U.S. Derivatives Practice Overview
The U.S. derivatives markets remain active with robust activity driven by ongoing regulatory reform, market volatility and strong capital and financing markets. The U.S. Commodity Futures Trading Commission, and the U.S. Prudential Regulators margin rules entered phase 5 and captured a greater portion of market participants. In addition, impending benchmark rate transition issues have driven demand for advice related to rate fallbacks in documentation and related ISDA protocols. There are also issues related to potential rate mismatches caused by different adjustments of rates in derivatives transactions and the underlying asset being hedged by those transactions. Product innovation also accelerated in cryptocurrency-based derivatives and related trading activity.
Although 2020 was a difficult year in many ways, the global derivatives market saw an increase in gross market value from $11.6 trillion at year-end 2019 to $15.5 trillion through mid-June 2020; a 33% increase in only six months. Market activity across numerous sectors in the United Sates created increased demand for legal services, including pandemic related defaults in the mortgage-backed securities markets; volatility in the energy markets in the first half of 2020; increased volume of equity derivatives in the second half of 2020; and increased activity in finance-related hedges. Margin requirements have also been affected by the extreme market volatility, which has provided a real-world test of the operation of margin models in stressed conditions that had previously been considered only theoretically. For cleared derivatives, clearing operations accommodated the increased market activity, with a notable increase in margin posted with central counterparties in the first half of 2020.
Market volatility is not the only factor driving activity in the derivatives market. The CFTC and the Prudential Regulators have continued phase-in of uncleared swap margin requirements (mostly to align the U.S. standards to other regulatory frameworks such as BSBS/IOSCO). The Securities and Exchange Commission has largely completed its security-based swap rulemakings, including security-based swap capital and margin requirements. With the first security-based swap dealer registration requirements on the horizon for late 2021, market participants and industry groups have begun to prepare in earnest. The CFTC adopted a flurry of long-awaited regulations toward the end of 2020, including as to futures position limits, futures commission merchant and clearing organization bankruptcy rules, electronic trading principles and SEF regulation. Additionally, in light of the change in administration following the 2020 U.S. election, CFTC Commissioner Rostin Benham was promoted to Acting Chair of the CFTC. With Benham at the helm of the CFTC, the Commission has increased focus on commodity derivatives (such as natural gas and silver); the U.S.’s adoption of carbon trading; climate-related market risk; market structure; interest rate benchmark reform; and diversity in the derivatives industry.
In addition, derivatives market participants have been preparing for the upcoming reference rate benchmark transition. The Inter-Bank Offered Rates (IBORs) in several currencies have been the preferred reference rates used in derivatives instruments for many years. However, following a rate-fixing manipulation scandal, global regulators have been pressuring industry participants to cease referencing IBOR-based rates in their contracts, and to replace such rates with certain risk-free rates that are intended to have a lower risk of price manipulation. The recent announcement by the U.K. Financial Conduct Authority, which regulates certain IBOR rates, that most non-USD LIBOR settings will permanently cease immediately after December 31, 2021 and that the principal USD LIBOR settings will cease after June 30, 2023 has provided more certainty to the market as to the timing of the transition.
To assist derivatives market participants with the transition, the International Swaps and Derivatives Association (ISDA) published Supplement number 70 to the 2006 ISDA Definitions and the ISDA 2020 IBOR Fallbacks Protocol, which provide fallback language for various IBORs to adjusted risk-free rates referenced in new and legacy derivatives contracts respectively. Upon the cessation of a particular IBOR, contracts subject to the protocol, or incorporating IBOR definitions as set out in the 2006 ISDA Definitions, will instead reference adjusted risk-free rates published by Bloomberg.
To assist loan market participants in the US, the Alternative Reference Rates Committee (ARRC) has developed recommended fallback language for various loan types which would reference an adjusted Secured Overnight Financing Rate as the fallback rate. Because amending existing agreements to remove LIBOR references has been challenging in many instances, the ARRC also proposed a legislative fix providing for existing New York State law governed contracts to incorporate the ARRC-recommended fallback language where the parties have not elected otherwise. This proposal has been incorporated into the most recent draft New York State budget. Similar federal legislation has also been proposed.
Market participants continue to work through incorporating fallback language into their contracts and to address issues arising with more bespoke contracts and loan-linked derivatives contracts.
Another recent trend in the derivatives market has been the increased demand for and use of cryptocurrencies such as bitcoin. Although most cryptocurrency activity to date has been in the cash market, there has been increasing interest in the development and use of cryptocurrency-related derivatives, including swaps and options on cryptocurrencies, as well as cryptocurrency financing activity involving repurchase transactions or loans of cryptocurrencies. With many major banks and traditional trading platforms beginning to embrace crypto, increased government interest in digital currencies (potentially including a digital dollar) and the dramatic increase in both trading volume and the value of cryptocurrencies such as bitcoin and ether, the increased activity in this market seems likely to continue.