An Interview with ISDA CEO Scott O’Malia: Digitization, Libor, ESG, and Uncleared Margin
Q2 2021
Derivatives markets globally are seeing a major shift this year on the back of two developments:
1) the Libor transition is progressing, with 30 Libor settings either ceasing or becoming non-representative after December 31, and 2) Phase 5 of the regulatory initial margin (IM) requirements for non-centrally cleared or uncleared derivatives will be implemented.
Kevin McPartland, Head of Market Structure and Technology Research, Coalition Greenwich, spoke with Scott O’Malia, CEO, International Swaps and Derivatives Association (ISDA), about these developments, as well as on the digital transformation of, and impact of environmental, social and corporate governance (ESG) on the derivatives market.
Edited excerpts:
At the CFTC, you effectively created the rules for the derivatives market, and now you're implementing them. What has that transition been like?
When I was told about my nomination for the CFTC position in 2008, a friend said, “Scott, it’s a sleepy little agency and you should think about getting a hobby to fill your time.” But lo and behold, Gary Gensler became chairman of the CFTC. We had a financial event, and then the regulatory environment, which put the CFTC on everybody’s radar.
Between 2010 and 2014, we voted on some 65 Final Rules. We transformed the entire market structure for non-cleared products. Today, we have trade execution in 23 jurisdictions, 17 out of 24 FSB (Financial Stability Board) jurisdictions have mandatory clearing, and 90% of the interest-rate derivatives market notional is cleared at a clearinghouse, against zero in 2010.
My job has changed significantly now that I'm on this side. But it was fascinating and, clearly, a full-time job. I also loved doing the work on the Technology Advisory Committee, focusing on high-frequency automated trading and data standards.
Derivatives markets technology is about much more than e-trading. Can you talk about what has been impactful and what we should keep an eye on?
You hear of high-frequency trading and how trading platforms are using artificial intelligence. But then you look at the derivatives business and it feels like a museum tour. Take collateral [management] that is still using fax machines, for example. We shouldn't have such a huge contrast. But we do, and we have to think about the transition.
We're thinking about the strategies to bring greater efficiency, automation and digitalization to transform the industry.
There is a lot of common infrastructure thanks to regulations—trade execution, clearing and a mandatory and global perspective on posting margin, which we're halfway through. We have a really big Phase 5 for uncleared margin rules this year, where thousands of buy-side counterparties will come into scope. And they need automated solutions to deliver the collateral efficiently.
So, it is an opportunity to bring transformation using this common infrastructure. Our role is to help develop standards. Any trading market has a taxonomy on describing events, interfacing and getting data. We want to extend that standardization to derivatives—not to make it on exchange necessarily, but to give that capability to automate and digitize.
Talking about ESG, what impact does it have on the derivatives markets?
Because cash bonds and loans are green products they will see the investments. But derivatives can back these up as hedge and risk tools.
Data suggests it’s going to take $100 trillion a year to transform our economies. That’s enormous financial resources, and you need to have risk management tools, whether it's duration or any other type of risk.
We've adopted green principles, a principle for pricing carbon, the Paris Accord. Some 1,400 firms have said they will have a net-zero carbon strategy. That’s going to mean investing in new technologies to reduce carbon and voluntary carbon trading. I think ISDA can provide documentation, definitions and help with the carbon registry. It's an exciting thing to do, and I think we're up for it.
The death of Libor has been communicated. Do you feel the industry is prepared for this?
I feel like the guy in the cartoon with the sandwich board that says the end is near. I’ve been able to watch this from CFTC.
We've since unpacked the questions around what we need to do and walked through the principles around how to upgrade existing interbank offered rates (IBOR) to make them more resilient. Now, we're at the stage of ending Libor. Twenty-four of them are going to cease publication on December 31. Another six are going to be phased out by the Financial Conduct Authority of the U.K., calling them non-representative. And, five USD Libor settings will end on June 30, 2023. So, Libor is irreversibly heading to its demise.
At ISDA, we’ve been working on the transition since 2016. There's an enormous book of long-term contracts written against Libor, which will exist long beyond 2023. We need to create a fail-safe to make sure contracts have a reference price when Libor disappears. So we developed a methodology to transition from IBOR to a risk-free rate. The fallback became effective in January 2021 and has seen enormous uptake, with nearly 14,000 participants signed on to the protocol to adjust their contracts.
That gives us the confidence that ending Libor will not result in massive dislocation of these long-term contracts, that they have a reference price based on the risk-free rates, which are better, safer rates that are transparent and based on real transactions. And that makes the system safer.
Finally, where are we with uncleared margins?
This is a big year for uncleared margins, because the buy side really comes in scope with that $50 billion threshold. We have 314 entities coming in with 3,600 counterparties. Next year, over 700 entities with 5,000 counterparties.
This is a massive repapering. You have to repaper using credit support annexes (CSAs) and the new regulatory documentation. We've published that on a digital platform for people to create digital contracts. We've also created ISDA SIMM or standard initial margin model, a transparent regulatory-approved model for everybody.
Those are great mutualized services that are efficient and effective. But it really comes down to counterparties sitting down, putting in place the documentation and operations to have the custodians ready, figuring out how to operationalize it, and then the execution and getting the collateral exchanged.
There's a lot of work to be done. The deadline is September, and then 2022 for Phase 6. We can't say it often enough: Work with your counterparties and custodians to make sure you're ready to exchange collateral in September.
It's a big lift. We haven’t done as many (entities) in the first four phases over the past five years as we're going to do in 2021. And that's the big challenge because we phased it in as regulators with the big banks first. Now, it's the buy side, and it's a big operational challenge.