Calls for radical rethink of derivatives body

Ethical Markets Reforming Global Finance

By Gillian Tett
Published: August 26 2010 19:45 | Last updated: August 26 2010 19:45

Five years ago, the International Swaps and Derivatives Association held a lavish 20th anniversary dinner among the dinosaur skeletons in London’s National History Museum.

The mood was triumphant. No wonder: back then the derivatives market was exploding, and ISDA’s belief in the value of self-regulation was so widely shared that one senior banker quipped that ISDA did not need external lobbyists “since we have Alan Greenspan [former Federal Reserve chairman] doing that”. How times change. This year, ISDA marked its 25th birthday. However, there was no public bash. Instead, the word “ISDA” has become distinctly toxic in Washington and Brussels’ political circles.

Meanwhile, as financial reform intensifies, some of its own members are quietly asking questions about the future of the group.
After all, ISDA’s self-described mission is to champion the cause of “privately negotiated” derivatives contracts (ie those concluded in the over-the-counter market, away from any public exchange). However, many politicians and regulators partly blame the OTC market for the recent crisis, and want to push more derivatives on to public exchanges and clearing platforms. So can ISDA still play an effective lobbying role? The answer is of interest to more than just derivatives experts. For the story of ISDA is not just a mirror of modern finance; it also provides a fascinating cautionary moral about the dangers of hubris and group think.

To understand this, some history. When ISDA was first created back in 1985, it had two functions: one was to champion the cause of OTC derivatives, as a lobby group; but the second was to create the infrastructure for the derivatives world, in a manner that would minimise the need for government meddling.

More specifically, one of ISDA’s crowning achievements was to create a set of documents to standardise derivatives contracts (known as the ISDA Master Agreement). It also encouraged the banks to post collateral against deals and practise prudent risk management. And that, in turn, made the banks confident enough to strike OTC deals with each other, without using regulated exchanges or clearing houses. In the Wild West of the 1980s and 1990s derivatives frontier, ISDA was like a town preacher: it helped to build an effective community not by using a police force, but by issuing sermons and commandments that appealed to everybody to behave well, for the public good.

For 20 years, this self-regulation worked well – or so ISDA thought. The Master Agreement dominated, enabling the OTC derivatives market to boom, and ISDA’s membership swelled above 800. In the 1990s ISDA also repeatedly fended off efforts to impose more regulation over the derivatives world, through deft, aggressive lobbying. But then, as so often in the corporate world, ISDA became the victim of its own success. Precisely because it believed so deeply in its own free-market rhetoric, it failed to prevent the crazy abuses of the credit bubble. And because it felt so politically self-confident – having won those 1990s lobbying battles – it failed to spot the risk of a political backlash. This was not necessarily the fault of the ISDA secretariat: since the body is mostly funded by its 200-odd dealer members, these call the shots. But the result was that when the financial crisis hit, ISDA brushed away calls for reform. That left it marginalised from much of the political debate.

Can it recover? Conrad Voldstad, a renowned former derivatives trader who recently arrived to run the group, is trying hard to do that. These days, he says that ISDA supports more regulation, and clearing platforms. However, the group also insists that it would be impossible to move much of the derivatives activity to exchanges any time soon. So a plethora of ISDA committees – with some 2,000 members – are doing sensible-but-dull things to improve OTC infrastructure, such as tearing up redundant contracts. They have also just significantly boosted the ISDA budget to cope with a wave of new requests from the Federal Reserve and other regulators.

But for my money, I think ISDA will need more deft repositioning, if it ever wants to remove the “toxic” political tag – let alone regain real clout. It is clear that the financial industry does need some trade group for derivatives, if nothing else to exchange ideas; but it would make far more sense for ISDA to clearly widen its mandate beyond the OTC world, to cover exchanges too and swap execution facilities, say. It would also be sensible to encourage far more investor involvement (just four of the 24 outside directors are from the buyside).

Most importantly, however, ISDA could take a leaf out of Mr Greenspan’s book and admit it made a mistake by assuming self-regulation would always work. Perhaps, to signal a fresh start, it could give itself a new name. Any suggestions on a postcard; just don’t mention that lavish party. Or those dinosaur bones.

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