The International Swaps and Derivatives Association (ISDA) has released new guidance which sets a path for emerging and developing economies to build safe and efficient derivatives markets.
The trade association highlights that for an emerging derivatives market to be effective, a wide range of factors need to exist, including legal and regulatory frameworks, the diversity of market participants and the sophistication of risk management.
Several emerging and developing markets have already made the step to implement legislation which recognises the enforceability of close-out netting; however, increased measures need to be adopted to develop strong derivatives markets that can support investment and economic growth.
“There are a number of standard issues that need to be solved to develop a well-functioning derivatives market, from netting and collateral enforceability to the appropriate market structure for derivatives, particularly with respect to clearing.”
“Effective risk management is fundamental to rising living standards and should not be available only in developed markets, so we have a duty to promote effective derivatives markets all over the world,” said Eric Litvack, chairman of ISDA.
“As in developed markets, the reduction of risk brings greater certainty on future flows and allows business and investment to take place with greater confidence.”
ISDA notes that given the often relatively high volatility in GDP, exchange rates, interest rates and capital flows in emerging markets, derivatives can offer a means of facilitating effective risk management and access to capital.
“There are a number of standard issues that need to be solved to develop a well-functioning derivatives market, from netting and collateral enforceability to the appropriate market structure for derivatives, particularly with respect to clearing,” said Axel van Nederveen, managing director and treasurer of the European Bank for Reconstruction and Development, and vice chairman of ISDA.“It is very important we have a clear roadmap on the key elements that are needed.”
The enforceability of close-out netting has been pinpointed by ISDA as the most critical legal issue that needs to be addressed to ensure a well-functioning derivatives market can grow.
By allowing parties to reduce their obligations to a single net payment due from one party to another, ISDA claims that netting dramatically reduces credit risk in the event of a default. Data from the Bank for International Settlements (BIS) shows that close-out netting reduces the gross market value of outstanding derivatives transactions by nearly 80%.
Managing credit risk on a net basis as opposed to a gross basis increases liquidity and credit capacity, according to ISDA. In addition, recognition of netting also removes barriers to international participation, supporting the development of liquid and efficient capital markets.
“For the dealers that act as intermediaries to numerous end users, netting is the critical mechanism that allows them to offset the sum of their risks and provide intermediation at the best price,” said Litvack.
“Once netting is in place, dealers can provide wider access to derivatives-based risk management, which creates greater certainty and will fuel investment and economic growth.”
ISDA also highlighted that diverse market participation, sophisticated risk governance and risk management are essential to aid emerging and developing economies in building safe and efficient derivatives markets.
With a focus on individual firms, the trade association notes that both the board of directors and senior management are responsible for risk, albeit in different ways.
According to ISDA, the board should understand, approve and review risk management policies that senior management teams have developed. In addition, the scope of the firm’s derivatives activities should be defined by the board, alongside defining the reasons why the firm is undertaking those transactions, its market and credit risk exposure, and its risk processes and controls.
“Taken as a whole, this work is all about how you define and design the next stage of a derivatives market once netting has been achieved. Every market has historically had its own way of doing things and there is no single playbook that can be simply applied to every market, but the ISDA policy framework should be a very helpful tool in making sure the most important issues are addressed,” concluded van Nederveen.
ISDA’s full whitepaper, Policy Framework for Safe and Efficient Derivatives Activity in Emerging and Developing Markets, can be accessed here.