November 1st, 2018 by Nick Railton-Edwards
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The CFTC’s Office of the Chief Economist (OCE) has responded to industry petitions to mitigate the widely-forecasted IM Phase 5 oncoming storm. Readers will recall the July 2018 ISDA/SIFMA white paper previewing the phase 5 population explosion and recommending various reduction strategies:

• Raising the in-scope AANA threshold from $8bn. to $100bn.
• Postponing mandatory compliance until the $50mn. IM threshold is breached
• Excluding physically-settled FX swaps from the AANA calculation

The CFTC report is ostensibly neutral as to the merits of these suggestions or the likelihood of their implementation. However, an excerpt of the italicised “findings” highlights their tacit approval of the argument that systemic risk reduction is not linearly correlated with in scope population (note that the figures refer to US entities rather than global):

• While Phases 1 through 4 capture just over 40 entities, Phase 5 could bring 700 entities in scope, which together encompass only 11% of the AANA across all phases
• Nearly 60% of entities coming into scope in Phase 5 have AANAs of less than $25 billion, and over 75% have AANAs less than $50 billion. These subsets of entities comprise about 15% and 30% of total Phase 5 AANA, respectively
• Phase 5 entities will span a variety of business sectors. The average AANA of newly in-scope swap dealers, however, will be many times that of any other sector
• Excluding physically-settled FX swaps from AANA could reduce the number of Phase 5 entities by nearly 30%
• Phase 5 compliance could require implementing nearly 7,000 IM relationships. Excluding physically settled FX swaps from AANA could reduce that number to under 5,000

The report makes repeated reference to the exclusion of physically-settled FX swaps from the AANA calculation, noting that these transactions are exempt from IM (although technically IM does apply to the risk not associated with principal exchange e.g. the interest rate component). Despite the boilerplate asserting that the paper represents the views of the OCE rather than the Commission, we may infer that FX Swaps AANA exemption is the CFTC’s favoured phase 5 population reduction method.

There is clearly some sense in the industry’s Pareto principle proposals- systemic risk is far from normally distributed and the $8bn. threshold was selected with reference to the largely irrelevant clearing threshold. However, proposals are pointless if impracticable; the CFTC has a relatively flexible remit to implement (or postpone) the broad aims of Dodd-Frank, in the EU the industry recommendations imply changes to the Level 1 text of EMIR requiring prolonged passage through the trilogue process. Projected phase 5 populations are hardly a surprise, the industry seems to have elected brinkmanship over patient persuasion; it’s generally better to mention the iceberg while it is on the horizon rather than imminently colliding. There has been speculation that Phase 5 may itself be phased in, each stage triggered by successive intra-phase thresholds. Assuming this “solution” ends at the $8bn population, it may be achieved by a series of regulatory delays rather than reform. However laudable or likely these recommendations are, they militate against certainty and clarity. The sure way to succeed at IM is to start early and partner with specialists, rather than hope for regulatory redemption which may or may not transpire.

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