Transparency within over the counter (OTC) derivative markets is at the heart of the G20 declaration on financial reform and a key component to reducing systemic risk. To achieve transparency, product and process standardisation are being carefully scrutinised as trade documentation must become consistent enough for electronic processing – a mandate of such legislation as the Dodd-Frank Act and the European Markets Infrastructure Regulation (EMIR).
The key delivery this year is the publication of the 2011 ISDA Equity Derivatives Definitions. These definitions represent the single largest overhaul of OTC trade documentation methodology since definition booklets were first introduced. The goal is to create a standardised documentation structure fit for the 21st century, built to facilitate electronic processing across the full range of equity derivative products.
While the industry is well aware of these pending changes, most market participants are unprepared. The magnitude of these changes should not be underestimated as the implementation will significantly impact technology, processes and people across the front, middle and back office.
To achieve standardisation, dramatic changes are required to:
- Ensure a smooth path between legal agreement of terms and electronic processing.
- Increase the number of products that can be processed electronically.
- Increase the number of participants agreeing to market standard defaults.
- Provide a future-proof model that can accommodate inevitable new products and terms.
The 2011 terms break new ground with the following:
- FpML-compliant format: the new definitions are the first to be created and published in a machine-readable format, having been developed in Financial products Markup Language (FpML) and specifically engineered to facilitate electronic processing for both confirmation matching and reporting purposes.
- Matrix approach: this method will replace the old master confirmation agreement (MCA) structure, propagating an approach already proven in credit derivatives. Matrix terms are merely adhered to by parties on ISDA’s website, thus eliminating the need for prolonged bilateral negotiation and greatly minimising paper-based processing. This is a time- and resource-intensive process given the amount of smaller players in this market and the fact that matrix terms are merely adhered to by parties on ISDA’s website. Finally, there is the flexibility to agree to bilateral terms if desired via the matrix support agreement (MSA), although the hope is that this will be the exception and not the rule.
- Modular structure: the new approach enables many additional products and complex exotic combinations to be built within the existing structure and language of the definitions. It allows for changes and additions that will occur to the terminology over time and the terms will be adaptable enough to incorporate enhancements within the existing framework – something with which previous ISDA definitional booklets have struggled.
Before the definitions’ full potential can be realised, several major hurdles need to be addressed.
- The need to implement quickly: the process to adhere to and implement these definitions has yet to be approved. It has been suggested that the new terms will not be actively used until a matrix is in place for that product. If this is the case, there will be pressure to agree upon and implement the matrix in a timely fashion so the extensive legal negotiation has not gone to waste.
- Handling bespoke documentation: conversely, if participants can use the definitions without a matrix using any of the menu items, questions arise as to how matching platforms will cope with electronic versions of bespoke documentation. Effectively, these platforms will need to potentially process confirmations with any electable term from the new definitions, increasing the number of fields from the current average of twenty or so to over fifty.
- Engaging the business: traders need to be engaged in the process in order to agree to default elections from the list of menu options and create the matrix for each product. This is not always an easy task given a firm’s obvious focus on revenue generation and may delay agreement.
- Spoilt for choice: the approach taken by the legal community thus far is to look at all hypothetical situations and devise language to cover these eventualities in the interest of providing as much protection for their firms as possible. The proliferation of elections under the new definitions creates a headache for the market in trying to agree defaults for matrices.
- Managing transition: the process, from agreement of each matrix to electronic eligibility, needs to be carefully managed. For a period, there will be cross over between the old 2002 terms and the new definitions. This could cause considerable legal basis risk if not coordinated across the market.
- Retail products: the terms impact goes beyond the OTC market. Participants will be required to update legal prospectuses for retail and securitised products so they mirror the new definitions and avoid legal basis risk.
- Change management: participants will have to complete internal analysis to determine how to make these changes within the required timeframes. The scope is considerable and will impact the front-to-back trade life cycle – from trade capture GUI enhancements to automated template management projects.
- Resourcing the change: market participants are already addressing other key initiatives such as clearing and reporting and will be hard-pressed to find the budget and staffing needed to make necessary changes. This could impact their ability to meet the proposed deadlines, making delays expected.
Taking the First Step Towards a More Secure Marketplace
The OTC equity derivatives market is unique in many respects. While, there are valid reasons for the low percentage of electronically eligible transactions, it is clear the market should strive to deliver greater standardisation across its products and processes.
The 2011 ISDA Equity Derivatives Definitions promise participants the tools to rectify past problems, harmonise current templates, and standardise new products. They also promote electronic processing and provide a sound framework for OTC equity derivatives well into the 21st century. It is clear, however, that the publication of these terms is only the start of a long and potentially arduous road towards a more secure marketplace. Market participants need to be prepared and ready to tackle these challenges head-on within their firms and in co-operation with the industry to one day realise their full potential.
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