ISDA says notional is not measure of risk, outlines use in derivatives regulation

Derivatives markets have undergone a significant transformation in response to reforms set out by
the Group-of-20 (G-20) nations in 2009. Substantial progress has been made in each of the five
major areas targeted by the G-20: central clearing, capital, margining, trade reporting and trade
execution. As a result of these reforms, financial markets are stronger, safer and more resilient.
With these fundamental improvements securely in place, policy-makers and industry participants
are now exploring ways in which financial regulation can be further enhanced to encourage growth,
improve liquidity and increase efficiency.

One way to enhance regulatory oversight is to recalibrate certain regulatory requirements to more appropriately reflect the risk associated with derivatives, and to reduce the cost and compliance burden for end users and smaller financial institutions that do not pose a systemic risk to the financial system.

In implementing the G-20 reforms, regulators have relied heavily on notional amount outstanding
as a measure to curtail derivatives risk. For example, under CFTC rules, entities have to register as
swap dealers and so comply with a variety of requirements if their aggregate gross notional amount
of swaps over the prior 12 months is above $8 billion.

While notional amount is helpful in understanding the extent of trading activity, it is not a measure
of risk. For example, if one counterparty enters into a fixed-for-floating swap with a notional
amount of $100 million, there is no payment of $100 million and neither counterparty is at risk of
losing $100 million during the life of the transaction.

Among other things, notional amount does not differentiate between derivatives transactions based
on different underlying assets or reflect the level of risk in a firm’s derivatives portfolio. Risk in
derivatives may be assessed based on other metrics, such as price changes, volatility, and leverage
and hedge ratios. There is now growing recognition of the value of a risk-based regulatory framework, in which regulatory and prudential supervisory requirements and mandates hinge on risk exposures and not on arbitrary and/or non-risk-based metrics and thresholds.

To advance discussion on the merits of a risk-based regulatory framework, ISDA has conducted an
analysis of global derivatives rules to identify the major areas in which notional amount and other
non-risk-based measures feature prominently. Each of the five major  [central clearing of derivatives; margin requirements for non-cleared derivatives; derivatives trade execution/trading obligation; derivatives trade reporting; capital] areas of regulatory reform is discussed, and a variety of jurisdictions is covered.

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