The International Swaps and Derivatives Association (ISDA) recently celebrated its silver jubilee. ISDA is a trade organisation of participants for over-the-counter (OTC) derivatives market and is headquartered in New York. The 25th anniversary celebrations, I am told, were pretty muted as compared to the lavish celebration in 2005 that marked 20 years of ISDA. Back then, derivative markets were exploding, and ISDA?s belief in its core values of self-regulation was so widely shared that bankers used to joke around that the association did not need external lobbyists ?since it had Alan Greenspan doing that?. The tide has changed pretty quickly. These days, the word ?ISDA? has become distinctly tainted in the Fed and other central bank circles. Meanwhile, as financial reforms intensify, the body has started to ask some serious questions about what it needs to change to sound less noxious and regain some of its lost glory. For starters, it would do well to rename itself ?International Derivatives Standards Association??IDSA! Let me explain why.
When ISDA was created, the purpose was two-fold. First, to create infrastructure for the derivatives market in a manner that would minimise the need for regulatory intervention. Self-regulation was the foundation on which the infrastructure was to be built. Second, it was to function as an interest group that would champion the cause of OTC derivatives. One of ISDA?s crowning achievements was to create the ISDA Master Agreement, which made executing derivative contracts hassle-free. ISDA also encouraged banks to practise risk management. This made banks confident enough to strike OTC deals with each other without using exchanges or clearing houses. In the turbulent territory of derivatives, ISDA was like a counsellor. It helped build an effective community by issuing guidelines and directives that appealed to everybody to behave well, for the derivatives market?s good.
For more than 20 years, this self-regulation worked well?or so ISDA thought. It repeatedly fended off efforts to impose more regulation through deft lobbying. But then, ISDA became a victim of its own success. It believed so deeply in self-regulation rhetoric that it ignored the outrageous abuses of derivatives. And because it felt so self-confident, having won those lobbying battles for more than two decades, it failed to spot the risk of a backlash. Consequently, when the financial crisis hit, ISDA brushed away calls for reform. It still believed in self-regulation while the mood elsewhere had changed. This left it marginalised from much of the political debate, and ISDA today is a noxious word among regulators.
If it ever wants to remove the ?toxic? tag?let alone regain lost clout?ISDA needs to reposition itself. First, it needs to stop campaigning for lesser regulation. The sooner it accepts its mistake that lack of regulation has been to the detriment of derivative markets, it would find itself more relevant in central bank circles. Currently, ISDA insists that it would be impossible to move much of the derivatives activity to exchanges any time soon. It seems to think that if the $600-odd trillion dollar industry moves to exchanges, ISDA may become irrelevant. Not quite true. It is evident that the derivatives industry indeed needs some trade group, if nothing else to exchange ideas, as in the past. It would make far more sense for ISDA to widen its mandate beyond the OTC world. If it can use its influence to ensure better standards and transparency in the derivatives market, it will not only make the global capital markets less risky but will also strengthen the health of financial institutions, whose interests it seeks to advocate.
Twenty-five years ago, ISDA asked banks to do good risk management. This made banks trust each other and do business. Currently, that trust of banks in their own community and in the larger economy is running thin. By ensuring better standards and by moving to the public domain, i.e., exchanges and clearing houses, it would make derivatives market less risky. It has the clout to be the ?IDSA?, which is so badly needed today to shrink the derivatives market size that is more than 10 times of the world?s GDP. Central banks, with all their regulatory power, are finding it difficult to do that. The banking industry would implement these standards with the right attitude if the directive came from its own industry association. Guidelines and directives, along with regulation often work better than just the regulatory stick, especially during troubled times.
In its 25th year, ISDA would do well to emulate its most influential ?lobbyist??Alan Greenspan. The former US central banker admitted in 2008 that self-regulation ideology that had guided his tenure as Fed?s chairman did not work the way he thought. ISDA could be humble enough to admit that in the first place. And may be as a sign that it can do a world of good to the current troubled derivatives market, and not just to remove the toxicity, it could give itself a better name?IDSA.
?The author, formerly with JPMorgan Chase, is CEO, Quantum Phinance