International Swaps Research Articles

Discrepancy between regulations and practice in initial margin calculation

Counterparty risk remains an issue in over-the-counter derivative transactions following the 2008 financial crisis. While the margin for a derivative transaction can only be transferred until just before the counterparty’s default, the exposure of the derivative transaction can vary stochastically during the margin period of risk, that is, the period from the counterparty’s default to the actual closing-out of the transaction. Thus, the anticipated positive exposure may not be recognized, resulting in counterparty risk. Considering it is difficult to calculate the initial margin (IM) according to the regulations, IM has been calculated in practice using a simplified method proposed by the International Swaps and Derivatives Association (ISDA), which is called the ISDA Standard Initial Margin Model (“ISDA SIMM”). In this study, we derive an approximate formula for some counterparty risk indicators for a stochastic volatility model and illustrate numerical analyses for a call option in the SABR model as an example to examine the effect of the discrepancy between regulations and practices in margin calculation. Our results imply that the IM calculated in practice may be insufficient for counterparty risk management, particularly when the market is volatile.

Model Legislation of the International Swaps and Derivatives Association: Harmonization instead of Unification

Since 1996 the International Swaps and Derivatives Association (ISDA) has been extremely successful in preparing and promoting model acts that have been implemented in more than 80 jurisdictions, including the Russian Federation. This circumstance is unique because ISDA, unlike intergovernmental organizations in the field of harmonization and unification of private law, does not have the status of an international organization, being a non-profit corporation. Nevertheless, its model laws, being in demand by legislators from different countries, put ISDA’s activities in the field of harmonization of private law on a par with such international organizations as Unidroit and UNCITRAL. The paper provides a brief description of the basics of the activities of this association. Special attention is given to the preparation of standard framework agreements and terms of contracts. The evolution of its model legislation is traced in detail, including the model laws of 1996, 2002, 2006 and 2018. It is noted that up to 2018, there was a tendency to expand privileges for derivative transactions, including in terms of their types and degree of protection. However, after the collapse of the leading investment bank Lehman Brothers and the subsequent global financial crisis, regulatory approaches to derivatives privileges changed, which was reflected in the latest ISDA model Act.

Досуговые сообщества в условиях Специальной военной операции (на примере посткроссинга)

Opinion polls show a high level of support for the Special military operation in Russian society. The main task is we have a rather limited knowledge about the peculiarities of social perception of changes in the everyday world which are the consequences of a Special military operation. The sphere of leisure takes a special place here because western sanctions changed the place and structure of vacation for Russians, restricted access to certain cultural products, sports events, and social networks. This article presents the results of a study of a hobby community of postcrossing - the swap of postcards. The purpose of the study was to determine the specifics of the perception of changes occurring in leisure practice under the influence of the Special military operation. The choice of the postcrossing community as the subject of research is determined by the fact that this type of leisure was originally formed as an international exchange of postcards, which is outside politics. After the start of the Special military operation, this hobby faced a significant restriction of postal communications between Russia and other countries and the politicization of participants in international swaps, which seriously affected leisure practices. The methodology of the study is quantitative and qualitative content analysis of posts and comments of thematic groups of the VK social network. According to the results, the peculiarities of the emotional perception of the changes taking place were established, three main models of leisure activities in new conditions were fixed, as well as the peculiarities of the semantic understanding of hobbies within each of them. The authors are sure that the information obtained on the postcrossing can be extrapolated to a wide range of other leisure social groups, both related to exchange, collecting (philately, philocarty, etc.), and mainly women's leisure groups (scrapbooking, embroidery, etc.). It helps us more adequately understand the specifics of the influence of the Special military operation on the leisure sphere in as a whole.

Sovereign credit default swaps: Managing risks when the fiscal house rumbles

This paper seeks to dissect risks which stem from the features of a sovereign credit default swap under the architecture of the 2014 ISDA Credit Derivatives Definitions (the 2014 Definitions). The paper begins with an overview of the market structure and functions of a sovereign credit default swap, followed by a brief discussion of the landscape behind the product. It then provides a narrative on specific risk considerations, mapped under broad themes such as the Credit Derivatives Physical Settlement Matrix (the Matrix) terms published by the International Swaps and Derivatives Association, Inc. ( ISDA) (including trigger obligations, deliverable obligations, credit events and settlement risk). Examples of Credit Derivatives Determinations Committee (DC) deliberations have been drawn in to elucidate aspects of how the product terms are applied in practice. The goal of the paper is to assist practitioners, infrastructure providers, risk managers, regulators, academics, sovereign issuers and creditors to identify risks and assess the efficiency of sovereign credit default swaps (SOVCDS) as a hedging tool. Due to the vastness of the subject, the paper focuses on SOVCDS traded as a `Standard` transaction type (TType) under the Matrix, where a DC credit event announcement crystallises settlement obligations.

Foreign Exchange Committee Master Agreements as International Contractual Standards for Foreign Exchange Derivatives

INTRODUCTION. The ISDA Master Agreement is possibly the most authoritative cross-border contractual standard in the world of financial markets. It also serves as an example for the local transactional documentation drafters in various countries to regulate the conclusion and performance of over-the-counter derivatives transactions by means of bilateral contracts. However, international master agreements for derivatives and other financial products are not limited to the templates produced by International Swaps and Derivatives Association (ISDA). Foreign Exchange Committee (FXC) suggests a remarkable alternative to the documents maintained by this powerful industry club as far as transactions with foreign currency are concerned.MATERIALS AND METHODS. International Foreign Exchange and Currency Option Master Agreement (IFXCO) and other FXC master agreements served as primary sources of the present article. Its methodological base is represented by general scientific methods (analysis, synthesis, induction, deduction) as well as specific legal research methods. In particular, formal legal method was employed for the literal interpretation of the provisions of FXC standard documentation, historical method was invoked to describe the evolution of standard FXC templates, while comparative legal method was used to undertake a comparative analysis of insolvency laws where appropriate.RESEARCH RESULTS. The article gives a general overview of master agreements in financial markets to put FXC documentation into a broader context of standard contracts publication in financial markets. The analysis of FXC master agreements is carried out through conclusion and performance of FX transactions as well as risk mitigation mechanisms analysis such as close-out netting and collateral. Moreover, the article covers governing law and enforceability issues as well as puts FXC documentation into Russian legal context. Although Russian court, with a high degree of probability, will recognize the choice of governing law made by the parties to the relevant master agreement published by FXC, the enforceability of collateral and close-out netting provisions amidst the bankruptcy of a Russian entity is not secured due to non-recognition of FXC documentation by the Russian authorities.DISCUSSION AND CONCLUSIONS. Author comes to conclusion that despite FXC master agreements are not able to compete with ISDA documentation. However, they are popular with certain financial institutions active in foreign exchange markets. To facilitate the development of Russian financial market the list of recognized master agreements should be broadened by addition of documentation produced by FXC. Arguably, it is necessary to amend these provisions and make them compliant with UNIDROIT as well for the purposes of transactions with banks from the countries considered “friendly” to Russia.

The ISDA Master Agreement and the Recognition of a Latent Contractual Network

Abstract It is argued that contract law has yet to develop a coherent approach for recognising networks. This article uses the International Swaps and Derivatives Association Master Agreement, along with the systems which have been developed around it, as a case study for contractual networks which exist at the peripheries of current conceptions, partially recognised by law but also developing private technological solutions to augment their connectivity.

Public choice and private contracting in financial markets

ABSTRACT In this article, I propose that high levels of concentration in markets make the production of standardised contracts in those markets more likely to be captured by the dominant players creating opportunities for them to extract rents and further reduce competition through contract and market design. I examine how contracts produced by the International Swaps and Derivatives Association (ISDA) shaped the organisation and its activities. ISDA’s governance was dominated by a concentrated group of dealer banks who benefited from the opaque OTC market microstructure revolving around ISDA’s standardised contracts. The organisation’s activities, such as lobbying and data collection, were aimed in part at preserving that microstructure allowing dominant firms to extract rents and reduce competition. In the absence of policy interventions, standardised contracts produced by trade associations can become captured in ways not dissimilar to public regulation.

Trust, Confidence, and Automation: The ISDA Master Agreement as a Smart Contract

The International Swaps and Derivatives Association (ISDA) Master Agreement (MA) is the prevailing contract in the Over-the-Counter (OTC) derivatives market. Its efficacy derives from, inter alia, the network effect. As the OTC derivatives market expanded so did users of the MA. During and after the MA’s creation, the market underwent extensive deregulation and the standard-form agreement soon filled the lacuna left by retreating regulation. Its ubiquity in the market has created a level of trust and confidence, not only in the terms of the MA itself but between parties which may not have otherwise entered into a business relationship. With the impending introduction by ISDA of a smart contract version, this article investigates whether automation will harmonize or disrupt trust and confidence in the MA. ISDA, derivatives, standard-form, trust, confidence, smart legal contracts

Arbitration in Derivatives Contracts

In recent years, the International Swaps and Derivatives Association (ISDA) has increasingly facilitated the use of arbitration as a means of resolving disputes arising out of derivatives transactions. Although the financial services industry is said to have traditionally preferred court-based dispute resolution, a number of factors suggest that market participants ought to consider the particular advantages of arbitration for such disputes. In particular, factors such as the ability of arbitration to mitigate enforcement risks in the absence of the mutual recognition of judgments and to deal with competing regulatory standards both in European and international derivatives suggest that arbitration should play an important role in the resolution of such disputes. This article reviews the history of arbitration in derivatives disputes and considers the recent moves by ISDA to facilitate the use of arbitration as a means of dispute resolution. It also considers the various options now available in this regard to market participants who seek to use ISDA standard form documentation, and the factors affecting the use of arbitration as a dispute resolution mechanism. It concludes that more research and data is required to monitor the use of arbitration in this area. Arbitration – arbitral rules and institutions – ISDA – Derivatives – financial services – arbitral award, recognition and enforcement – enforcement – choice of law

Industry adoption scenarios for authoritative data stores using the International Swaps and Derivatives Association Common Domain Model

In this paper we explore opportunities for the post-trade industry to standardize and simplify in order to significantly increase efficiency and reduce costs. We start by summarizing relevant industry problems (inconsistent processes, inconsistent data and duplicated data) and then present the corresponding potential industry solutions (process standardization, data standardization and authoritative data stores).

Logical English meets legal English for swaps and derivatives

In this paper, we present an informal introduction to Logical English (LE) and illustrate its use to standardise the legal wording of the Automatic Early Termination (AET) clauses of International Swaps and Derivatives Association (ISDA) Agreements. LE can be viewed both as an alternative to conventional legal English for expressing legal documents, and as an alternative to conventional computer languages for automating legal documents. LE is a controlled natural language (CNL), which is designed both to be computer-executable and to be readable by English speakers without special training. The basic form of LE is syntactic sugar for logic programs, in which all sentences have the same standard form, either as rules of the form conclusion if conditions or as unconditional sentences of the form conclusion. However, LE extends normal logic programming by introducing features that are present in other computer languages and other logics. These features include typed variables signalled by common nouns, and existentially quantified variables in the conclusions of sentences signalled by indefinite articles. Although LE translates naturally into a logic programming language such as Prolog or ASP, it can also serve as a neutral standard, which can be compiled into other lower-level computer languages.

Of standards and technology: ISDA and technological change in the OTC derivatives market

ABSTRACT For enthusiasts, distributed ledger technology (DLT) and smart contract technology (SCT) promise a future of frictionless interactions and decentralisation. In practice, however, it is widely acknowledged that this vision faces significant challenges. These include legal challenges, technological challenges, but also implementation challenges. The latter arise because delivering the DLT/SCT vision does not take place in a vacuum, but in a setting populated by existing market actors that operate on the basis of pre-existing technologies and absent an industry-wide layer of standards to support technological change and the vision of frictionless interactions. This article seeks to contribute to the literature interested in implementation challenges. Its aim is two-fold: to examine implementation challenges and to take stock of current market efforts to overcome them. In particular, this article focusses on the efforts of the International Swaps and Derivatives Association (ISDA) and its initiatives to ‘standardise to digitise’. It will show that these initiatives can usefully be examined as an attempt to help the industry coordinate on a common foundational standards layer. However, this article also finds that the success of ISDA’s efforts is by no means certain. Nor are its efforts without raising some concerns.

Biases in CDS Spreads after the CDS Big Bang

The International Swaps and Derivatives Association (ISDA) credit default swap (CDS) standard model assumes a single flat hazard rate (default intensity) rather than a term structure of hazard rates. This assumption introduces biases into CDS spreads for empirical research after the CDS Big Bang. This article is the first to document the biases and provide a simple correction scheme. We quantify the biases using a large panel of CDS data for the period from April 2010 to October 2016. The correction is important for measures based on differences in CDS spreads, such as CDS-bond basis. <b>TOPICS:</b>Credit default swaps, credit risk management <b>Key Findings</b> • The flat hazard rate assumption in the International Swaps and Derivatives Association, Inc., credit default swap (CDS) standard model introduces biases into CDS spreads for empirical research after the CDS Big Bang. • We provide a simple correction scheme to address the biases. • The correction is important for measures based on differences in CDS spreads, such as CDS-bond basis.

Regulation Without the State: The Example of Financial Services

There are frequent calls for financial markets to be more actively regulated by state agencies, such as the Financial Conduct Authority or the Prudential Regulation Authority. They reflect neo-classical, market-failure approaches to economics, which suggest that the market does not maximise welfare if certain conditions do not hold and that government action is required to move the market towards the welfare-maximising position. But we cannot know whether government regulatory action will move us away from or towards the welfare-maximising position unless we also make unrealistic assumptions about behaviour in regulatory agencies. The neo-classical, market-failure approach therefore takes us down an intellectual rabbit hole. It is instead possible to think of regulation as part of the set of services provided by the market, rather than something that to be done to the market ex-post. The discovery of regulatory organisations is part of the entrepreneurial market process. Regulatory institutions evolving within the market continue to evolve, despite the attempts by government agencies to regulate markets in very detailed ways. Modern examples would include the International Swaps and Derivatives Association (ISDA), whose record during the financial crisis was faultless. There are disadvantages arising from private regulatory bodies: they can encourage cartelistic behaviour and may prove less effective where the economic activity in question gives rise to widespread social costs beyond market participants. However, we should reject market failure analysis and operate under the assumption that the market can provide regulatory services because they are valued by market participants. Where statutory regulation is used, it should generally be voluntary with products not regulated by the statutory regulator being clearly identified as such.

Design discussion on the ISDA Common Domain Model

A new initiative from the International Swaps and Derivatives Association (ISDA) aims to establish a Common Domain Model (ISDA CDM): a new standard for data and process representation across the full range of derivatives instruments. The resulting standardisation of workflow will not only reduce the cost of traditional processing but will also facilitate new platforms using distributed ledger technology and enable processing via smart contracts. The design of the ISDA CDM is at an early stage and the draft definition contains considerable complexity and ambiguity. This paper contributes by offering insight, critical analysis and discussion relating to important topics in the design space such as data lineage, timestamps, consistency, operations, events, state and state transitions.

Commodity derivatives, contract law, and food security

ABSTRACTSpeculation in commodity derivative markets has been linked to the causation of the 2007–11 global food crisis. Derivatives have also been implicated in the causation of the global financial crisis. Much of the legal scholarship on derivatives is concerned with how best to regulate their use. Other work has pointed to the role of transnational actors, such as the International Swaps and Derivatives Association (ISDA), in facilitating the growth of the global derivatives market. What is missing in this scholarship is an account of how the norms of contract law have been altered, extended, and even distorted to create a new generation of financial assets linked to food prices. In this paper, I begin a project of examining how the trade in commodity derivatives has disrupted some of the established principles of contract law, and I reflect on the significance of my findings for the debate about derivatives regulation.

The Collateral-Linked Currency Forward (CLCF) Contract: Blockchain-Enabled OTC Currency Forward Market Infrastructure

We eliminate the primary source of uncompensated risk from trading in one of the largest sectors of the global financial markets. Market infrastructure enhancements are achieved in the foreign exchange (FX) forward contract market by integrating distributed ledger technology (DLT) into the creation of collateral-linked contracts for currency forwards (CLCF). Specifically, we deploy DLT with embedded automation as the shared platform for bilateral FX forward contracts, including operational provisions of International Swaps and Derivatives Association and Credit Support Annex agreements. Through automation, we link the economics of the currency forward contract and the price-volatility-induced counterparty exposures, bringing intraday counterparty risk to within mutually acceptable ranges. The essential benefits of the over-the-counter market structure are preserved because CLCF contracts remain bilateral to allow for customized terms and conditions between market participants. Reduced concentration risk is also preserved because there is no central counterparty or central clearing organization into which all risks are pooled. As a result, liquidity is enhanced and risk is reduced in the FX forward contract market.

Credit Derivative Theory &amp; Practice A Credit Primer &amp; Review of the Impact of ISDA Standardization on Credit Default Swap Pricing &amp; Credit Model Calibration

In this paper we review the pricing and model calibration of Credit Default Swaps referring to both the International Swaps and Derivatives Association (ISDA) CDS contract and credit model standardization guidelines. Furthermore we provide an Excel pricing workbook to supplement the materials discussed. The main goal is for this paper to act as a credit primer and to review the impact and purpose of ISDA contract and model standardization on credit pricing and modelling techniques. We review the Credit Default Swap (CDS) product highlighting contract specifications, terminology and how the product has been standardized for increased liquidity and XVA capital cost reduction. We perform a fundamental review of probability and credit modelling, outlining standard market assumptions and techniques used by traders and other market practitioners. Furthermore we demonstrate how to price CDS contracts, calibrate credit models and discuss the ISDA Standard Model, ISDA Fair Value Model and Bloomberg Fair Value Models in particular. In conclusion we discuss CDS liquidity, the need for credit index proxies to hedge credit risk and outline liquidity alternatives to this such as the use of sector and index CDS contracts.

Forecasting initial margin requirements: A model evaluation

The introduction of mandatory margining for non-cleared derivatives portfolios has major implications for the pricing and risk measurement of over-the-counter (OTC) derivatives. In particular, a model for estimating future initial margin requirements is necessary to enable the calculation of relevant pricing adjustments, net counterparty credit exposures and credit capital requirements. Existing literature on the topic suggests a model that makes use of regression techniques, but little detail is available on the predictive quality of these models within a Monte Carlo simulation framework. We review these regression-based initial margin models in detail and compare their output against the actual margin requirements measured by the International Swaps and Derivatives Association standard initial margin model (ISDA SIMM) methodology. We observe that the models generally perform well for single trades but show some degradation for larger diversified portfolios. We investigate potential extensions and improvements to the model, along with examining some additional ‘conservatism’ features that may have application in the context of credit exposure measurement. The initial margin modelling approaches discussed here are similarly applicable to centrally cleared or exchange-traded portfolios.

Transnationalism and Financial Regulation Change: A Case of Derivative Markets

This article investigates the transnational flow of state, non-state and supranational norms governing over-the-counter (OTC) derivatives at both the contractual and regulatory level. Our analysis reveals that the flow of these norms has fashioned a multi-layered transnational legal order. The flow of norms involves the dynamic processes of ‘uploading’ by powerful markets and ‘downloading’ by peripheral states. Asymmetry in economic power between states drives the transnational flow of norms, which are carried by players such as financial intermediaries, professionals, international organisations and regulators. We observe that various factors may affect the outcomes of transnational flow, resulting in different degrees of convergence or divergence in peripheral states. We examine the norms governing OTC derivatives and find that the transnational flow of contractual norms (specifically the International Swaps and Derivatives Association Master Agreement) results in a high degree of convergence. However, the downloading of regulatory norms depends on the economic situation, market conditions and other national interests of peripheral states. This article shows that powerful states can expect smaller markets to accept uploaded norms when the benefits involved are reciprocal and the norms do not conflict with more pressing local concerns. Under the right conditions, therefore, regulations can be globally harmonised without the need for international treaties.