zurich. Meanwhile, Evan Picoult, managing director
in risk architecture at Citigroup in New York, ran the North
American Risk Management Committee. Other active participants
dealing with risk management issues at the time included Charles
Smithson, now a partner at Rutter Associates in New York and Mark
Brickell, now chief executive of Blackbird Holdings.
At the time, Joe Bauman, then at Citicorp, now a consultant for
WestLB, was chairman of ISDA. Wallace recalls that soon-to-be ISDA
chairman Gay Huey Evans, who was a senior managing director at
Bankers Trust and is now a director of the markets and exchanges
division of the Financial Services Authority, also took a leading role.
“In 1994, there was a lot of work done on VAR and incorporating that into Basel capital regulation,” says Wallace. “We
achieved capital changes for market risk in 1996.” Smithson
adds that ISDA was also successful in achieving increased
recognition for netting among international regulators.
The Association took an important step to increase its
engagement with regulators in 1996 by incorporating
risk management into its charter. To reinforce its focus
on this area, ISDA opened a London office and recruited Matthew Elderfield, now head of department for
Charles Smithson, a founding member of ISDA’s Risk
Management Committee
Risk March 2005
Risk management
major retail groups at the UK’s Financial Services Authority, from
the London Investment Banking Association to run it.
Elderfield says that by 1996, the Basel Committee had recently
developed a capital standard for market risk, although there were
two main exceptions. The first was modelling so-called specific risk,
linked to line-specific modelling, and the other was the treatment of
counterparty risk linked to netting of future exposures.
This meant most dealers spent their time scrambling to put in
place the correct market risk frameworks before the new rules came
into force in 1998. “This was the beginning of the implementation
of VAR models at large banks,” recalls Michel Crouhy, head of financial engineering at CDC Ixis in Paris, who at the time worked for
CIBC alongside Robert Mark, then on the ISDA board. “The capital
savings were huge from using internal models,” Crouhy adds.
David Mengle, ISDA’s head of research, was employed by JP
Morgan at the time. “ISDA was a major force in moving market risk
capital regulation from a prescriptive, and probably unworkable,
approach to an innovative approach that harnesses banks’ internal
models,” says Mengle. “The result has become a template for regulation that seeks to complement – instead of second guess – banks’
internal risk measurements,” he adds. The success of this template
encouraged ISDA to adopt a similar approach moving forwards.
But the most important area of work for Elderfield and ISDA at
this time centred on engaging with the financial supervisors to establish the best regulatory capital treatment for credit risk. ISDA argued
strongly that the 1988 Basel Accord treatment of credit risk was overly conservative and the whole area of credit risk needed a complete
redesign. “We really acted as a catalyst to open up the Basel Accord,”
says Elderfield. Adam Gilbert, chief operating officer of JP Morgan’s
credit product group, who was then working for the Federal Reserve
following a stint at the Bank for International Settlements, confirms
this take on events. “Yes, ISDA definitely played a vital role.”
And it achieved this by demonstrating a strong credibility with
regulators. “Although we were talking about key risk management
principles, we backed it up with real work, by doing test runs of
models and modelling portfolios,” says Elderfield. “That helped
reinforce the credibility of ISDA.”
In June 1999, the Basel Committee on Banking Supervision published its first consultative paper on Basel II. It was the same month
that Emmanuelle Sebton – described by Citigroup’s Picoult as “topnotch” – took over risk management responsibilities at the
Association from Elderfield. “The treatment recommended [by the
Basel Committee] for credit risk was more or less what we expected,” says Sebton. “But I don’t think anyone in the industry thought
the regulators would deem it necessary to tie in an operational risk
charge as well.”
Another area of concern for ISDA members was the Committee’s
perceived need for a foundation internal ratings-based approach –
something that will not be adopted in the US. “A lot of time was
spent by the Committee itself trying to assign regulator values to
the parameters they were setting in foundation, which we thought
was better used elsewhere,” Sebton says.
Over the following five years, ISDA staff and member committees
achieved a number of breakthroughs with the Basel Committee.
These include a commitment to review counterparty credit risk treatment and the handling of double default risk. The calibration of the
internal ratings-based function was itself proposed by ISDA, as were
some of the calibrations for operational risk. “ISDA had a significant
role in the treatment of collateral in the Accord,” Sebton adds.
ISDA is now working on a joint project with the Basel Committee
and the International Organisation of Securities Commissions – with
the European Commission acting as an observer – to examine the
To promote financial stability in a rapidly evolving and increasingly sophisticated global financial system, it is important that regulation and supervision harnesses and encourages developments in
industry's own risk management practices. This has been the central principle behind the Basel Committee on Banking Supervision's
recent work to review the capital framework for banks (Basel II).
The success of such an approach is, of course, completely dependent on input from the industry itself, which is why the Basel
Committee has placed such emphasis on consultation and dialogue
during the process of building Basel II. I am very glad to say that
ISDA has been a key partner in this dialogue and has made a very
positive contribution to the development of the new framework.
For our part, the Basel Committee is committed to continuing its
dialogue with the industry in the future, and at the same time as
congratulating ISDA on their 20th anniversary, I can say that we
very much look forward to their continued input in
this process.
Jaime Caruana, chairman of the
Basel Committee on Banking Supervision
Personal account
Brian Crowe, deputy chief executive of corporate banking and
financial markets, Royal Bank of Scotland
ISDA board: 1994–1997.
The highlight of my experience on the ISDA board was the way in
which the Association, led by Gay Huey Evans at the time, created
a profile with the regulatory community in Europe. ISDA promoted
itself as a constructive industry body; a body that brought technical
expertise to the issues of the day.
This role principally arose because of the focus on the technicalities of achieving Economic and Monetary Monetary Union within
the EU in an efficient and straightforward manner; ensuring that
the launch of the euro was successfully achieved in the financial
markets. This in turn created an environment in which ISDA's
advice has been sought on numerous European issues since then,
enhancing the standing of the Association.
capital treatment of certain trading book positions. Sebton says these
positions were singled out for immediate review in the Basel II capital Accord and include areas such as counterparty risk, double-default
risk, short-term maturity risk and illiquid positions.
The current regulatory capital treatment in these areas is considered overly punitive. Double-default risk, for example, is the risk of
loss resulting from simultaneous default by both the credit borrower
and guarantor. The current rules implicitly assume that a default by
the guarantor implies a default by the borrower as well. But the
financial services community argues that two defaults would practically never occur together.
JP Morgan’s Gilbert says the Basel Committee is likely to publish
its recommendations in a consultation paper within the next three
months. “Then there will be a short consultation period, with the
new rules due to be implemented in 2008 along with the rest of
Basel II,” Gilbert adds. ■
ISDA 20th Anniversary
Product innovation and
a new appreciation of
the opportunities
available are
encouraging both
investors and corporate
hedgers to revisit the
foreign exchange and
commodity markets
Dismal stock market returns. A
historically low interest-rate environment. And commentators warning that we
may be entering a secular bear market in
equities. It’s little wonder that investors are
revisiting the foreign exchange and commodity markets in search of alternative,
uncorrelated investment opportunities and
the prospect of yield enhancement.
Of course, neither market is novel in and
of itself. But, derivatives dealers say, investors
ranging from traditional pension fund managers to free-wheeling specialist hedge funds
are turning to a range of commodity and FX
strategies to leverage existing exposures, or
to seek out entirely new investment plays.
Both markets have seen dramatic price
moves in recent years – for example, strong
demand from China has lifted metals and oil
prices, and the dollar’s slide against the euro
has emphasised the extent of currency risks
to both investors and hedgers. And these
price movements have been met with greater
sophistication among investors, and product
innovation from the dealer community.
“Foreign exchange has always been considered as an asset class by certain parts of the
investor community,” says Derek Sammann,
global head of foreign exchange options at
Calyon in London. “But, given the recent
returns in other asset classes, we are seeing a
vast increase in players actively leveraging FX
in search of returns. And the increased use of
currency options to leverage a market view is
further entrenching FX as an asset class
among a broader range of investors.”
As with corporate hedgers (see box),
investors fall into three categories when it
comes to their appetite for FX risk, says
Sammann. The most conservative consider
foreign exchange exposures as an unwanted
risk, to be hedged where it occurs using
basic currency overlay programmes.
More sophisticated investors view their FX
position as an asset to be leveraged – using
FX options – to deliver enhanced returns. For
example, Sammann explains, a UK-based asset
manager with US holdings may be naturally
long dollars. He could buy a leveraged zerocost structure that serves to both express his
US dollar view as well as act as a natural takeprofit for his underlying dollar position.
Furthermore, the increasing sophistication
of FX options users is driving the development of a whole new range of instruments
allowing investors to express their view on
FX volatility. Cash-settled volatility products
– forward volatility agreements, volatility
swaps, or correlation swaps – allow investors
to express a ‘pure’ view on FX volatility.
“An investor seeking to express a view on
the direction of FX volatility could buy or sell
straddles, and be absolutely right about their
view, but not still get paid,” says Sammann.
Whereas other underlying option characteristics – interest rates, time value, etc – can
mask the pure volatility position, these new
products provide a clear and intuitive means
to trade FX volatility as an asset, he adds.
In the last category of investor are those
that create FX exposure as a means to embed
leverage in other asset classes. For example,
Sammann reports growing demand for FXlinked deposit or interest rate structures.
Such structures can be either capital protected or, where leverage is more important than
a redemption guarantee, a higher level of
risk can be incorporated to suit the individual’s risk appetite.
Similarly, Etienne Amic, Calyon’s global
head of commodities trading, identifies two
clear categories of commodity investors.
“There are those that are aware that commodities are at an attractive point in the cycle,
but they’re not experts – they appreciate that
they don’t know the technical aspects, the
supply and demand characteristics, which
drive particular commodities,” he says.
These investors are snapping up options
on established baskets of commodity prices –
such as the Goldman Sachs Commodity
Index, which is made up of 24 weighted
commodity prices. Others, he says, prefer to
express their views via customised indexes,
made up maybe of a handful of commodities. And, as with FX structures, varying levels of capital protection are available, he says.
In addition to these investors, Amic says
that Calyon is seeing demand for mediumterm notes with specific – and often exotic –
embedded commodity exposure. “The suspicion is that these are commodity producers
with a view on the fortunes of their own
commodity,” he says.
And, with an eye on considerably more
specialist trading strategies, are the hedge
funds. As the global growth of the hedge
funds continues apace, some have created successful niches trading commodity markets –
and, in some cases, taking the place of the
merchant energy companies brought down to
earth by the collapse of Enron in late 2001.
“They aren’t making their money by punting the market, and simply taking a long or
short position in the commodity of their
choice,” he explains. “They’re putting on
positions that exploit geographical spreads,
reflecting the economics of transport, quality spreads, such as between various grades of
crude oil, or time spreads, playing on the
economics of storage.”
“For hedge funds, these risks are pure
alpha – they’re not well understood by the
majority of the financial community, and
there are good opportunities for arbitrage.
And, even when expressing a directional
view, investors benefit from the fact that
commodity returns tend to be completely
uncorrelated with everything else,” he adds.
As an example, Amic cites the evolution of
the UK gas market over the past three years.
Traditionally, gas utilities have sold gas to
their consumers via long-term (usually annual) fixed contracts, while for fiscal reasons
producers tend to prefer to sell no more
than one month ahead. Bridging the gap were US energy trading
companies, such as Enron, Williams etc, who would carry the transformation risk, effectively acting like banks, by committing capital
on the likely outcome of future spot prices.
Since the sector’s retrenchment in 2002, the hedge funds have
stepped up – to their great profit, says Amic. He points to October
last year, when supply constraints temporarily forced the price of gas
to be delivered during Q1’05 from 30p/therm to above 80p/therm
in a matter of weeks. “The amount of risk premium being priced by
the market at the peak of the booking season for gas utilities was
completely unreasonable,” he says.
“More and more hedge funds are taking on this kind of risk. It’s
what the best oil companies or banks were doing – getting into the
details of an industry, and understanding the risks and rewards,” he
adds. “And it’s far more lucrative than shorting bonds, for example.
We’re going to see a lot more hedge funds taking on risks such as
these over the coming years.” ■
Name: Derek L. Sammann, Global Head of Foreign Exchange Options
Tel: +44 207 214 7457
Name: Etienne Amic, Global Head of Commodities Trading
Tel: +44 207 214 6572
Derek Sammann
Not speculating, but hedging
Just as investor approaches to foreign
exchange or commodity exposures can be
characterised according to risk appetite, so
too can those of corporate hedgers. And, just
as the sophistication of investors is increasing
in respect of these two asset classes, so too is
that of corporate risk managers.
More cautious companies continue to consider FX risk as a liability, and something to be
eliminated as cheaply and simply as possible.
However, Calyon’s Sammann argues that a
growing number of corporates are constructing active currency risk management programmes that look at FX risk as an asset class
that can be exploited to generate returns.
For example, a risk manager might introduce leverage to outperform an exchange-rate
benchmark. A geared accrual product, for
instance, would allow the corporate to buy a
certain geared amount of currency forward at
an attractive rate, every day that certain conditions were met. Should, however, the currency reach a certain level, the contract would
knock out, leaving the corporate with what
they’ve already accrued.
“There’s a continued drive for companies to
use their assets as profitably as possible and,
given the commoditisation of FX options,
increasingly sophisticated product catalogues
from banks, and the broader understanding
of derivatives by corporates, we’re seeking
greater corporate take-up of such strategies,”
says Sammann.
Growing sophistication is equally evident
within commodity risk management, argues
Etienne Amic. “There’s a trend towards trying
to identify a company’s real economic risk,”
he says, citing a South African coal producer
with dollar revenues, costs in rand and, of
course, exposure to the coal price. “We’d
offer a product that combines both commodity and FX risk,” he says, “typically a collar
allowing the producer to be protected against
unfavourable market outcomes at a reasonable cost, or no cost at all”.
Hedgers face yet more complexity in quantifying exposures. Amic gives the example of a
Spanish gas distribution company, which buys
liquefied natural gas from the Middle East,
priced off the Brent crude benchmark, in dollars. Its domestic customers, however, pay in
euros, in contracts priced against fuel oil, gas
oil and Spanish electricity. Through its industrial production, the company is effectively
taking significant refining margin and foreign
exchange risks, which are intimately intertwined, the nominal FX exposure being
dependent on the market value of the commodities themselves.
“Corporates are becoming more aware of
the intricacies of commodity markets,” Amic
says, noting that many are now trading freight
derivatives. The growth in that market has
been driven by the prodigious increase in
international trade and the bottlenecks that
have appeared in the shipping industry as a
result – such as that which occurred last
October, when lost output caused by
Hurricane Ivan in the Gulf of Mexico had to be
replaced by crude tankered from Middle East.
Freight prices soared as a result and the
volatility has since then guaranteed good volumes in the associated derivatives markets.
Similar phenomena have been witnessed in
the base metals and agricultural industries,
he adds.
But it’s not just the customer’s risk that
needs to be accurately assessed. “There’s a
challenge for banks to integrate their credit
assessment with the market price of commodities,” Amic says, pointing to the problems in trying to sell a long-dated hedge to a
poorly rated emerging market producer
of hydrocarbons.
In trying to sell its production forward, the
producer would potentially find itself up
against bank credit controls that limit exposure to a single signature. If the price was to
rise, so too would the bank’s credit exposure
to the producer – further discouraging the
bank’s credit committee from approving a
long-term deal. On the other hand, points out
Amic, higher prices would strengthen the producer’s business.
“The challenge for us is trying to predict, in
a dynamic way, how commodity prices will
affect our clients’ balance-sheets,” he says.
“Good progress has been made over the past
few years in this respect”.
Calyon congratulates ISDA on its 20th anniversary
of G-30
Some sharp words from the right
regulators sparked an industry-wide initiative to establish a template for managing risks associated with derivatives. It’s
known now simply as the ‘G-30 report’.
By Mark Brickell, David Brunner and
Patrick de Saint-Aignan
In February 1992, Gerald
Corrigan, then president of the
Federal Reserve Bank of New York,
delivered a speech with a widely reported
warning to the derivatives industry about
its practices. People paid attention.
A few months later, Charles Taylor,
executive director of the Group of
Thirty (G-30), told Mark Brickell at
JP Morgan that the G-30, largely
comprising current and former regulators, and chaired by Paul Volcker, had
urged him to do a study of derivatives.
Taylor was Washington-based, politically astute and energetic. Brickell
conferred internally at JP Morgan with
derivatives head Peter Hancock and
chairman Dennis Weatherstone, then
told Taylor they’d be glad to help him
put together a working group of
expert swap practitioners.
Patrick de Saint-Aignan of Morgan
Stanley and David Brunner of Paribas
From left to right: James Healy, CSFB; David Brunner, Paribas; Patrick de Saint Aignan, Morgan Stanley; David Gelber,
HSBC; Charles Taylor, G-30; Malcolm Basing, Swiss Bank Corp; Akira Watanabe, Mitsubishi Bank; Daniel Cunningham,
were selected as co-chairs of the
Cravath; Halsey Bullen, FASB; Ian Scott, Guinness; Charles Smithson, Chase Manhattan; Mark Brickell, JP Morgan;
working group. They chose Robert
Robert Mackay, Virginia Tech; Robert Casper, Cravath; Tsuyoshi Hase, IBJ; Ken Raisler, Sullivan & Cromwell;
Mackay, a PhD economist and
Peter Hancock, JP Morgan (company affiliations as of 1993)
derivatives expert, who had served as
duced being codified as regulation. Another Chicago Nobel laurechief-of-staff at the Commodity Futures Trading Commission, to
ate, Friedrich von Hayek, had observed that the surest way to stifle
serve as the principal adviser. The team assembled a working group
innovation is to take current best practices and convert them into
from around the globe: dealers; end-users, including Merck,
rigid requirements. The group was taking a defensive stance on the
McDonald’s and Guinness; lawyers and accountants; but no regulafuture growth of their business. Miller understood all of that.
tors. Twelve of the 26 were ISDA board members or advisers.
Weatherstone’s objectives for the study were clear: “This should
The group was overseen by a 14-person steering committee
not be a study that gathers dust on a shelf. I want to produce a
chaired by Weatherstone. It included Peter Cooke, an ex-Bank of
guide by practitioners for practitioners that has so much useful,
England regulator and first chairman of the Basel Committee.
practical advice that it will be referred to for years to come.”
Mackay and Brickell travelled to the University of Chicago to
Brunner and de Saint-Aignan formed subcommittees to deal with
recruit Nobel laureate Merton Miller to help steer. Miller’s underdifferent types of risk: market risk, credit risk, operational risk, legal
standing of free market principles would help the executives and exrisk and systemic risk. They asked each working group member to
regulators when they met to assess the working group’s product.
submit his or her best recommendations. Over the next nine
The whole project was fraught with peril for the swaps world.
months, a tight timetable imposed by Weatherstone, they syntheThere was a clear danger of having any recommendation it pro-
Risk March 2005
sised about 130 recommendations into 20 for practitioners and four
for legislators, regulators and supervisors. At the same time, in
January 1993, a Survey of Industry Practice was launched with the
assistance of Price Waterhouse.
Working group members submitted material for other members to
read, refine and submit to a core drafting and editing group for further work. They invested hundreds of hours to produce three volumes, released in July 1993. The first contained the recommendations and an explanation of derivatives activity, designed to demystify
and make the business accessible to the public. The second contained
the working papers, detailed explanations of how the principles
should or could be put into practice. The third volume reviewed
legal enforceability issues in nine jurisdictions, a report assembled
through the contributions of nine law firms under the co-ordination
of Dan Cunningham of Cravath, Swaine & Moore. Later, in March
1994, the Survey of Industry Practice was published.
There were hours of meetings to talk through sections of the
report. At JP Morgan alone, Weatherstone parcelled out the document to experts at the firm, including Hancock and, notably, Steven
Thieke, former executive vice-president at the New York Fed. David
Boorstin was hired to edit the document and turn it into a readable
form. If a camel is a horse designed by a committee, this was an
attempt to transform the camel into a thoroughbred.
Regulators studied the document, drew on it for ideas, but never
turned it into a codified set of rules. So the group achieved its purposes: a report that demystified derivatives for the layman and the
policy-maker but stopped short of regulation. Practitioners got a
benchmark against which they could assess the quality of their
own risk management. Firms systematically went out and assessed
their performance against each of the recommendations. A
subsequent volume, in December 1994, reported the results of
the benchmarking. The project was widely complimented. Corrigan
himself brandished it at a House Banking Committee hearing, saying the industry had tackled the issue.
The report was a great valedictory gift from Weatherstone, a trader
by background, to the financial world, as he approached the end of
his tenure at JP Morgan. It made clear that derivatives posed the same
risks that firms face in their traditional financial and business activities,
and established the important corollary that the best risk management
practices for derivatives are also helpful in managing the same risks in
traditional financial instruments. In short, you could benefit from the
report even if your firm had never done a single swap.
And the report has stood the test of time. It is still useful today. ■
Key highlights of the G-30 report
■ Emphasises the importance and benefits of mark-to-market for
dealers every day as a way of keeping track of the value of positions and the risks inherent therein.
■ Laid out principles of value-at-risk (VAR), using statistical analysis to
assess potential changes in portfolio value by risk type (delta,
gamma, etc).
■ Put VAR out to the widest audience it had ever received; it is widely
used by financial institutions today.
■ Described how to measure credit exposure, using market value plus a
measure of exposure reflecting potential shift in market value.
■ Recommended establishment of independent market risk and credit
risk management functions.
■ Recommended using Master Agreements.
■ Recommended derivatives should be accounted for in the same
way as the risks they are used to manage.
■ Urged netting be enforceable by law.
Personal account
Katie MacWilliams, chief financial officer,
Coors Brewers
ISDA board: 1990 – 1992.
Wow! What a bunch of old memories to dust
off. I first heard about the swaps market in 1983 and executed my
first deal in February 1984 as an end user while working in the
treasury department at Sears, Roebuck and Co. In those pre-ISDA,
days, I experienced first-hand the huge need for this highly creative
and rapidly developing market to establish its very own set of common language and a shared approach to documentation. I joined
the swaps team at First National Bank of Chicago in 1985. I was
invited to join the ISDA board in 1989. It was a fascinating time
and much of the focus was on education and ensuring a regulatory
environment that would support the value, creativity and sustainability of this still new market.
What a success… and I count myself very lucky to have been
a small part it in the early days. ISDA, congratulations on
your 20th!
ISDA 20th Anniversary
a derivatives code
The historical development of Japan’s
derivatives market has closely followed
that of the US and Europe, but the
evolution of legislation has been more
idiosyncratic. By Sarfraz Thind
The growth in the global derivatives business in the 1980s
required a document that could support transactions across
regions. So the potential benefits of ISDA’s Master Agreement soon
became evident in Japan. “The nature of the derivatives business
being conducted on a cross-border basis meant we wanted global
standardised documentation,” says Akira Watanabe, former head of
derivatives at Mitsubishi Bank and now president of Nippon Revival
Services, and vice-chairman of the Association between 1990 and
1992. “The Master Agreement had an umbrella structure covering
all products. This was a brilliant idea.”
Watanabe formed ISDA’s Japan Committee in 1986, while he was
head of derivatives at Mitsubishi Bank, and played a significant role in
expanding membership and establishing dialogue with the regulators.
He says that at the beginning, domestic institutions were sceptical
about the benefits of the Master Agreement. “It was a challenge to
have it accepted,” says Watanabe. “Firstly it was written in English,
which most of the Japanese members thought cumbersome to read,
and it was painfully lengthy. For people used to dealing with foreign
exchange or money markets where you only have to incorporate the
terms ‘I buy, you sell’ it seemed too time-consuming.”
Watanabe worked alongside Akihiro Wani, a partner at Linklaters
covering derivatives and structured finance, and legal counsel for ISDA
in Japan since the early 1990s, at which time he represented Mitsui,
Yasuda, Wani & Maeda, to promote the Master Agreement. The two
persuaded the Japanese market that the document could be used as an
international standard, allowing Japanese derivatives users to trade with
any counterparty anywhere in the world. And once it was established
there would be no need to issue a repeat of the document.
To help matters, ISDA’s Japan Committee initiated a project to
translate the Master Agreement, and supplementary guidebook, into
Risk March 2005
Japanese, in 1993. And ISDA garnered help from the Bank of
Japan, in particular from Hiroshi Nakaso, who worked as an official
in the Financial Systems Department at the time.
“The regulators had been quite receptive to the ISDA Master,”
says Wani. “They were impressed by the sophisticated documentation structure, which incorporated the Master Agreement,
Definitions and Confirmations.” Although the receptiveness of the
market to the Master Agreement grew during the mid-1990s, convincing the Japanese legislators to pass a law enshrining the closeout netting provisions proved a much more difficult task.
ISDA had commissioned a legal opinion on the enforceability of
close-out netting in 1987, but this only covered financial claims on
interest rate and currency swap transactions. Watanabe and Wani
worked together on a redraft of the opinion, to include newer types
of transactions involving products such as options and commodity
derivatives, and asked the Japanese regulatory authorities, including
the Bank of Japan, the Ministry of Finance and the Ministry of
Justice, to accept the draft.
“The regulators did not want to show their position clearly
because there was no existing statutory provision covering close-out
netting,” says Wani. “We started to persuade them that the results
of close-out netting could be achieved through the application of
set-off precedents developed by Japanese courts and drew upon similar legislation in the existing Bankruptcy Code.”
But the process was made difficult because officials at the Ministry
of Justice were reluctant to amend the bankruptcy law or institute
new legislation incorporating the enforceability of close-out netting.
So rather than wait for close-out netting to be incorporated into
the legislature, Watanabe and Wani took a more practical route.
“We made a deal with the Ministry of Justice, which said that if we
could get a strong legal opinion from the leading academic in this
field, Professor Koji Shindo, of the University of Tokyo, as to the
enforceability of close-out netting they would not object to the
overall interpretation,” says Watanabe. “While this was not as clear
as an amendment to the existing law, it was deemed sufficient.”
They obtained a strong legal opinion from Shindo on the enforceability of the provisions in 1992. However, it was not until 1998 that
the Ministry of Finance finally issued a law to enact the close-out netting provisions. Again, this was only a partial validation and was only
applicable in cases where one counterparty was a financial institution
resident in Japan. ISDA has continued to lobby the government to
make the netting legislation applicable on a wider basis, and this year
the Ministry of Justice amended the bankruptcy code, confirming the
enforceability of close-out netting for all institutions.
In 1998, the same year as the original close-out netting legislation
came into effect, the Japanese market experienced one of its biggest
shocks following the failure of Long Term Credit Bank of Japan
(LTCB). As well as being one of the biggest lenders in Japan,
LTCB had a derivatives portfolio worth some ¥50 trillion ($463 billion) in notional, mostly composed of interest rate and currency
swap trades with foreign and domestic counterparties.
It was feared that a disorderly collapse by the bank would trigger a
default event under the ISDA Master Agreement, which in turn
would lead to cross defaults and amplify disruption in other markets,
creating a systemic panic. To prevent this, the Japanese government
eventually agreed to nationalise LTCB, and honour its outstanding
obligations. But the nationalisation process took several months, and,
in the interim period, LTCB came under huge market pressure.
ISDA’s role in allaying a potential crisis was crucial. It became a
de facto intermediary between the regulators, trying to persuade the
market that obligations would be honoured, and LTCB’s obligees,
whose confidence in the bank and its guarantees of payment deteriorated day by day. “ISDA co-operated with the Japanese regulators
and prevented the occurrence of systemic risk,” says Wani. “No
derivative transaction with LTCB was terminated.”
ISDA’s Japan Committee has also upheld member interests on a
long-term basis in partnership with the US and European offices.
The Japan Committee has also been an active participant in the
Basel II dialogue, working closely with the regulatory authorities.
One of the important early issues related to the treatment of capital requirements for credit portfolios. “The Bank for International
Settlements did not initially recognise the effects of close-out netting provisions for the calculation of capital requirements for counterparty credit risk, which meant banks would have to set aside too
much capital against their credit portfolios. This would have proved
very costly,” says Watanabe. “ISDA members across the globe
worked closely together to develop a more realistic means of calculating credit exposures on a portfolio basis.”
And ISDA has also presented a united front in other significant
dialogues – for example, the definition of default events for credit
default swaps, an issue that was resolved more recently.
Yusaku Manabe, deputy general manager in the structured products division at Mitsubishi Securities in Tokyo, and board member
and co-chair of ISDA’s Japan Steering Committee, says the
Association has been in close contact with the European office in
debating this issue with the regulators. “We have had some good
Basel II dialogue,” he says. “For example, in the beginning the regulators required restructuring to be covered for banks to get capital
relief through credit derivatives. After much discussion, this was
revised in the final consultative paper, and they agreed to allow 60%
of the amount of the hedge to be obtained, without the need for
the restructuring terminology.”
ISDA had already worked with the Japanese regulatory authorities
to have ‘obligation acceleration’ and ‘repudiation/moratorium’ terms
dropped from the list of credit events for credit default swaps in 2002,
a year after this occurred in Europe. And, says Manabe, the Basel
negotiations have been very important in determining market practices for credit risk transfer in Japan. “Japanese banks have been seriously looking for credit risk management tools,” says Manabe. “ISDA
is considering working on a code of conduct for the treatment of
insider information with regards to credit risk transfer, as has already
been issued in the US and Europe.”
ISDA has also worked to promote better understanding of credit
derivatives documentation with the release of a Japanese translation of
the ISDA Credit Derivatives Definitions in 2003. Furthermore, as in
other jurisdictions, the treatment of collateralised derivatives remains
an important subject for the Japanese market. “The members consider there to be a mismatch between market practice and the regulation,” says Tomoko Morita, policy director and head of ISDA’s Tokyo
office. “However, ISDA has been working closely with the Japanese
Financial Services Agency (FSA) to resolve this situation.”
ISDA has also helped to resolve issues more acutely felt in the
Japanese market, with emissions trading currently a hot topic. “At
the moment it is difficult for Japanese financial institutions to trade
emissions rights in the domestic market, because the legal interpretation and accounting treatments are still under discussion,” says
Hidetaka Hara, executive director, global markets planning department at Nomura Securities in Tokyo, and an ISDA board member.
Although public awareness has increased since Russia announced
its decision to ratify the Kyoto Protocol in 2004, Japanese regulators are still grappling with the most fundamental aspects of emis-
Personal account
George Handjinicolaou, founding partner,
Etolian Capital Group
Alternate board member representing Security
Pacific Hoare Govett, in London (1987–1990)
Having had the privilege to serve on the ISDA board in the early
days, I can say that the over-the-counter derivatives market wouldn't
be where it is today were it not for standard documentation. ISDA
always looked for input from end-users, such as corporate treasurers, government entities and Federal Reserve officials. Negotiating
the terms to find a fine balance between the dealer and the enduser is very important. The market could only have grown as it has
with standardised contracts acceptable to all users. ISDA's initiative
to set documentation standards was the lubricant that made the
market explode. If ISDA continues to function as it has done in the
past, it will provide the leadership required as the market-place
generates new products.
sions trading. ISDA set up the Emissions Trading Working Group
in late 2003, and established a dialogue with the Financial Services
Agency and Ministry of the Environment last year, but there is still
work to be done. “Manifold agencies are looking to govern over
emissions trading,” says Hara, who is also co-chair of the Japan
steering committee. “On the one hand, regulators have been looking at it from an environmental perspective, but on the other it is
being discussed as a taxation or industrial competitiveness issue. We
are looking to find a balance between the two.”
ISDA has also been working to promote legal certainty in the area
of weather derivatives, which remains an important issue for participants. Japan has a buoyant weather derivatives business. The issuance
of ISDA’s global long-form weather derivatives confirmation in 2003
helped to bring greater standardisation to the market, making it easier
for Japanese institutions to do transactions with foreign counterparties. As participants have humorously pointed out, the spate of
mergers in Japan over the past few years has seen a decline in
ISDA’s Japanese membership. But the influence and usefulness of
the association remains as strong as ever. ■
ISDA 20th Anniversary
Global reach
legal certainty
ISDA has worked tirelessly to spread legal certainty for derivatives transactions and the
lawful enforceability of collateral and netting across the globe. By Sarfraz Thind
Prussia’s Iron Chancellor, Otto von Bismarck, once remarked:
“Laws are like sausages. It is better not to see them being
made.” But the importance of ISDA’s work in providing legal certainty for derivatives has not gone unnoticed.
It can easily be seen in the expansion of the Association’s influence
across the globe. The ISDA Master Agreement is now used in more
than 90% of over-the-counter derivatives transactions worldwide.
And ISDA has had a hand in averting episodes of systemic risk.
The following articles look at how ISDA has aided the development of derivatives legislation through its regional committees –
divided into central and eastern Europe plus an Islamic Finance Law
Working Group, Latin America and the Asia-Pacific region.
‘Netting’ central and eastern Europe
The central and eastern European region has grown steadily in economic importance since the collapse of the Berlin Wall in 1989, just
four years after ISDA was first chartered. During the ensuing period, a
host of these countries have sought closer ties with the West, culminating in a raft of former Eastern Bloc countries joining the EU last year.
Douglas Bongartz-Renaud, managing director and head of structured risk, financial markets and derivatives at ABN Amro in
Amsterdam, chairman of ISDA’s Central & Eastern European
Committee, and longest serving member on ISDA’s board, says the
expansion of ISDA’s activities in this area, which loosely stretches
from EU accession/candidate countries and CIS (Commonwealth of
Independent States) countries as far as Israel, has mirrored the transition of the European derivatives business. “I thought it was very
important for ISDA to expand its international role as derivatives use
and technology has expanded in the last 10 years,” he says.
But one of ISDA’s greatest areas of focus has been to help develop
derivatives regulations in four EU accession countries: the Czech
Republic, Hungary, Poland and Slovakia. “The rationale for ISDA
getting involved in any regional market is where it is gaining signifi-
Risk March 2005
Douglas Bongartz-Renaud,
ABN Amro
Global reach
cance in OTC derivatives,” says Richard Metcalfe, senior policy
director with responsibility for all of ISDA’s regional activities and
co-head of its European office in London.
ISDA set up its European Emerging Markets Task Force in 1997,
but really became actively involved with the four main accession
countries six years ago in conjunction with the European Bank for
Reconstruction and Development (EBRD), which was looking to
deploy some of its resources to regenerate the economies in emerging European states. The major focus was the implementation of netting legislation. At the time, the existing legislative structure in the
Czech Republic, Hungary, Poland and Slovakia posed special problems for the lawyers working on the project.
“The projects in these countries have had to recognise that historically the local insolvency regime was ‘pro-debtor’, unlike in countries
like the UK, where the underlying law is much more protective of
creditor counterparties,” says Jeff Golden, partner and co-head of
the US law and derivatives practices at Allen and Overy in London,
who has worked as a legal adviser to ISDA since its foundation.
“Accordingly, most central European legal systems prohibited postinsolvency set off for the benefit of a creditor in cases where, as a
matter of English insolvency law, set off would be mandatory.”
While the level of sophistication among local law firms has been
extremely high, ISDA has faced some technical challenges – not least
the linguistic gaps. For example, the absence of the word ‘netting’ in
Slavic languages meant it first had to define a legal concept for the word
before it could explain how the netting reforms could be achieved.
Similar difficulties arose in Poland. The Polish government initially
adopted close-out netting provisions that were only enforceable in a
Polish court, against Polish counterparties and in the Polish language.
But the government eventually relented in the face of ISDA’s lobbying and amended this, adopting broader netting legislation in 2003.
Hungary had adopted the close-out netting legislation a year
earlier and the Czech Republic followed suit in May 2004, with
ISDA’s netting opinion now pending. The work in Slovakia continues, with new legislation expected this year.
While the absence of close-out netting has never prevented derivatives trades from taking place in the region, the new legislation has
added a level of safety for participants. And the benefits in these countries are likely to grow as demand for derivatives products increases.
“The Czech banking market is already very internationalised,” says
Stefan Balgary, Prague-based country treasurer for the Czech Republic
at Citibank. “But the introduction of the close-out netting provisions
should open the door for local investors who have previously been
quite conservative, and will serve to increase the level of confidence of
the international banks doing business in these markets.”
Allen and Overy’s Golden is full of praise for these countries’ legislative reforms. “The statutory reforms adopted in countries like
Hungary and the Czech Republic are of the highest order, putting
statutory support for close-out netting on a level footing with the
position in many more developed economies,” says Golden.
He adds that ISDA views these efforts as serving as a model for
ongoing projects in other developing markets, including Russia, where
the historical background is not altogether different. While the EBRD
mainly worked alongside ISDA in Hungary and the Czech Republic,
ISDA 20th Anniversary
Global reach
Mike Bass, Standard Chartered
it does not rule out a further collaboration with the association in some
of the important Balkan states in the future, says Michel Nussbaumer,
head of the legal transition team at the EBRD in London.
In its push to create a more level playing field across Europe, ISDA
also submitted a proposal to the European Commission in 2003 suggesting the adoption of a European netting directive aimed at harmonising the netting regimes in the EU member states. This may
have some particular value for the accession and candidate countries.
“Close-out netting is already widely recognised in the original 15
EU states,” says Niall Lenihan, head of the financial legislation and
practices division at the European Central Bank. “So there has been
more of an impetus for this legislation to involve the newer accession
countries.” Since its establishment of the Central and Eastern
European Committee, ISDA has also lent a hand in the development
of close-out netting legislation in Greece and presented its legal
opinion on the enforceability of established close-out netting in
Turkey in 2002. It is currently involved in efforts towards close-out
netting in Israel.
With more countries set to enter the EU, the region is set to attract
increased investment and interest from foreign parties. ISDA remains
committed to bridging gaps across the ever-developing derivatives
landscape. It is looking to assist with the development of netting laws
in countries such as Romania, Croatia, Slovenia and Kazakhstan. In
Russia, ISDA has met with various parliamentary committees and
commented on draft bills affecting derivatives. It currently participates
in a working group with local banking associations and regulators to
discuss progress of financial legislation, especially derivatives.
New challenges in Islamic-law countries
ISDA has been asked to deliver its expertise in jurisdictions ranging
from Iceland to Botswana, the Maldives and Marshall Islands. But
one important new area where the Association is currently directing
resources is to the Islamic jurisdictions in the Middle East and
Southeast Asia. ISDA conducts work in these countries through its
Islamic Finance Law Group, which is co-ordinated by Peter Werner,
a London-based ISDA policy director. The purpose of risk management is recognised as valid under Sharia Law. But the boundary separating derivatives as instruments used for risk management rather
Risk March 2005
than speculation (qimar) remains open to debate.
While work is still at the early stages, the Association has held discussions with regulators in Bahrain, the UAE (United Arab
Emirates), Qatar, Saudi Arabia, Kuwait and Malaysia to discuss issues
relating to Islamic law arising for ISDA documentation.
Kimberly Summe, ISDA general counsel in New York, says there
are some obvious challenges. “For example, Sharia Law prohibits the
assessment of interest, there are certain derivatives types where the
underlier is not allowed, like pork futures or casino-related income,
and there are concerns over force majeure provisions,” she says.
Werner adds there are four main schools of thought in Islam, all of
which apply Sharia Law in different ways. This presents some challenges, as the influence of Sharia Law is very dissimilar in different
countries and regions of the Islamic world.
But there are signs the market is warming to ISDA’s approaches.
Zeti Akhtar Aziz, governor of the central bank of Malaysia, told a
banking seminar in Kuala Lumpur last year that Sharia-compliant
derivatives markets could have a positive impact for predominantly
Muslim countries. “It is evident that the derivatives business has
global opportunities since risk in today’s financial environment is a
product of uncertainties prevailing in the global markets, whether
financial or non-financial,” said Aziz. “The ISDA Master Agreements
have been the universal means of bringing order and certainty to the
complex and rapidly developing world of OTC derivatives.”
ISDA opened its Singapore office in 2000 as a focal point for work
in a complex region that encompasses highly developed derivatives
markets such as Australia, Hong Kong and Singapore, with emerging
giants such as China and India, and less well-developed countries
such as Taiwan, Thailand and Indonesia. But its commitment to the
Asia-Pacific region crystallised from its help in tackling issues related
to the Asian economic crisis that snowballed from late 1997.
Then, the Malaysian government’s legislation banning non-residents from holding its currency in 1998 threatened to wipe out
tens of billions of US dollar-equivalent offshore ringgit accounts
and challenged the region’s financial stability. ISDA members,
however, made a major contribution to alleviating the potential
systemic risk arising from the law change by providing a forum
where concerned parties could discuss how best to settle trades by
Global reach
Personal account
Denise Boutross McGlone, assistant treasurer, Lucent Technologies
ISDA board: 1987–1988
“Those were the days my friend”… that’s the tune that comes to mind when I think of the early days of the derivatives market.
Faced with the opportunity of a lifetime – the chance to shape a market that would ultimately redefine the way risk is identified,
measured and managed-a group of dedicated individuals came together in the 1980s. What I remember is the challenge, the opportunity, our collaborative approach to the issues, and the fun and excitement of it all.
You might not believe this, but in the early part of the 1980s, end-users were matched to other end-users and transactions were executed simultaneously – back to back, matched dollar for dollar, date for date. Trading conventions and documents were not standard so every detail was a point of
negotiation. Legal fees were exorbitant as each document was separately negotiated and risk upon closeout was uncertain.
Then, along came ISDA. This group recognised the challenge of transforming this emerging market from an expensive, customised market characterised by huge margins, low volumes and a few participants into a market that would withstand the test of time and become immensely profitable.
ISDA’s work led to an explosion in volume, instruments and range of uses for these instruments. However, education was also one of ISDA’s accomplishments. Meetings to explain the products and markets with government officials were frequent, sometimes frustrating and sometimes funny.
During one ISDA testimony to Congress, a frustrated law-maker suggested that they could never understand these complicated new fangled products. I suspect all would understand the plain vanilla boxes and arrows if we showed them that same diagram today. Therein lies ISDA’s success.
the deadline set by the government. “There was a lot of market dislocation at that time and lots of questions to be answered in terms of
market practices,” says Michael Bass, Singapore-based global head of
rates and foreign exchange at Standard Chartered and ISDA board
member. “ISDA’s Asia-Pacific steering committee proved to be a
vital forum for this.”
ISDA members organised daily conference calls between the most
significant market participants, including representatives of the
Malaysian government, to enable an orderly unwinding of trades
linked to the ringgit. The co-operation shown by members was
praised by George Soros – denounced by the Malaysian prime minister of the time, Mahathir Mohamad, as being one of the chief culprits in the crisis – in his testimony before the US Congress in 1998.
“Many jurisdictions in Asia don’t have legislation or any precedent case law directly relevant to derivatives transactions,” says
Derek Göbel, head of the legal and transaction management group
at BNP Paribas in Hong Kong. “In situations where institutions in
those countries want to enter into derivatives transactions but the
law is lagging behind, you end up with legal risk, which is where
ISDA has helped.” But, as in other regions, the key for ISDA in the
Asia-Pacific region has been to gain the support of local institutions
through which it can build relations with the most appropriate regulatory bodies. And, over time, the association has seen greater openness from regulators
“The attitude of regulators in this part of the world has moved
from being generally defensive to much more accommodating in
recent times,” says Bass. “The regulators realise that you need to balance out more open regimes with sound regulatory practices.”
ISDA’s work in countries such as India and China has produced
tangible benefits. The explosion in derivatives volumes in India in the
past few years has increased the need for legislative certainty for
ISDA members. And support for ISDA by the banking regulator, the
Reserve Bank of India (RBI), has proven strong. “The RBI makes
annual inspections of banks, and expects them to be using ISDA
Master Agreements for derivatives transactions,” says H Jayesh, principal of Juris Corporation, based in Mumbai, who has worked alongside ISDA in India. “Banks not using them are invariably reprimanded – it is not taken lightly.”
Jayesh says interest from local participants in understanding ISDA
Risk March 2005
documentation has increased exponentially in the past few years,
although he believes there is still a long way to go. But, with local
banks now increasingly looking to sign up as ISDA members, the
signs are positive. And, following consultations with its Indian members, ISDA commissioned a legal opinion to attest to the enforceability of close-out netting under Indian law in early 2005.
There remain, however, some outstanding issues. For example,
OTC derivatives may still be regarded as speculative or betting
instruments in India, and could potentially fall under the country’s
gaming regulation. Although this is more of a theoretical than a
practical problem, since derivatives continue to be traded in the market, it remains something under consideration.
ISDA members have also enjoyed some important successes with
the Chinese authorities to help develop China’s derivatives business.
The China Banking Regulatory Commission, China’s banking regulator, issued the first major regulations governing the domestic derivatives business at the beginning of 2004.
These established the risk management and internal control frameworks required for institutions choosing to engage in derivatives
transactions and cleared up ambiguity arising from a 1995 edict by
the Chinese central bank, the People’s Bank of China, which stipulated that derivatives transactions must be used for hedging purposes
only, and not for speculation.
“ISDA advised and commented heavily on the regulations and
around 70% of the comments were taken on board,” says BNP
Paribas’ Göbel. “The regulation has benefited the market because
people can price more competitively, for example, with less risk premium.” ISDA is focusing on the rewrite of the bankruptcy legislation in
the country, lobbying regulators and lawmakers to include language
on close-out netting, says Angela Papesch, a policy director and head
of ISDA’s Asia-Pacific office in Singapore.
The Association published a technical paper on netting in China
last year, which gave a snapshot of the prevailing insolvency legislation, for use by international members seeking to do business with
local participants. Papesch says the Chinese authorities have been
extremely supportive of ISDA’s efforts, both on a consultative basis,
and in helping with educational and language issues. “This has made
it much easier for us to resolve some of the more technical points,”
says Papesch.
Global reach
Personal account
Richard Grove, managing director,
Bank of America
ISDA board: 1997–2001 (and former CEO)
ISDA is a remarkable story. For 20 years, ISDA’s
members, many of them fierce competitors in the market-place,
have worked together to develop the infrastructure that has
allowed the derivatives industry to flourish. ISDA’s success has
much to do with its adherence to three central tenets. Firstly, the
organisation is member-driven and member dependent. Even as
ISDA’s full-time staff has evolved into a highly professional team,
the organisation’s agenda has continued to be set by an active
board of directors and much of the organisation’s work has continued to be performed by dedicated volunteers drawn from its
member firms. Second, ISDA has defined its scope to include all
off-exchange derivatives. Thus, ISDA has played a vital role in facilitating the development of not only fixed-income and currency
derivatives, but also equity, commodity and credit derivatives.
Third, ISDA has viewed derivatives as transactions having global
relevance. The organisation has avoided becoming too closely
identified with any one regional market. Concerns, which existed in
the mid-1990s, that ISDA was too focused on the US market were
put to rest by the opening of active offices in London, Tokyo,
Singapore and Brussels. ISDA’s success in establishing itself as a
truly global organisation is underscored by the fact that its membership now derives from 46 countries.
Since the Bank of China became the first local bank to join ISDA
in 2000, the local membership has grown, enabling the Association
to shape its agenda and focus more closely on the needs of the
domestic market. While its focus has been in the developing markets
in the region, ISDA’s Asia-Pacific Committee has also had some
influence in older derivatives markets, such as Hong Kong and
Singapore. Through its strong ties with regulatory bodies such as the
Hong Kong Monetary Authority and the Monetary Authority of
Singapore, ISDA has arranged a number of seminars for market participants as well as regulators. It has also worked with local trade
bodies such as the Australian Financial Markets Association to push
education in the region.
There are still a number of countries where the Association’s
sphere of influence is less strong. This is primarily due to language
challenges in countries such as South Korea and Thailand, or low
market volumes, as is the case in Pakistan and Vietnam.
But even in these areas ISDA’s influence is growing. ISDA’s latest
member at the time of writing the article was United Bank in
Pakistan, which comes from a country where there has been little
formal work done as yet. “Although this is not an area we have
focused on, ultimately institutions speak to each other and use of
ISDA’s standardised documentation grows through word of mouth,”
says Papesch.
Latin push
Latin America’s derivatives markets have matured gradually in the
past few years, matched by a more rigorous legislative infrastructure.
While ISDA established its Latin American Committee in 2000, its
influence in this region has been less direct than in other markets.
Risk March 2005
“The derivatives business in Brazil is driven by government regulations, which determine exactly what banks can do,” says Márcio
Bonfiglioli, chief legal counsel and head of compliance for Brazil at
Citibank in Sao Paulo, and co-chair of the ISDA Latin American
Committee. “Therefore, derivatives players need to have a close
interaction with the regulators, usually through local associations, to
review and discuss potential changes to the regulations. Brazilian
authorities have been open to such approach.”
In South America, ISDA has been most active in Brazil, the
biggest derivatives market in the region. The Brazilian National
Congress approved a new bankruptcy law in 2004, which tightened
up the close-out netting provisions for derivatives transactions among
local counterparties. “The new law provides a greater certainty that
the bankruptcy trustee will not be in a position to cherry pick assets
in the case of a default,” says Bonfiglioli. Although it was not directly
involved in the drawing up of the new law, ISDA stayed in close contact with local regulators, law firms and financial associations providing support and guidance based on its international experience.
ISDA stayed in close contact with local law firms and financial
associations during the drafting process, monitoring the developments, and issued a legal opinion on the law.
Although the majority of domestic banks continue to use their
own swap Master Agreements, ISDA has supported the development of a Brazilian swap Master Agreement, which was
published in 2004. And members have been trying to promote a
better understanding of the benefits of the document. “We have
been pointing out the exhaustiveness of the ISDA Master
Agreement, which covers a whole range of derivatives products,
whereas the documents the local banks have been using tend only
to cover swaps,” says Bonifglioli.
Bonfiglioli believes the market is gradually seeing greater activity
from foreign participants, making the need for sound legislation
more important. For example, ISDA worked with the central government to develop Brazilian credit derivatives regulations. “At present, the rules limit the ability to shed risk out of the financial markets,” he says. “We need more flexible regulations, which ISDA can
help with.”
Mexico is another market where ISDA’s influence has grown. The
Association was influential in the adoption of close-out netting, part
of the new bankruptcy legislation in 2000, supporting local banks to
lobby the regulators.
The Association submitted legal opinion on the netting legislation
in 2001, its first in the Latin American region. And the legislation
has been important in boosting derivatives volumes in the country,
says Pablo Perezalonso, partner in financial transactions at Ritch
Heather y Mueller in Mexico City. “The old rules carried no
special provisions for early termination and close-out netting of
derivatives. With the new law we have more legal certainty for
derivatives participants, which has served to boost transaction volumes,” says Perezalonso.
ISDA also helped provide comments on the draft of a local Master
Agreement, which draws heavily on the ISDA Master Agreement. “It
is very similar to the ISDA Master Agreement, but this way we can
factor in issues specific to local laws and practice, such as the language differences,” says Perezalonso.
Perezalonso, who worked on the draft, which came into effect in
late 2003, says the local authorities have been keen to enforce the
use of the document for local banks, as well as the ISDA Master
Agreement, which has been used by foreign banks in the country. In
more recent times, the Association has brought its influence to bear
on collateral reform discussions with local law firms and banks,
although this remains in its initial stages. ■
Higher Standards
in Risk Management.
Honoring 20 years of ISDA leadership.
Bank of America congratulates the International Swaps and Derivatives
Association on its enduring contributions to our profession. We are
proud to share your commitment to creating new opportunities across
all asset classes – with innovation, teamwork and integrity.
© 2005.
Mass market
ISDA began standardising collateral documentation in the
1990s, producing its first ‘credit support annex’ in 1994.
Its work resulted in $1 trillion of collateral used last year.
By John Ferry
The use of collateral, which involves
the posting of cash or other assets to
act as security on a deal, has increased dramatically in the past 10 years. ISDA’s
annual Margin Survey estimates that just
over $1 trillion of collateral was being used
in derivatives deals at the start of 2004, up
by 40% from the previous year. It also
reported more than 54,000 collateral
agreements in place.
The foundations that made widespread
use of collateral possible were arguably laid
by ISDA documentation, but it was not
until the financial crises of the late 1990s –
Russia’s default, the Asian crisis and the
near-collapse of Long-Term Capital
Management – that the use of collateral as
a credit risk mitigation technique was given
its first big test. “That was the first time firms had actually enforced
collateral and relied on their collateral agreements,” says Robert
McWilliam, head of counterparty exposure management for global
markets, fixed income and trading at ABN Amro in London.
“It is precisely in those types of market stress scenarios that we
were able to appreciate the real benefits of collateralisation of credit
exposures in our over-the-counter derivatives trading,” says Michael
Clarke, a founding member of ISDA’s Collateral Committee and
consultant to ISDA. “What was most gratifying in the wake of these
crises was that the collateral did the job it was supposed to do, reinforcing its value as a risk mitigation mechanism of choice.”
The use of collateral can bestow a number of benefits on a dealer.
Reducing its credit risk to a particular counterparty means it can do
more business with it, while regulators recognise the credit risk reducing benefits of collateral agreements and so provide capital relief.
“The recognition of credit risk in the trading book has grown in
the past few years,” says McWilliam. “With that has come a greater
appreciation of credit risk by traders who have more traditionally
been focused on market risk – and this has spurred the desire to
mitigate credit risk more efficiently.
Risk March 2005
“We’re in a healthy regulatory
capital position, so effectively we
are redeploying that capital elsewhere in the business,” he adds.
Using collateral also makes it
easier for dealers to put together
longer-dated derivatives deals for
end-users with correspondingly
long liabilities – a 30-year swap
hedge for a pension fund or
insurance company, for example.
“The value of the collateral
programme is partly the value of
the capital relief, but most of the
benefit is in increased deal flow,”
Robert McWilliam,
adds McWilliam.
ABN Amro
“Most banks are currently collateralising around half their
derivatives transactions and related margined activity, though in some
sectors such as the hedge fund business the figure is nearer to 100%,”
says Clarke, who expects the exponential growth in the use of collateral
to continue. “In a few years’ time, firms may be unwilling to do business without collateral support,” he adds, predicting that the vast
majority of derivatives exposures will eventually be collateralised
While its principal functions are the mitigation of counterparty
credit risk, freeing trading lines and reducing regulatory capital, the
use of collateral can have other ancillary benefits, for example, providing readier access to the derivatives market to participants such as
hedge funds.
The rapid growth in the use of collateral is starting to have a big
impact on the OTC derivatives industry as a whole. “Assuming the
hedge fund industry continues to control a larger and larger proportion
of overall assets under management, we’re going to see the concept of
enterprise-wide collateralisation continue to grow,” says Kevin Sypolt,
New York-based global margin manager at Merrill Lynch’s global equity financing business and a chairman of ISDA’s Collateral Committee.
Sypolt says the industry should be moving away from a model
where different derivatives products act as essentially stand-alone busi-
nesses when it comes to, for instance, making margin calls. “It used to
be everything was ‘siloed’ by product, but hedge funds are breaking
down those barriers. They are saying they may not know from day to
day what their product mix is going to be, but they want to have the
ability to put everything together. That means a single margin call for
a particular counterparty across all its products.” He believes the next
stage is risk offsets, where dealers would not just add up the individual margin figures for a counterparty but look at the overall risk they
are carrying with that counterparty then look for natural offsets. Or,
as McWilliam says: “We’re moving more from a buy-and-hold model
to a buy, restructure and distribute model for risk management.”
Currently, only larger firms can handle this move to enterprisewide collateral management. And even for many of them, managing
collateral on this basis remains aspirational, says Clarke.
In the established repo and securities lending markets, broker-dealers are using all manner of securities as collateral and actively trade
their collateral, some even establishing collateral desks to focus solely
on this exercise. “This gives a good indication of where directionally
the OTC derivatives market might be heading,” says Murray Brown,
product head for derivatives collateral management at JP Morgan
Institutional Trust Services in London. He believes there is no reason
why people should not be able to net their exposures and use the
same pools of collateral for their OTC and exchange-based business.
“Even further down the track, if you’re trading repos or lending
securities – anything where exposures are created and collateral used –
then conceivably it should be possible to net all those together and just
use one common pool. The enterprise-wide view of collateral management has only seen some limited movement to date, but I expect there
will be more movement in that direction in the future,” Brown says.
These trends present some pretty daunting challenges, and benefits.
As the use of collateral grows, the administrative burden of manag-
ing credit support annexes (CSAs), and making and receiving margin payments also goes up. This can be expensive. “Our research
shows that the small to medium-size player in this market conservatively is going to be paying $300,000 a year plus just to to support
their CSAs. And that’s without investing in a recognised system,”
says Brown.
To mitigate these costs, and the associated administrative burden,
some dealers offer to manage their client’s collateral on a third-party
basis. ABN Amro offers such a service. “If you are a regional bank
in a small town in Italy you’re going to struggle to build up expertise in collateral, so you’re going to want a service provider like your
custodian to do this sort of activity for you,” says McWilliam.
“Established market players may also find it more economical to
outsource their collateral operations rather than invest in systems
and people,” he adds.
JP Morgan is also getting a specific derivatives and collateral
management business off the ground for clients. This involves valuing customer derivatives positions so any margin moves can be
agreed and calculated. Management of CSAs is also provided via
systems that apply the thresholds and eligibility criteria specified
by the customer’s collateral agreements. This determines whether
the customer’s exposure is adequately collateralised with acceptable
assets. In the event of a threshold being breached, JP Morgan
contacts the counterparty to agree on a margin movement,
and if a dispute occurs it reconciles the customer’s valuations with
the counterpart’s.
The handling of collateral custody and movements is also outsourced, with the group using its custodial network to provide cash
and securities accounts in different markets and tracking ‘rehypothecation’ – an industry term for the reuse of collateral – movements.
Valuation and corporate actions services on rehypothecation positions is also provided. “We’re looking to offer an end-to-end posttrade OTC derivatives collateral management service, which will
A primer on documentation
The collateralisation of derivatives exposures first
emerged in the US in the mid-1990s. ISDA began
a process of standardising the documentation that
forms collateral agreements when it published its
first ‘credit support annex’ (CSA) in 1994, based
on New York law. A year later, it published similar
documents based on English and Japanese law.
Before ISDA developed the CSA, dealers generally used their own in-house pledge agreements.
“The ISDA credit support documentation caters
to both the pledge and transfer methods of collateralising trades,” says Kimberly Summe, ISDA’s general counsel. “Although the principles are essentially
the same, practice varies in the major jurisdictions
covered by the ISDA documents. In the US, for
example, participants favour to pledge or assign
securities, while practice in the UK is to transfer
assets to the collateral counterpart,” she adds.
“These documents in total account for nearly
80% of the collateral documentation used in the
world today,” says Paul Harding, managing director of London-based consultancy company
Derivatives Documentation.
The ‘threshold’ amount in these agreements is
the amount of unsecured credit you are willing to
give the counterparty before you require it to
deliver collateral. For a highly rated counterparty,
that can be $30 million or $40 million, although
the parties could agree to a much lower amount.
ISDA’s CSA requires that only the exposure in
excess of a party’s threshold needs to be collateralised. A simple example could be an end-user
that has been set a threshold of $1 million where
the secured party’s exposure is $1.5 million. In
this case, the end-user would have to pledge
$500,000 in collateral. But once the dealer’s exposure to the end-user has dropped below the $1million mark, that $500,000 has to be returned. If
an end-user were set a zero threshold by its dealer, which could happen if it did not have a credit
rating for example, then it would have to pledge
collateral as soon as it traded.
The agreements generally also refer to a ‘minimum transfer amount’, which is the minimum
amount that has to be exceeded before collateral
must be transferred. Participants refer to this as a
‘nuisance amount’, meaning you don’t have to
pledge or return collateral until a certain minimum amount of change to the amount of exposure has occurred. The actual amount can vary
from $100,000 up to millions of dollars.
The CSA defines the types of assets that will be
considered as eligible collateral under the terms of
the agreement. In theory, any type of asset could
be used to underpin the pledge, but in practice
only a limited number of asset types, such as cash
and government securities, are accepted.
However, this is changing as the market expands,
and dealers report an increased willingness to
accept, for example, asset-backed securities and
US agency debt as collateral.
In 1998, ISDA produced a book of guidelines
for practitioners that described the collateral
process. It followed this up a year later with a
review of how collateral had performed during
the earlier stressful periods. From this, 22 recommendations on possible improvements were
made. Progress in collateral practices was then
reported on in ISDA’s 1999 Collateral Review.
ISDA 20th Anniversary
make a strong economic and risk management case for outsourcing,” says Brown.
Developments such as this undoubtedly improve the efficiency of
the collateral process, but dealers warn that the operational process as
it stands is still too labour-intensive. “People are sending out tens to
hundreds of margin calls per day by email and following them up with
phone calls. Some big firms have armies of junior staff processing this
stuff,” says McWilliam.
Johanna Schwab, a New York-based ISDA policy director, who works with the organisation’s collateral committee says the need for more automation is being addressed. “ISDA’s operations committee is well advanced in its recommendations
for automating the operational procedures,” she
says. “Portfolio reconciliation, for example, is definitely something we will continue to recommend.”
Sypolt says the industry should get to grips with
portfolio reconciliation sooner rather than later.
“We should be reconciling the information on a
more regular basis so dealers know what their discrepancies are and can work through them on a
Murray Brown,
much quicker basis, especially as we are seeing conJP Morgan
centrations of derivatives positions in the dealer
community,” he says. “It’s not unusual to see two dealers with
15,000 or 20,000 open positions at any one point in time. When
there’s a margin call between the two of them and you have a discrepancy, where do you start looking? It’s a needle in a haystack.”
The current portfolio reconciliation process could cause problems if a
dealer went down, says Sypolt. “Often it takes a crisis to force everyone
to work at something, but I hope it doesn’t come to that,” he says.
“My concern is that a big derivatives player has problems and suddenly
some dealers realise they may not know their exposures.”
Ultimately, say practitioners, some sort of central clearing house for
collateral could develop. “There are systems to help us track and manage our collateral process, but I think you need some sort of utility to
sit in the middle. It would make sense for us all to visit a single collateral information exchange to place our margin calls and pick-up any calls
made on us,” says McWilliam.
ISDA’s Schwab says the idea of setting up a collateral clearing
house has been identified as a future trend. But at the moment it is
nothing more than an idea, although Schwab says ISDA is ready to
act in the best needs of its members if there was sufficient demand to
move in this direction.
So what other areas need to be addressed as the use of collateral
continues to expand and mature? The development of the legal
process is vitally important and already well in hand.
“One of ISDA’s core missions is to promote legal
certainty in the financial markets by helping to develop sound modern legal regimes in the leading derivatives markets and enhancing the compatibility of fundamental legal principles between those regimes,”
says Lawrence Brandman, vice-chairman of ISDA’s
Collateral Law Reform Group and also legal
director, credit and bankruptcy at Goldman Sachs
in New York.
The Collateral Law Reform Group was formed in
1999 to promote and monitor improved legislation.
Brandman says financial product development, potential cross-border activity and technological innovation
have at times outpaced the development of creditor
rights, property, contract and insolvency laws in a
number of countries. This means ISDA is continually trying to promote financial law reform to strengthen creditors’ rights under collateral agreements. “These efforts include encouraging countries to
introduce close-out netting legislation, publication of a ‘Model
Netting Act’ and providing information on market practice and
other support issues,” says Brandman. Close-out netting is a provision that, in the event of default, offsetting credit exposures
between the two parties involved in a deal will be combined into a
single net payment.
No-one doubts that as more dealers and end-users adopt collateralisation as a standard procedure, ISDA’s margin surveys will continue to report its increased use. This growth will present new challenges, but as long as the industry is ready to respond to these with
procedural and technological developments, and the pushing of
legal reforms, the exponential growth will benefit everyone. ■
Collateral development – key dates
1994 – ISDA publishes its Credit Support
Agreement (CSA) annex based on New York
law. This adds a bilateral mark-to-market
collateral agreement to its Master Agreement.
1995 – ISDA publishes its CSAs based on English
and Japanese laws. These accelerate the use of collateral for derivatives transactions by major dealers.
1996 – ISDA Collateral Committee formed to
ment practices, it also analyses the lessons
learned from the experience of collateral management practitioners during the periods of market
stress in 1997 and 1998. It also makes recommendations for improving market practices,
including calls for regulators to review their legal
and supervisory frameworks related to collateral,
and to consider changes that could encourage
collateral management development as a credit
risk mitigation technique.
address collateral issues that members face.
2000 – ISDA publishes its Collateral Survey,
1998 – ISDA publishes Guidelines for Collateral
Practitioners. The guide becomes an invaluable
reference point for industry practitioners.
1999 – ISDA publishes its Collateral Review. As
well as recording the state of collateral manage-
Risk March 2005
which confirms collateral management has
become an established discipline. It also calls for
the continuation of efforts to eliminate legal
uncertainty regarding the enforceability of
netting and collateral agreements, rigorously
applied risk management systems and
procedures, and for automated technology solutions to support the expanding use of collateral.
It is renamed the Margin Survey the next year,
reflecting market parlance, and subsequently
published annually, detailing the continued
growth of collateral management.
2001 – ISDA completes work on its Margin
Provisions, a new regime for collateral use. It details
common operational provisions and offers more
streamlined timing and dispute resolution
2003 – ISDA Collateral Asset Definitions, which
standardise the descriptions of commonly used
collateral assets in various jurisdictions.
2005 – ISDA publishes revised Collateral Guidelines.
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to STP
ISDA has played a vital role in
co-ordinating efforts to improve the
efficiency of OTC derivatives trading.
It is a critical issue for dealers and is
attracting more end-user attention.
By John Ferry
Risk March 2005
In the early days of interest rate swaps trading, it could take
days, or even weeks, to process transactions. But as legal
contracts and pricing models became more standardised, processing efficiency became increasingly important to dealers wanting to
preserve their margins.
“I think we’ve started to get a good handle on making the processing of the derivatives business operate in a way that requires no
fingerprints, and also goes a long way towards reducing the risks
associated with all the operational issues,” says Jerry del Missier,
global head of rates and private equity and regional head for
Europe at Barclays Capital in London.
Eric Richard, global head of fixed-income client service at BNP
Paribas in London and European co-chair of ISDA’s FpML standards committee, agrees. “There is a certain understanding within
the industry that if you don’t have something upstream, such as
affirmation of confirmations, then you aren’t going to go further in
your settlement automation, so there is certainly more to do there.”
Chip Carver, the London-based chief executive of SwapsWire,
which participates in ISDA’s FpML working groups, says things
have already come a long way.
“The majority of our interest rate derivatives trades are being
done inside of 20 minutes. This would have been T+5 [five days]
if you go back two or three years ago.” There is no doubt that
industry initiatives such as SwapsWire and the US-based
Depository Trust & Clearing Corporation’s (DTCC) Deriv/SERV
– not to mention the emergence of the Financial Products Markup Language (FpML) – have made the dream of straight-through
processing (STP) more of a reality (see box). Dealers are now able
to push through more derivatives deals than ever due to the massive efficiency increases seen in these past few years.
But del Missier, an ISDA board member between 1999 and 2004,
adds: “There are tremendous opportunities for moving up the product complexity curve. The more you move away from plain vanilla,
the more manual intervention is still required, so I think there can
probably still be more work done on the inter-dealer side.”
ISDA members are keenly aware of the need to expand the
product range covered by processing systems while further
increasing the automation of different stages of the deal process.
At the end of 2003, the Association published a consultative
paper, where it laid out the goals for the industry in terms of
automation for the next three years. “The first focus in that plan
was the confirmation, affirmation and legal execution of derivatives,” says Karel Engelen, a New York-based ISDA policy director. On confirmation, the goal was to execute all vanilla interdealer transactions on their trade date +1 with the exception of
certain time-zones.
A deadline of December 2006 was set for counterparties to
improve confirmation matching for all products, automate cashflow
reconciliation and come to intra-product netting and active management of the historic trade portfolio, for example through tear-up
arrangements; the process of reducing gross positions while retaining the overall risk level.
ISDA has called for movement in cross-product netting and portfolio reconciliation by the end of next year. By this time, systems
should be able to undertake cross-product matching and netting of
cashflows across all over-the-counter transactions for any settlement
date, while the market should move towards the reconciliation of
daily trading and legacy portfolios to reconcile exposure and allow
for collateral management.
A glance at ISDA’s 2004 Operations Benchmarking Survey
shows the industry is automating at a steady pace. In this survey,
ISDA asked respondents for the percentage of OTC derivatives
volumes handled with no, or minimal, manual intervention, at several key stages in the deal chain. The Association reported that
trade data for approximately 96% of forward rate agreements
(FRAs) and vanilla trades reach the back office on the trade date,
ISDA 20th Anniversary
Photograph: Alex Segre
Jerry del Missier, Barclays Capital
and that with the exception of credit derivatives, all trade data
reaches the back office by T+1.
It also found that currency options and FRAs are the most automated, followed closely by vanilla interest rate swaps. Credit, equity
and commodity derivatives still tended to be less automated,
although the gap is narrowing. Credit derivatives saw the most significant increase in automation, most probably because SwapsWire
and DTCC’s deriv/SERV came on line.
The highest degree of automation occurred in the transfer of
trade data from front office to operations, for the transfer of data
from operations system to general ledger, and for nostro reconciliation. The least automated function remains the imaging of incoming confirmations and the matching of details of confirmations, but
ISDA noted there has been significant growth since 2003 in the
automation of these functions.
“If you define STP as trades getting entered then moved automatically to the middle and back office, then most of the larger
dealers have relatively automated STP within their organisations
now,” says Brian Lynn, New York-based manager of specialist derivatives processing technology consultants Global Electronics
Markets. He adds: “Now, with initiatives such as SwapsWire, the bar
has been raised so that STP is where you have automation of the
actual data input from the upside. That is an area that will rapidly
develop over the next year or two.”
As well as improving the processing of derivatives trades, the
product coverage is also expanding, says Lynn. “It started with the
easy products and now the dealers are trying to cover smaller and
smaller pools of liquidity. Now it is a question of how many trading
groups within firms have to be brought on the system – and how
many buy-side firms.”
Risk March 2005
Buy-side needs
As more fund managers and companies expand their use of derivatives, there is increasing pressure to address some of the processing
needs of buy-side companies. “When we brought out our strategic
plan a year and a half ago, we knew we had to bring those people
on board,” says ISDA’s Engelen.
But getting end-users engaged in setting derivatives industry
standards and adopting things such as FpML is no easy task. By
its nature, the end-user market is more fragmented than the dealer community, so gaining any kind of consensus on their needs is
“I think there will always be a difference of interest in the sense
that some issues will always be more important for the dealer community than they will for the end-users,” says del Missier. “At the
end of the day, even one of the most active end-users is still going
to be doing just a fraction of the volumes of one of the top five
dealers, so their interests are going to be different.”
Del Missier says he believes end-users’ concerns are dominated by
issues about transparency, price discovery, collateral and portfolio
management in general. “We [leading derivatives dealers] are all
comfortable with tens of thousands of swaps in a portfolio, but how
does the user community deal with that? Will they need more
industrial-strength risk management architecture? Is there room for
initiatives to do these bulk tear-ups? Some of these issues will
become important for the more active users.”
But there are signs that the end-user base is willing to be proactive. “Initiatives like FpML have tended to involve dealers getting
together,” says Lynn. “It wasn’t that the dealers tried to exclude
anybody, but just that it’s harder for the buy side to get together.
It’s created a situation where the standards have developed more on
the dealers’ side than on the buy-side needs, but I think the buy
side is starting to pick that up.”
SwapsWire’s Carver adds: “The buy side ultimately will care
about STP, but they are faced with the problem that
every confirmation they get from the various dealers is different.
They have to read every single word of the confirmation to make
sure it is in the form they want and there’s not something
unusual in it.”
Buy-side companies can plug into SwapsWire and deriv/SERV
over the web as a quick and easy step towards gaining some form
of STP. But the emergence last year of the Data Standards
Working Group, which represents the needs of hedge funds,
shows the buy side is prepared to be proactive in its own right.
“The Data Standards Working Group was initiated by hedge
funds that were looking for information from dealers about their
positions,” says Lynn. “What it brings to the table, which plain
FpML had not done up until now, is reporting the net present
values of trades,” Lynn adds.
“One of the things hedge funds are interested in, in addition to
trade confirmation, is whether they can do all the rest of the processing with us. They don’t want different providers for different
parts,” says Peter Axilrod, head of new business development at the
DTCC in New York. He adds that the DTCC has just gone live
with its second-generation platform, which reconciles payments,
nets payments and maintains a database of deals. “Ultimately, later
this year we’ll feed them into a central settlements processor,” he
says, adding that the company also plans to release a portfolio reconciliation service. This would be used for mark-to-market reconciliation and collateralisation.
Lynn says hedge fund managers are more likely to look across a
range of asset classes compared with dealers. “This creates challenges for dealers in implementation,” Lynn says. “This is an area
that dealers tend to think of as proprietary – how they provide
information to their clients. The issue has been a lack of consistency
of the data formats, but that barrier is starting to come down now,
and already dealers are working on developing those feeds for the
Data Standards Working Group.”
This could lay the foundations for the next stage of development
Personal account
Ken McCormick, investor
ISDA board: 1985–1987
My memories about the birth of ISDA recall the
great respect and affection I have for a number
of investment banking colleagues of the 1980s. ISDA’s early history trailed by a few years the early steps of the swap market itself –
“The $70 Billion Baby” as a First Boston advertisement called it in
1984. The midwives of that baby were colourful, creative and of
high moral character – great builders of the business.
In ISDA, we were interested in the creation of an industry group
to strengthen the development of our markets. While seemingly
inevitable in hindsight, the permanent acceptance of swap instruments was not a given outcome to the dozen or so individuals
who pioneered them.
Swap entrepreneurs started in corporate finance departments
and treasuries, moved in and out of newly formed capital markets
groups, on and off trading floors or to Eurobond desks. Senior
executives of banks were initially uncertain what to do with the
rapid emergence of swaps. ISDA helped define us and
strengthen the market.
A few individuals from highly competitive firms sat around neutral meeting areas throughout 1984 and committed themselves to
an industry group: standardised documents, measuring market volumes, self-regulation. We knew something big was being created,
but we had no idea how big and mature that baby would become.
for the electronic handling of derivatives trades. “When you start
having these standards it allows that information to be analysed by a
third-party system. You could take a feed of information from a
dealer and pass that across to a third party to independently evaluate,” says Lynn. ■
Straight-through processing – where it’s at
A number of industry initiatives, together with
derivatives deal-matching platforms, have
emerged in the past five years with the aim of
increasing the efficiency of the front- to backoffice trade process. The best-known initiative is
the Financial Products Markup Language (FpML), a
set of industry standard protocols that lets electronic systems deal with derivatives trades. ISDA
took on the development of FpML as a major initiative at the start of 2002, with the goal of creating the same level of standardisation for electronic
trading and documentation as it does through
legal documentation.
“The problem was how to represent all the
details of a derivatives trade in a language that is
both rich enough to make sure you capture all the
specifics of a derivatives trade, while at the same
time being flexible so you can make changes to it
very quickly in order to follow the market,” says
ISDA policy director Karel Engelen. In its latest
operations survey, ISDA found that around 80% of
companies that had adopted FpML planned to
increase its usage within the following year.
FpML’s significance, and that of the trading
platforms such as SwapsWire and deriv/SERV that
use the protocol, cannot be downplayed. “With
an industry that has had year after year of phenomenal growth rates, we’ve created a lot of
operational challenges for ourselves,” says Jerry
del Missier, Barclays Capital’s global head of rates
and former ISDA board director.
“FpML is the foundation of derivatives processing today,” says Janet Wynn, general manager of
derivatives services at the Depository Trust &
Clearing Corporation in New York.
SwapsWire and deriv/SERV have emerged as
leading platforms for matching trades. SwapsWire
has become the central hub for interest rate derivatives, while the DTCC commands the credit
default swaps arena. But as they expand, the platforms are increasingly moving into each other’s
areas of core competency.
Both now cover most of the main derivatives
asset classes, with the exception of equity derivatives, which they are bringing online. Equity
options were launched on deriv/SERV in November
and the company says it plans to expand to
include variance swaps and equity swaps.
SwapsWire, meanwhile, is set to launch its equity
derivatives offering in April. “The way our system
is designed, adding products to it is not really
the challenge. The challenge is building up
the network,” says SwapsWire chief executive
Chip Carver.
ISDA 20th Anniversary
to the future
Christopher Jeffery,
deputy editor
Michele Faissola, global
head of rates, Deutsche
Bank, London
Frederic Janbon, global
head of fixed income trading, BNP Paribas, London
Risk March 2005
Sean Notley, co-head of
fixed income in Europe,
Morgan Stanley, London
The OTC derivatives market has enjoyed unprecedented growth in terms of its
global reach and the speed of its development during the past 20 years. And
ISDA has played a central role. ISDA exhibits some unusual characteristics for a
trade association. Firstly, it is global in nature and functions across a range of different asset classes. It also engages all the disparate departments involved in the
trading process and arguably represents all market participants.
The Association’s work in legal documentation is well recorded. As is its
engagement with international regulators to promote legal enforceability of
derivatives contracts and the acceptance of risk mitigation devices such as collateral and netting. But ISDA and its members still face plenty of challenges. These
range from improving the industry’s poor record on post-trade processing to
facilitating the opening up of strategic new markets such as China, Russia and
Brazil. Another critical task is the creation of building blocks to establish major
new global markets in areas such as energy, commodities and emissions.
And as derivatives increasingly enter everyday life, ISDA may also play a
pivotal role by engaging with regulators to establish codes of conduct related to
the sale of retail products that contain embedded derivatives. Staying on this
education theme, the Association arguably still has more to do to educate regulators – not to mention the mainstream Press – about concerns over
derivatives concentration and leverage associated with hedge funds.
One of ISDA’s greatest strengths is that it has broadly represented the
strategic developments of the financial institutions that were its founders. But
there is one important difference. These global dealers are merging their OTC
derivatives businesses with their cash businesses. And this poses a tough
question: Just how many trade associations are needed in the future? And
should ISDA be one of them?
These are some of the subjects Risk’s Christopher Jeffery put to six members of
ISDA’s board at a roundtable discussion held in Canary Wharf, London.
Benoit de Vitry, global head
of commodities and emerging
market rates, Barclays Capital
Kenneth Tremain, head of
North American rates trading, Citigroup, New York
Hidetaka Hara, executive
director, Nomura Securities,
Photography: Joy Ekpeti
ISDA board roundtable
■ Christopher Jeffery, Risk: Volumes in the largest segment of
the OTC derivatives market – interest rate swaps – already outstrip
the size of the government bond markets. What do you consider
to be the most important factors that will maintain growth in
OTC derivatives? And what can ISDA do to help to ensure continued market growth?
■ Faissola: As you say, swaps have overtaken Treasuries as the key
duration management tool in the US. And this shift towards derivatives increasingly applies to other asset classes. More and more players are entering the market – we assign more ISDA Master
Agreements with corporates and money managers than ever before.
There is an understanding at financial institutions and corporates
that improving risk management and overall performance necessarily
involves the use of derivatives. There is also innovation.
Customising hedging requires more structured transactions – not
just simple delta-one trades. And this requires more hedging, which
creates a virtuous circle that generates growth.
■ Janbon: The first very important condition to ensure the
fixed income derivatives market continues to grow in the
US and in Europe is to dramatically improve the quality and
robustness of post-trade processes. This industry has shown a fantastic ability to innovate, find new products, increase volumes and
attract new participants. But it has not been particularly good at
improving post-trade processes. ISDA has put in place some
strong initiatives to improve these processes, such as codes of best
practice among large players, and its sponsoring of FpML.
Another growth condition is to continue to enlarge the range of
participants in the market. While a number of new players, such as
hedge funds, make a living out of derivatives, there are still a lot
of large money market managers and large mutual funds, particularly in Europe, that are very involved in fixed income, but don’t
use fixed income derivatives.
■ Notley: In the past, risk management was done in a clumsy way,
for example conducting duration management through the use of
Treasury securities. Derivatives give the market the ability to transfer
risks in a very selective and specific way. Pension funds are a good
example of new participants. They are waking up to the fact that
they have liabilities. Derivatives provide them with the potential to
minimise their risk and be highly selective about the risks they want
to take. For example, they may want to take credit risk, but in doing
that they needn’t necessarily want to take exposure to interest rate
risk. That’s an important element.
And let’s just be clear: we can move this way out of the interest-rate and foreign exchange space. There are more applications
on the commodities side, such as energy derivatives, and maybe
we can hear a little bit about that later. There is a broad move by
organisations, ranging from governments to corporates to financial institutions, to be clear about the risks they face. And derivatives give them the ability to be very precise about their risk management techniques – that’s not going to go away. ISDA acts
very much as the lubricant by providing standardisation of documents and increased efficiency in post-trade processing. The
potential for expansion is manifold, in terms of geography, the
types of industries, and indeed the range of products – it’s as
broad as your imagination.
■ De Vitry: Geography is very important. Countries such as
China, for example, are making a massive effort to understand
other countries’ regulations and adapt their own regulations to
match, so that they are standardised with the rest of the world. Of
course, some countries still have a long way to go. But as countries
Personal account
Heinrich Linz, head of corporate center and
member of the group executive board,
Winterthur Group
ISDA board: 1992–1997
In the summer of 1981, I saw an article in the Financial Times about
a novel transaction between IBM and the World Bank called a “cross
currency swap”. I made two decisions: first, to extend my academic
thesis on the bond markets to include something I believed would
fundamentally change the course of financial markets. And, secondly, to try and get into this market as fast as I could.
Although I think I made the right judgement about swaps, I
vastly underestimated the growth of this instrument over the coming decades. What is clear, however, is that these growth rates
would not have been possible without ISDA – which I usually
mis-spell intentionally as the “International Swap Documentation
Association”. It turned out that what in fact mattered most was to
create a document that made it possible to trade and hedge an
instrument to manage the market risk and to be able to net the
credit risk. Without this document, our way of life in OTC derivatives would have been impossible.
Having moved on into the credit and insurance markets, I still
find that they suffer from the lack of an inter-company, internationally exchangeable document that facilitates portfolio and
risk management.
Thinking back, my tribute goes to the people that had the vision
to push for the original ISDA Master Document and made special
efforts against all the difficulties to make this such a success story.
such as China wake up, the growth potential is huge. The other
benefit is that ISDA is an association that crosses asset classes.
Increasingly, people have a better understanding of their risks and
they know a lot of their risks are correlated. They need the same
base to conduct netting. One of ISDA’s roles is to promote uniformity of documentation.
■ Tremain: Many of the press reports we’ve seen in the past 10
years tend to be fairly negative. ISDA plays a very important role in
education, which works well with regulators. ISDA is focusing on
increasing it’s efforts to provide education to members of the mainstream press concerning the positive developments brought about
by derivatives. Improving confidence in the derivatives markets and
getting this positive message across to the mainstream is critical to
the continued growth of derivatives.
■ Hara: From a Japanese perspective, JGB [Japanese government
bond] issuance has kept growing. And there is the potential for
almost all market counterparties to increase their usage of swaps
and other interest-rate derivatives for hedging purposes. It’s a feature that is more common to the Japanese market than other
developed market economies. Also, in contrast to many countries
in the West, there is still the potential for a large increase in the
usage of collateral and automation in Japan. It is more likely we
will see larger growth in the Japanese market compared with other
developed markets. ISDA has particularly targeted efforts to set up
seminars and other intellectual assistance for regional banks and
asset managers in Japan.
ISDA 20th Anniversary
ISDA board roundtable
■ Risk: Let’s look first at automation and
straight-through-processing, presumably critical areas to improve
margins for your businesses and an area where ISDA has worked
hard to improve post-trade processes. If the derivatives business is
really so competitive and innovative, why don’t dealers start conducting electronic trading of OTC swaps in a similar way to cash
bonds? Some parties would argue that this is because large dealers
don’t want to open up the OTC markets.
■ Notley: There’s a big difference between the confirmation of a
cash bond or foreign exchange transaction and a derivatives transaction. The processing costs for OTC products are many, many times
more than the processing costs for bond and FX trades. We cannot
afford to execute the number of transactions in, say, OTC interest
rate and credit products that we can afford to process in these other
markets. Dealers are happy making prices of €1 million to €5 million in the FX and inter-dealer bond markets and then repeatedly
trade these transactions as their back office can support it. With the
OTC derivatives market, that’s not possible; we have to deal in true
wholesale amounts of a minimum range between €25 million to
€50 million. When you’re making a price in the inter-bank market,
you’re effectively writing a competitor an option – an option to deal
on that price. Now, if we’re successful with the processing efficien-
Risk March 2005
cies that ISDA drives for, where we can process 50 to 100 times the
volume, then that may change.
■ De Vitry: There is a big difference in these instruments. Highly
liquid electronic markets tend to have about five to 10 benchmarks
and all the volume is done in the benchmarks. One of the benefits
of OTC is the flexibility and diversity of needs. It provides you with
the ability to move away from the benchmarks. So you don’t have
just five or 10 products; you have 5,000 products. Energy is a good
example. In the OTC energy market there are around 500 indexes.
Out of those, perhaps there are enough participants to have three or
four benchmarks that are suitable for electronic trading.
■ Tremain: I agree. It’s about the complexity of the products.
And also the fact that the voice-brokering system has worked well
for large trading sizes.
■ De Vitry: There’s also a big difference with credit. Some of the
OTC instruments are very credit sensitive and you need a lot of
appetite for credit risk with other counterparties. And this is not
uniform. Do you have a credit support annex, or not? That’s another impediment. And it becomes a lot more acute when you offer
products out to 30 years.
■ Notley: While you are not willing to write an option by showing
your competitor a price. The situation is different in the businessto-consumer area, where there are several electronic platforms for
foreign exchange and interest rate derivatives. This works because
you are prepared to write an option to your client.
■ Risk: Since ISDA incorporated risk management into its charter
in 1996 it has played a strong role liaising with leading regulators
around the world regarding their treatment of OTC derivatives.
What are some of the critical issues that need to be dealt with now
and in the future?
■ De Vitry: There are many different regions and they all have
different requirements. But disclosure is one of the issues at the
forefront of the thoughts of all the regulators. Talking specifically
about emerging markets, controls and disclosure are critical issues.
C19693 ISDA 297x230 V2
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ISDA board roundtable
The idea is to make sure that people understand the risks of the
transactions, and that margins are fair. Understanding the products is a very important topic for emerging market regulators and
some are more advanced than others. Our role is to help them to
get to that point.
■ Janbon: I see three major challenges: First, whereas this industry
has been self-regulated so far, the development of the retail structured notes business constitutes a special challenge. Indeed, this is
an activity where ‘quasi’ derivatives – embedded in structured
instruments – are sold indirectly to private individuals. It is important that regulators, together with ISDA, help define a compliance
framework for this kind of business.
Second, there has been a tremendous convergence between cash
and derivatives markets in all asset classes. This can create some difficulties as national regulators, quite rightly, want to maintain control of their cash markets, whereas OTC derivatives markets remain
largely unregulated and global. Addressing regulatory issues related
to both cash and derivatives markets in a consistent way will be an
important challenge.
Lastly, we’ve seen a fantastic explosion in the number of hedge
funds, many of which use derivatives to take advantage of market
inefficiencies. This has created a lot of concern about leverage. It’s
important that ISDA and other participants reassure regulators by
helping to disclose details of this leverage and the risks associated
with hedge funds. The same goes for credit risk transfer away from
banks to insurance companies. It has been one of the great themes
of the credit derivatives market and it’s important that the fixed
income derivatives industry continues to educate insurance companies about the risks they take and demonstrates to regulators that
this is not an irresponsible activity.
■ Faissola: From a purely practical angle, one of the challenges we
face as global organisations is that we manage our risk exposure on a
global basis, with standard processes and procedures. But national
regulators do not always agree on what those standards should be.
Federal Reserve chairman Alan Greenspan has expressed vocal support
on risk transfers from the banking industry to a variety of other
investors. But there are other regulators who don’t necessarily share
his view – and no, I’m not going to go into specifics. This is an
area where ISDA can play a significant role in speaking to individual regulators and creating a consensus.
■ Risk: So you are raising the subject of education. How
do make sure people actually understand what this business
is about? And should you change some of these surveys
that come out with dizzying notional values?
■ Faissola: There are two types of education. The first is
about developing the industry, through end-user education
and through helping to develop new markets. The other
type of education is more geared to the public, politicians and the media. The second part is the area
that we could improve on. Many people still
think of derivatives only as a means of
increasing leverage; they don’t appreciate derivatives’ value in managing
■ Notley: We could try to present the benefits better. For
example, we have pension
funds in the UK buying unitised products that are created
from a combination of assets,
securities, and derivatives
Risk March 2005
overlays, which go to mitigate the risks that have effectively been
built up over time. Things like that are really positive applications
of derivatives. But they don’t get heard. All you tend to hear are
the negatives
■ De Vitry: Another area is to look at the mortgage industry. You
have a choice of mortgages that are fixed-rate, floating, five-year
capped, or not capped. All of that is achieved through derivatives.
The basic retail client has fantastic products, on the mortgage side,
for example, that you couldn’t have without derivatives. That’s the
benefit of our products, that they provide flexibility.
■ Tremain: In cases where there are high-profile restatements,
derivatives always seem to get portrayed poorly in a story that is
more about the failure of individuals in a company to perform their
fiduciary responsibilities.
■ Notley: Coming back to your question about why the industry
doesn’t publish volume numbers or offer greater transparency. We are
wrestling with that all the time. But it is not easy to do. What do we
measure? There is such a broad range of products that we’re transacting that you end up adding apples, oranges and bananas. We’re talking about risk transfer. Maybe we should be measuring the amount of
risk transfer we’ve engaged in during a period, something of that
nature, but that becomes really detached from what a end-user or
reader is interested in.
■ Risk: You mentioned that ISDA also plays an important role in
helping to set up the appropriate framework to ensure legal certainty for derivatives transactions and associated risk mitigation techniques like netting and collateral in developing markets. How
important is this role?
■ Faissola: The geographical element is extremely important.
[ISDA chief executive] Bob [Pickel] travels to a lot of very interesting countries to explain to people such as politicians, who don’t
necessarily have financial backgrounds, how important it is to have
the right financial markets framework in place – not just for the
derivatives industry but the entire financial system. All these markets
are growing extremely fast, particularly the new Central and Eastern
European countries joining the euro – they need
more hedging and risk-transfer.
■ Janbon: Every new country or new
market is taking slightly less time to
develop than in the past.
■ Risk: But just how proactive can
ISDA be in educating financial regulators, politicians and the legal and
accounting authorities? I was in
Moscow recently. People are crying out
for change, but nothing is happening.
Presumably you can’t just tell central
banks or governments what
to do?
■ Faissola: While
the process by
which regulation
evolves may be
slow in some
countries, it
is rarely
because of
inertia or a
lack of
ISDA board roundtable
tion at the central bank or specific market regulator. Typically,
these areas are staffed by people of extremely high quality, who have legitimate and very incisive concerns. There
is a usually very active, open dialogue with the industry.
Nonetheless, the second phase, taking a proposal to
liberalise into legislation, is much more complicated.
That’s where the time is spent.
■ De Vitry: The difference between Russia and the
CE4 countries – Poland, the Czech Republic, Slovakia
and Hungary – is that they don’t have a legal
environment that will allow them to develop. This is not
the case in Russia. In emerging markets where the
regulatory and the legal environment is similar to the
rest of the world, things develop very, very quickly.
■ Janbon: The other one is
Brazil, which has had a very
good legal environment right
from the start.
■ De Vitry: China is another good example. What happens is that when you sort it
out with one regulator then
you already have a good
framework to deal with
another regulator.
■ Faissola: Actually, there
is a great deal of sophistication in Russia. The
domestic players are being
very active.
■ Risk: But you are conducting transactions with
counterparties in many of these emerging market countries,
regardless of domestic legal certainty. And you gain lucrative margins by conducting deals offshore through London or New York. Is
there a conflict between your roles as profit-making dealers and the
role of ISDA?
■ Faissola: Let’s be very clear: ISDA’s objective is to improve the
legal system in these countries; it is not to arbitrage the legal
system. The biggest concern we as market intermediaries
can have when we deal in developing markets is that the local
legal framework will not protect our and our clients’ economic
interests. My interests as a market intermediary and as an ISDA
member are to have as consistent an operating environment as
possible around the world. Very practically, if my legal
department does not feel comfortable that a netting agreement is
applicable in a particular market, I can’t do a meaningful amount
of business there.
■ Risk: What are the exciting new asset classes where ISDA is
planning to play an important role in developing legal certainty and
help with risk mitigation?
■ De Vitry: There has been a big change on the energy side in the
last few years, which has allowed banks to trade on the physical
power markets. This was needed, and you can see a convergence
between derivatives and cash, which represents a big development
for the market. Another important new area is emissions trading.
Every year in Europe there are allowances for 17 billion tonnes of
pollution each year. The market is currently trading at €7 per
tonne and we estimate that between 15 million and 20 million
Risk March 2005
tonnes will have been traded
since 1 January this year.
This is quite significant.
And it’s not a market comprised of five or six dealers,
there are 12,000 participants,
which makes it really
exciting. ISDA has a potentially important role due to
the three types of different
documentation currently available. There are a number of
issues to fix. Once that happens, I think the market will
explode. And it will become a
global market as the markets in
Europe, the US and Japan will
all be correlated so people will be able to exchange emission from
one country to another.
■ Risk: Given your comment about the emergence of new asset
classes and ISDA’s increasing role in developing a robust
framework to allow these relatively new businesses to thrive,
why are there so many people with a background in interest rates
on the board of directors? Would it not be a good idea to have
people that specialise in other asset classes represented on the board
of directors?
■ Faissola: There is no question that for historical reasons the
interest rate segment is better represented in ISDA than other areas
of the derivatives markets. The new board is firmly committed to
changing that and increasing the Association’s representation across
the industry.
■ Janbon: That’s true. But it’s also fair to say that throughout
2003 and 2004 we spent a very large amount of time at board
level discussing the big issue at the time, which was credit
derivatives. So it is inaccurate to say that because there are a lot of
representatives that started their careers as interest rate specialists,
we only discuss interest rates. Some of the most interesting
developments at the moment are in asset classes other than
interest rates.
■ Tremain: That’s a very good point. Trying to construct a
board that represents different asset classes, is geographically diverse
and represents different types of institutions has been a key topic
It's good to have someone by your side who knows the terrain.
At Wachovia, we help our clients find the green. As a leading provider of derivative and structured
products, we offer a full range of risk management solutions to our clients large and small. We are
proud to congratulate ISDA on 20 years of dedicated service to the financial services industry.
Through its commitment to excellence, ISDA delivers what risk managers and their clients need.
Together, we can achieve uncommon results.
Uncommon Wisdom
©2005 Wachovia Corporation 051152
ISDA board roundtable
Personal account
Steve Targett, group managing director, institutional financial services, ANZ Banking Group
ISDA board: 2000–2001
As the first executive from the Australian market elected to the board of ISDA, I was struck by the professional organisation surrounding all aspects of the Association. ISDA boasts a strong board, with representatives from investment banks, commercial
banks and other key industry participants; and global geographic coverage, supported by talented and committed staff. This, in my opinion, makes
ISDA the premier industry association and a role model for aspiring 'competitors'.
I want to highlight some of ISDA's achievements. First, the 1999 ISDA Credit Derivatives Definitions and shorter form standardised confirmation
that provided greater certainty and effectiveness to the credit default swap market. Second, ISDA's proactive creation and support of its member committees. Over time the number of ISDA committees has grown to 16, which has facilitated the international exchange of views, development of standardised global documentation and formulation of policy positions. Third, the 1987 ISDA Interest Rate and Currency Exchange Agreement. This
Master Agreement was pivotal in reducing legal uncertainty and risk globally in derivatives transactions and provided an internally acceptable umbrella
agreement for new counterparties.
And, finally, ISDA's handling of derivatives industry issues following on from the September 11 terrorist attacks. ISDA acted quickly following
September 11 to facilitate discussions with global market participants to identify and address various derivatives-related issues. Those issues included
the impact of the closure of the US equity markets, settlement and valuation, and documentation and legal issues.
of discussion at virtually every board meeting I have attended in the
past three years. On top of that, we need to get the right people –
the person who’s going to be an active board member. Historically,
perhaps because that is where the industry really began, it’s been
easier to find those individuals on the rates side of the business. But
it is definitely a goal of the board to have people that represent the
diversity of asset classes.
■ Faissola: There are many different communities playing an active
role in ISDA. For example, the equity community added tremendous value in the discussion on credit derivatives. And this helped us
to create standardised documentation for the credit derivatives market that satisfied the needs of market participants as well as regulators. We managed to create a highly complex and incredible business in just a few short years.
■ Janbon: This organisation has played an important role in
improving capital management through its various committees
involved in the Basel II process.
■ De Vitry: If you would like a specific example, membership of
the energy committee in the US and Europe is probably 70% nonfinancial institutions.
■ Notley: One other point. The makeup of ISDA in many ways
reflects the makeup of the firms who actively participate in ISDA.
The interest rate and foreign exchange markets were the original
successes for the application of derivatives. So that’s where people
like myself and others started and then rose up in our organisations.
Actually, that is changing now as these other asset classes become
more and more dominant.
■ Hara: In Tokyo, we have been working on the infrastructure for
developing products such as weather derivatives and emissions trading, and we have a number of non-financial institution members
involved in the discussion of those products. Different asset classes
are handled by different types of market players, in addition to
major financial institutions.
■ Risk: So by the sounds of it, you would have no objection to
having end-users sitting on the board of directors to reinforce the
idea that ISDA truly represents the interests of all its members?
■ Janbon: It’s a very good idea to have another end-user on the
board. But, at the same time, this organisation already comprises
two-thirds of end-users.
■ Faissola: ISDA’s objective is to grow the market for the benefit of
Risk March 2005
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ISDA board roundtable
all players. There is no place in that mandate for an outdated, zerosum view of buy-side and sell-side interests. If you look at the
documentation ISDA has developed recently, it is very balanced
between the buy-side and the sell-side – more so than any other
area of financial markets. Again, we have the same objectives
as market intermediaries: we want to develop a very long-term
business, not generate short-term benefits by taking advantage of
special situations.
■ Tremain: Well, I think the signalling is good if ISDA is perceived
as representing the market as a whole – both the buy-side and the
sell-side. The more we can foster that, the more credible we are as
an organisation.
■ Risk: ISDA is one of very few truly global associations. If you
look at other industry bodies, they are typically much
more fragmented geographically. ISDA’s development
seems to mirror the way most dealers have developed their businesses. But there is one crucial difference. Major dealers are merging
their derivatives and cash businesses. ISDA is very much a derivatives
association, not a cash markets association. How do you reconcile
that moving forward?
■ Notley: Our organisations are global in nature so we easily identify
with a global trade board such as ISDA. It is very important that it is
perceived as a global body as opposed to a regional one, and that –
along with the breadth of products it covers – does set it apart in a
fairly significant way. We’re conscious that ISDA is able to take the
successes it’s had with interest rates and other asset classes into other
areas so that we achieve harmonisation. All the board member firms of
ISDA are involved in all of these businesses, so it makes perfect sense
that ISDA reflects the constituents of those key member organisations.
■ Janbon: It is true. But the merging process between cash and
Risk March 2005
derivatives means there is a need for better cooperation with other
trade associations especially on the cash side. Many of them are
regional or domestic, which makes our task a bit more difficult.
■ Hara: ISDA has worked together with the Japanese Bankers
Association to give our comments to Japan’s regulator, the
Financial Services Agency, on Basel II. We have a very good
relationship with them. The reason is that they see us as a good
information source for what is happening internationally. The
other industry associations in Japan tend to have limited access to
international information sources. Although they are very
organised, we can provide additional information on what
has been happening in other geographical regions, like Europe
or the US. And so this process of collaborating with domestic
and international associations makes the discussion with the
regulator better.
■ Faissola: There is no question there are too many trade associations. I believe that our medium-term goal should be to have an
association that provides the industry with the broadest possible
scope for co-operation. How can we achieve that? From an ISDA
perspective, we want to represent the different asset classes and different players to the greatest extent compatible with our mandate.
At the same time, we recognise that, to be effective, we need to take
into account how our market is changing, such as how cash and
derivatives are merging. So we will work collaboratively with other
associations. I’m not going to second-guess where that co-operation
might lead.
■ Notley: And it’s a problem for all associations, not just ISDA.
■ Janbon: We need to develop cooperation and maybe move
towards mergers. But this presents a challenge, for we all have different views about how exactly we want to do that. Even though we
all participate in the various associations, they all have different features, different aims and different goals, and it’s not always easy to
combine them.
■ Tremain: It’s going to be a step-by-step process. In my view, the
way ISDA is organised is very beneficial to the markets. It will be
important to preserve that uniqueness and that structure going forward. How that couples with other cash organisations will be a stepby-step process. It’s really about getting around a few specific issues
and having collaborative efforts.
■ Risk: And finally, what is the biggest threat to the OTC derivatives market?
■ Janbon: The accounting framework for derivatives in both the
US and Europe has changed in the past two to three years. It’s
bound to create some new business opportunities for banks, but it
also presents risks. Corporates may not be able to use specifically tailor-made hedges because they may contain relatively longer-dated
and illiquid products. And this also threatens to remove the incentive for innovation.
■ Tremain: In my opinion, asymmetric or opaque accounting standards are directly linked to some of the big earnings restatements
that we have seen over the past couple of years.
■ Faissola: The accountancy profession as a whole has done a
great job keeping pace with the market’s evolution, but in some
specific cases there have been lapses. There have been cases where
the accounting treatment did not reflect the benefits of responsible hedging. This leads to inactivity, because nobody wants to run
the risks. And, over time, there may be severe consequences of
that inactivity. Just consider foreign exchange management.
If you were a European exporter and you didn’t hedge the
weakness of the dollar in the past couple of years, you would have
suffered terribly. ■
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