The paper sets out the views of an international policy working group on:
- Who must post collateral;
- What instruments will qualify as collateral; and
- How this collateral must be calculated and exchanged.
It is clear from the paper that there has been significant debate between members of the working group on the details of all proposals. There has been recognition of the potential impacts on market efficiency and liquidity if margin requirements are set too high. The favoured proposals seem weighted towards systemic concerns. As a result, collateral proposals are wide ranging, though for a smaller set of financial 'systemic' non-financial market participants.
Impacts for firms
These proposals will have a vast impact on the cost and operation of markets in non-centrally cleared derivatives. Significantly more collateral must be posted by all major participants. The cost of this collateral is likely to reduce the overall volume of trades and increase the costs of those trades that remain, with knock-on effects for other trading and funding models if limits are placed on the reuse of collateral held as initial margin as currently proposed.
- Higher margin requirements undermine some business models and raise the question of whether sufficient collateral will be available.
- The reaction of the buy-side to higher costs and subsequent impacts on pricing and demand for new services (eg. collateral transformation, trade optimisation).
- Differences between jurisdictions will complicate compliance and operations, but may drive opportunities.
- Models and governance may require significant change - for minimal benefit.
Actions firms should consider:
- Review existing bilateral business and assess which products are likely to remain bilateral or migrate to central clearing. Firms will need to assess the implications for pricing and the effects on client demand for bilateral versus cleared products.
- Trading operations must be better joined up as part of the broader asset and liability management of the firm to determine how increasingly scarce collateral is deployed.
- Monitor ongoing developments in key geographic markets. Consider implications for existing business models and opportunities to optimise activities across geographies.
- Models and surrounding governance must be updated, if these are to remain fit for purpose under an emerging policy approach, which is increasingly critical of models and may curtail potential benefits relative to regulatory standardised approaches.
- Finally, firms must assess their ability and appetite to build new products and services in light of the emerging landscape. These could include opportunities to source and/or create necessary collateral; or optimising the balance of product offerings across cleared and non-centrally cleared instruments depending on the market, the counterparty and the clients' requirements.
In the detail…
The document sets out seven primary requirements, with a number of key principles proposed to ensure requirements are effectively met. These proposals are set out in brief below.
Scope of coverage – instruments subject to the requirements
Proposal: The margin requirements apply to all non-centrally-cleared derivatives.
Scope of coverage – scope of applicability
Proposal: All 'covered entities' that engage in non-centrally-cleared derivatives must exchange, on a bilateral basis, initial and variation margin subject to mandatory minimum amounts.
Though in principle all derivatives are deemed in scope, the paper consults on whether certain classes – such as foreign exchange swaps and forwards, as suggested by US regulators – should be exempt from the margin requirements; and if so, what criteria might be used to identify when those exemptions apply.
The working group proposes that all financial firms and systemically important non-financial entities should be subject to both initial and variation margin. 'Covered companies' (ie. those entities in scope) may then be categorised into key market participants (eg. global banks); prudentially regulated entities (eg. banks, insurers); or non-prudentially regulated entities (eg. corporates). Non-systemic non-financials (how these will be defined is not clarified), as well as sovereigns and central banks, are excluded from the requirements.
The working group suggests tiered thresholds to trigger the requirements. The thresholds are set to align the level of initial margin to be exchanged between covered companies to their relative risk. More systemically risky firms get a lower threshold to ensure higher margin requirements. Thresholds would be applied to portfolios of trades, and the amount of initial margin required to be posted would be the excess of the total requirement calculated over and above the agreed threshold.
There was clearly a divergence of views on whether both initial and variation margin must be exchanged between all covered companies, with some participants concerned about the impact on liquidity. The threshold approach is intended to minimise unnecessary impacts while maintaining the objective of minimising systemic risk by protecting parties in the event of default. Yet concerns are likely to remain and divergent practices may emerge.
Baseline minimum amounts and methodologies for initial and variation margin
Proposal - Initial margin: May be calculated either by a model approved by each local supervisor or a standardised margin schedule (proposed in the consultation document).
Proposal – Variation margin: The full net current exposure of the non-centrally-cleared derivatives must be used.
Models must calculate potential loss to a 99 percent confidence level, over a 10-day horizon, which incorporates a period of significant stress. Diversification and netting benefits are expected to be more limited than current practice as netting would be allowed for assets in the same well-defined asset class.
The expectation is that internal models would be subject to rigorous back testing and actual margins will be reviewed by supervisors across the market - such trades would be compared to similar cleared trades - to identify inconsistencies. The working group is also considering allowing local supervisors to 'top up' margin requirements to achieve specific macro prudential objectives. Supervisory capabilities to review additional models and make cross-market comparisons may prove challenging.
The Consultation suggests, where possible, variation margin should be calculated daily; and a low minimum transfer amount should be established to prevent exposures growing while insufficiently collateralised.
Though these proposals allow the continued use of internal models, in practice they will require significant investment and governance for what may be relatively little benefit. These proposals reflect an increasing trend among policymakers – including the BCBS in its recent consultation 'Fundamental Review of the Trading Book' (read our alert on this from May 2012) – of greater scepticism towards the effectiveness of internal models. The increasing restrictions on key assumptions laid out in recent consultations drive some firms to choose the relatively higher requirements allowed for under standardised methods over the investment and maintenance of internal models where relatively little benefit (eg from reduced margins) may be available.
Eligible collateral for margin
Proposal: A relatively wide definition of acceptable collateral, including assets such as equities that form part of major indices; high quality corporate and covered bonds; and gold, alongside cash and high quality government and central bank securities.
The consultation also suggests that, "the illustrative list should not be viewed as being exhaustive". This breadth of potential collateral reflects concerns regarding the potential impact on market liquidity of increasing capital and collateral requirements, hence the allowance for a wide range of assets and local supervisory discretion over eligible collateral. However, these would be subject to substantial haircuts (derived from existing Basel Accord haircuts), which again may be calculated using approved internal models or a proposed standard schedule.
Treatment of provided margin
Proposal: Initial margin should be exchanged on a gross basis and fully segregated to ensure it will be fully available to either party in the event of a default – and both cash and non-cash initial margin should not be re-hypothecated or re-used.
Though the consultation states that there was broad consensus on this point, US regulators have raised concerns. These broadly centre on the potential knock-on capital impact for firms such as US broker dealers who are subject to net capital requirements, which give less favourable capital treatment for margin held with third party custodians.
Treatment of transactions with affiliates
Proposal: Full variation margin should be exchanged between affiliates. In terms of initial margin, local supervisors should review their own market conditions and put in place requirements as appropriate.
Once again there were divergent views, with some believing that variation margin is unnecessary, as long as specific criteria around common risk management procedures, full consolidation and lack of any legal impediments to a prompt transfer of funds owed could be established. Requiring margin will add significant cost and complexity to centralised booking and risk management models.
Interaction of national regimes in cross-border transactions
Proposal: Host country rules on margin should apply, as long as the home country supervisor is satisfied that these are consistent with the final BCBS/IOSCO framework. Branches should fall under the rules of home supervisors.
Relatively little is said in the consultation on this topic. The principle of a 'level playing field' is reiterated, as is the goal of minimising regulatory arbitrage or duplication between requirements. Supervisors are advised to cooperate and agree which set of rules should apply when transactions cross borders.
All of the above are subject to consultation and amendment.
Check out (PDF 203 KB) the full Consultation paper. Responses must be submitted by 28 September 2012.