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News April 18, 2011 Issue

Study On Standardizing Derivatives Released

Can the derivatives markets be standardized?

The answer might not be clear, but the architects of the Dodd-Frank Act at least want the issue explored.

Dodd-Frank Act Section 719(b) required the staffs of the CFTC and SEC to jointly study whether "standardized, computer-readable" metrics can be developed to describe both standard and complex derivatives. If such metrics are possible, Congress also wants to hear about the logistics and possible implementation of such a system. And finally, Section 719(b) asks if the technology capability exists, given the logistical issues, do the SEC and CFTC think a standardized system should be imposed on the derivatives markets? On April 7, the SEC and CFTC released their "Joint Study on the Feasibility of Mandating Algorithmic Descriptions for Derivatives" that answers those questions.

In summary:

Yes;

It will require building basic frameworks and exploring the cost-effectiveness of complete automation; and

Maybe a range of industry solutions within certain broad regulatory requirements would be best.

Here’s a bit more of what the 29-page study had to say:

In order to standardize characteristics of the over-the-counter derivatives markets to facilitate exchange trading of substantially all derivatives, relevant economic and legal terms need to be made machine-readable in a common format.

Some economic and legal terms have already been reduced to a computer-friendly format, but only as customized on private, proprietary systems that serve a single dealer, clearinghouse, or money manager. This perpetuates a "Tower of Babel" problem where risk systems cannot communicate without manual reconciliation and "transformation processing."

To the extent standardization across firms exists, it is primarily for transaction confirmation and clearing. Financial Product Markup Language and Financial Information Exchange (which additionally has its own markup language) are two standards used for these purposes, and "each provides some of the data needed to perform net exposure calculations for the instruments they cover."

The "Basel" process, implemented by the Basel Committee on Banking Supervision, requires regulated banks to analyze the master derivatives agreements and their credit support agreements, subject to regulatory oversight. A system like that could be put in place in the U.S. that "may assist in facilitating greater market transparency in OTC swaps."

Net exposure calculations should be constructed in a broader fashion to more accurately gauge a derivative’s risk.

The Dodd-Frank Act requires other transparency-enhancing changes in the derivatives markets that may be leveraged to achieve standardized derivatives trading. For example, the newly required swap data repositories (SDRs) will disseminate real-time information on swaps transactions that will be publicly available. SDRs will also receive additional non-public information that will be directly accessible by regulators to evaluate systemic risk.

Gaps that need to be filled include:

  • Lack of a universal, unique identifier system for parties and counterparties across all repositories and regulatory jurisdictions. Entity identifiers could be of significant benefit for systemic risk management, as would such a system for products and instrument identification.
  • Inconsistent data standards and reporting across all SDRs. Consistency across all data repositories has not been mandated. Both the SEC and CFTC have partially approached the issue in different manners.
  • Not enough standardized information about a transaction. "Essential" information in the general terms of derivatives agreements beyond a transaction’s basic identifying information (counterparties, notional amount, and reference entity) must be converted to machine-readable format to appropriately assess net exposures. "Having these documents in a machine-readable format could, among other things, facilitate analysis of how market events that trigger conditions in these legal documents would change the value of a derivative, and also a counterparty’s leverage and net exposure."

The SEC and the CFTC offered an observation at the study’s end that raised an issue for further thought. "As consideration is given to some sort of reference data standard or universal data utility, a key challenge will be establishing a governance structure for the maintenance of the standard or for the utility that is fair and efficient and that does not stifle innovation. Such a structure should also reflect an acceptable business model that is sustainable and not unduly burdensome."