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Today's Bullets:
What (or rather who) is ISDA?
ISDA's Role in The Financial World
ISDA and The Bankers
Inspirational Tweet:
You may have recently heard about a letter that ISDA issued to the Fed and FDIC related to US Treasuries and bank leverage requirements. Or basically, the elimination of them.
If you haven't, and before your eyes glaze over from boredom or confusion, hear me out.
This is a Big. Effing. Deal.
As in BFD.
Wait. Who is ISDA, what's the SLR, and why the heck should we care?
Have no fear, we are going to answer each of these and more, nice and easy as always.
But, there's just too much to cover in a single issue, so we're going to do something a little different for the next few weeks. We will break this topic up into three parts.
We're going to unpack it all, piece by piece, and keep it super easy to follow.
So, grab a big old cup of coffee, and get nice and comfortable for some banking regulation demystification with The Informationist.
🧐 What (or rather who) is ISDA?
Founded in 1985, the International Swaps and Derivatives Association (ISDA) was created to add structure and standards to an exponentially growing swaps and derivatives market. One that has absolutely ballooned since then.
How big is that market today?
Would you believe over $700T?
And this latest BIS (Bank of International Settlements) chart is over six month old, and only covers reported on-balance-sheet transactions.
And so, digging deeper into these BIS estimates puts the total notional value of global swaps and derivatives (including off-balance sheet items) at well over $1 quadrillion.
That's one billion millions.
Or one million billions.
Either way, you get the point.
But before we get too freaked out with this, the reality is that much of this value cancels itself out through hedges and offsets, leaving the true risk: counterparty.
Before getting into that, though, let's back up a moment and review what a swap is, exactly.
First, a swap is a contract between two parties (like a legal document) that agrees to exchange one risk for another. Pretty simple concept, actually, it just sounds complicated. I’ve traded thousands of swaps in my career, usually to hedge out interest rate or currency exposures.
How?
Just swap the fluctuations of one risk for another.
Let's say I was exposed to Swedish krona in a trade but did not want that exposure, I'd rather keep it in US dollars.
And say that my bank knew of another customer in Sweden who was exposed to US dollars but didn't want to be.
The banker would set up a swap where I would take on the exposure of the USD and the other customer would assume the fluctuations of the krona.
We would swap exposures.
And we would pay the bank a fee of this service.
Another type of swap you may have heard of is a Credit Default Swap or CDS.
The first time you heard of CDS was likely back in 2008 or 2009, when the entire housing market imploded. Michael Lewis’ book The Big Short went into great detail about the housing market implosion and how a few savvy investors made a killing investing in what are called CDSs.
If you have not yet read the book or seen the movie, I recommend it highly for a simple explanation of what the heck happened back then.
Or, if pressed on time, I wrote a short newsletter on it last year, and you can find that Issue, right here:
TL;DR: in the case of the housing crisis, CDSs were used to swap the risk of a tranche of debt (basically a bunch of homeowners loans all rolled into one bond) defaulting on its collective mortgage payments. Owners of the debt could get insurance on the default of that debt by buying CDS ‘insurance’.
And so, back to counterparty risk and the point of all this.
Just like a bank has a risk when they extend you a loan (you may stop paying), there is a risk the party opposite you in your swap is either unwilling or unable to pay the agreed-to swap. The trade, in effect, fails, and you as the CDS owner are left holding the bag, uninsured.
You may recall that there was a whole lot of this happening during the GFC when one party was unable to pay the CDS insurance they sold to another party. And it was such a tangled mess, even in the instances that Lehman and other banks were just the brokers and there was another counterparty, those got ‘lost’ (basically became untraceable with all the intricate trades) within the implosion.
Some CDS purchasers were out of luck and suffered the loss on their bonds that defaulted, plus the insurance premiums they paid for the now-defunct CDS protection.
This is where ISDA comes into play.
🔍 ISDA's Role in The Financial World?
As we said above, ISDA was created to add structure and standards to the swaps and derivatives market.
During the GFC, ISDA had a huge bullseye on its chest.
Why?
See, ISDA was formed to create and uphold standardized documentation and best practices, which are meant to reduce legal uncertainty and operational risks. And when you want to engage in derivatives trading with your prime broker, you sign what is called an ISDA Agreement, which is a legal contract that outlines the terms and conditions under which parties agree to trade derivatives.
The Master Agreement.
This agreement is then adjusted for each transaction to include specific treatments of collateral, calculations, payment schedules, etc.
That's all well and good, but this standardization does little to help with transparency and total risk management at the customer or counterparty level.
Which we all found out the hard way on 2008.
The result?
ISDA came under fire, as did the whole swaps and derivatives market.
But this market was and continues to be an important and growing piece of the investment world.
And let me be clear. Swaps and derivatives, if used responsibly, can be an efficient and effective way to reduce risks to portfolios and investments.
They can help investors avoid currency risks.
They can help banks avoid interest rate risks.
They can help lenders avoid default risk.
But when used for speculation and leverage and irresponsible purposes instead, they can be deadly.
Ask Long Term Capital Management.
Ask Lehman Brothers.
Ask AIG.
Ask ISDA.
Which is why ISDA has waded even deeper into recommendations and standards.
In response to the GFC, ISDA has pushed for more standardization and even central clearing (to increase transparency and reduce counterparty risks).
ISDA is also involved in developing global standards for collateral and margin requirements and risk management best practices.
All that said, actual regulatory oversight of all this is still left to the U.S. Commodity Futures Trading Commission (CFTC) and other national and international regulators.
By now you should be asking, why are we even talking about ISDA?
I thought this had to do with US Treasuries and banking requirements.
Why is ISDA writing a letter to the Fed about banking leverage and risk management ratios?
Well.
Do you know who the actual managing members of ISDA are? The ones setting all this policy?
✍️ ISDA and The Bankers
You'll be absolutely shocked to hear that the primary managers of ISDA are...
Bankers.
Between the Board of Directors, the Executive Committee, and the CEO and Senior Managment, we can see that the following banks and financial institutions are represented:
Société Générale, Blackrock, DE Shaw, JP Morgan, Morgan Stanley, Goldman Sachs, Credit Agricole, RBC Capital Markets, Mizuho Securities, and Standard Chartered Bank.
While of course it makes sense that the experience and knowledge of these managers are essential to the strength and effectiveness of ISDA, there's just one needling issue.
The vast majority of these directors, executives, and managers all still work at these banks while they hold their positions at ISDA.
And so, it comes as no surprise that ISDA is now wading into the waters of Basel III, US Treasury holdings at banks, and rules for calculating risk ratios.
If you want to get a head start, I encourage you to read the letter for yourself (it's linked in the line above).
But in the words of ISDA itself, the purpose of the letter was to urge [the Fed, the FDIC, and the OCC] to implement targeted reforms to the supplementary leverage ratio (SLR) ... for global systemically important bank[s] ... to preserve the resilience of the US Treasury markets, the US economy and the financial system more broadly.
As for what exactly is in the letter and why it matters, we will get into all of that in the next two parts.
Because that's enough ISDA talk for any Sunday.
I suggest you go and enjoy the rest of yours instead.
That’s it. I hope you feel a little bit smarter knowing about ISDA and are eager to learn more about their recent letter in the coming weeks.
If you enjoyed this newsletter and found it helpful, please share it with someone who you think will love it, too!
Talk soon,
James✌️