Swap Data Reporting – Remedy for Our Financial System?

October 26, 2011

The subprime Mortgage Backed Security (MBS) and the Credit Default Swap (CDS) were the twin evils on center stage of the financial crisis of 2007-2008.  Warren Buffet, the legendary investor, said in 2002: “Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” By contrast, Alan Greenspan, then the Chairman of the Federal Reserve, said in 2004 that “credit derivatives have helped to defuse financial crises”.  While hindsight shows Buffet’s wisdom to be right, to be fair, many were in the Greenspan camp prior to the crisis, and there is some truth in it – if used wisely, derivatives can be very powerful tools for managing risks as well as injecting liquidity to the market.

Over the Counter (OTC) derivatives in particular pose greater challenges because they are not traded on exchanges, hence there is significantly less information available such as volume, price and counterparty risk concentration. The inherent risk in this lack of information has led to a call for more transparency and  stronger reporting requirements in the derivatives marketplace.   In 2009, the G-20 summit in Pittsburg made a commitment that:

 “All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories.”

 Ever since, regulators around the world have been drafting rules to adhere to the commitment in their respective jurisdictions, most notably, the European Market Infrastructure Regulations (EMIR) in Europe and the Dodd-Frank Act in the United States. Under the mandate of the Dodd-Frank Act, both the Security and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) have issued rules for swap data reporting, a cornerstone of the new derivatives regime.

The swap data reporting requirement governs many types of swaps, including interest rate swap, currency swap and CDS.  The size of the swap market is mind-boggling. In 2007, the notional amount of CDS was $26.2 trillion, while the notional amount of interest rate swap was $310 trillion. As a comparison, the Gross Domestic Product of the U.S. was $14 trillion in the same year.  Even though the notional amount generally doesn’t change hands, it does have real economic significance. For example, in the case of a default, the seller of the CDS is obliged to pay the insured amount, which is the notional amount of the contract.

The sheer size of the swap market poses enormous risk to the overall financial market, hence the reason for the new rules and regulations. While each type of swaps has a different risk profile, one common theme across all swaps is the counterparty risk, a crucial mechanism of the chain effect observed during the financial crisis. On the other hand, financial institutions have legitimate reasons to safeguard sensitive business information. To address the needs of the regulators and market participants, the rules for swap data reporting have two components:

–          Real time public dissemination. Swaps are to be reported immediately to Swap Data Repositories (SDRs) or the regulators to improve market transparency and facilitate price discovery. Anonymities of counterparties are granted.

–          Confidential regulatory reporting. Full disclosure to the regulators for the purpose of assessing systemic risk. Counterparty information has to be provided because it is vital for assessing counterparty risks in the system.

While these new rules are making progress towards adherence to the 2009 G-20 commitment, the rule making process has made apparent the lack of coordination between the CFTC and the SEC. Each governing body issued a set of rules, similar but not identical.   For example, both call for unique counterparty identifier and unique swap identifier, but their terminologies differ, causing confusion and making it difficult to adhere to both requirements.  Furthermore, it exposed the deficiencies in the infrastructure of the financial market.  Take the unique counterparty identifier for example, while it plays a critical role in both organizations’ set of rules, we simply don’t have it yet.  (See our previous blog which discusses the Legal Entity Identifier (LEI), which will serve as the unique counterparty identifier.)

Swap data reporting and other regulations in progress will be instrumental in improving market transparency, enforcing market integrity and mitigating systemic risks. PORTIA has recently conducted a high level survey of all regulations including the Dodd-Frank Act and we are currently in the process of performing an in-depth study on the LEI and swap data reporting. We will share our findings with our client base through the client newsletters and client learning series.

Swap data reporting is a necessary fix for a glaring hole in the system. But how can regulations address the fundamental problems with financial innovation? Securitization, the powerful idea behind MBS, has been used by many as a tool for obfuscation and fraud. CDS, a brilliant piece of financial innovation, has become a textbook example of regulatory arbitrage. In essence insurance, CDS escaped stringent insurance regulations because it called itself “swap” instead of “insurance”.  If we don’t address underlying problems with incentives and culture, is it going to be just a matter of time before the new rules get circumvented? People have already pointed out loopholes in EMIR regarding OTC derivatives.

What is your take on the ongoing OTC derivatives regulations? How does your firm prepare to address the swap data reporting requirements?

–          Jian Helen Yang, Product Manager

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