The International Swaps and Derivatives Association (ISDA) recently wrapped up its 2012 annual meeting in Chicago and released its 2012 Margin Survey results that showed a continual increase in collateralization of over-the-counter swaps. ISDA noted that the increase in collateral reduces counterparty risk. This is important as many analysts still see
In an interesting twist ISDA, the agency that is suing the Commodity Futures Trading Commission (CFTC) over its position limit regime, invited CFTC Chairman Gary Gensler to speak at their event. Gensler laid out the Commission’s plan for regulating the swaps market.
While ISDA is a relatively unknown organization it holds considerable significance as it determines when credit events are defaults for the huge credit default swap (CDS) market, a $37 trillion market.
Here is what Jim Sinclair had to say about the power of ISDA in a recent interview with Futures.
FM: In a recent interview you referred to the International Swaps and Derivatives Association (ISDA) as one of the most powerful organizations in the world. This even though more OTC products will be cleared. Explain?
JS: It has proven to be so because they are the ones who declare whether a default is a default. Unless they declare it as a default the credit default swaps don’t function. If you have the power to determine whether something is a credit event or a default and the market for CDSs according to the Bank for International Settlement is $37 trillion then you are an economic entity more powerful than the Federal Reserve at a point of a Greek crisis because you are the guys who say whether a CDS functions.
FM: Would they retain this power for products that are cleared?
JS: As more of these things go to a clearinghouse there still has to be an arbiter over an event. Could the arbiter change? Yes, but it is unlikely because this organization is made up of the seven banks that have issued most of the CDSs.
FM: Is this dangerous?
JS: It is necessary. What is dangerous is the concept itself, because if a firm is making a living by issuing insurance policies but is not governed by an insurance regulator, how do you know a firm has the equity to meet their commitments if a default takes place? The dangerous item is an unregulated insurance company, which the brokers that issue the CDSs are. Right now it is the seven largest banks that issue the CDSs that are acting as insurance companies without insurance regulation.
FM: Have CDSs proven to be a fundamentally flawed product?
JS: Yes, but [they are] still out there to the tune of $700 trillion (meaning all OTC derivatives). The flaw is that they are specific performance contracts, unfunded. Unfunded specific performance contract is the definition of an OTC derivative. Now as an organization who rules $37 trillion worth of it and will decide if a credit event or a default has occurred, whether it is a CDS written on a major corporation listed on the New York Stock Exchange or whether it is written on Greek debt, according to the BIS the total amount outstanding is $37 trillion.
FM: How should they be regulated?
JS: How do you regulate what is already written? Now new ones can be put together with regulations with better definitions and could be cleared on an exchange. But in a crisis there has to be funding available to the writer to be able to perform on the contract. And nobody is proposing that they trade at 100% margin.
FM: Aren’t these binary products that should require 100% margin?
JS: It is impossible in the marketplace, and it would never be required on an exchange. If I make a contract with you to stand on my head in a clown suit if General Motors trades at $100, how are you going to regulate that? I am going to have to go out there in a clown suit. New ones could be written differently, older ones you could be stuck with. According to the Bank of International Settlements (BIS) the notional value of outstanding OTC derivatives was $1.144 quadrillion ($1,144,000,000,000,000) so they changed the method of valuation to values to maturity and took it from [that figure] to $700 trillion. This is the reason why QE must exist. Why the meltdown that was a product of the bankruptcy of Lehman Brothers and why the Treasury provided liquidity to the counterparties so that the derivatives could perform.
There is $37 trillion in [credit default swaps], both industrial and government issued. There is one body that will decide if any of those are called into performance. That body is the ISDA, that is the most powerful organization in the world. There are no rules. There may be rules defined by how a contract is written but there are no regulatory rules. The master agreement says the determination committee of the ISDA will determine if the event is a [default]. That is one hell of a powerful committee made up of the greatest names in finance.
