Large investment banks won an important concession from global regulators last month when the Basel Committee on Banking Supervision and the International Organization of Securities Commissions (IOSCO) proposed a softened set of initial margin rules for non-cleared over-the-counter (OTC) derivatives trades and relaxed the implementation schedule, allowing some participants to phase in compliance between 2015 and 2019. The committee’s proposed universal initial margin minimum threshold of €50 million for non-cleared derivatives trades means that market participants will avoid posting initial margin for smaller trades, which could reduce total liquidity costs for derivatives traders by 56%, according to a quantitative impact study conducted by the Bank for International Settlements in 2012.
While the reduction in upfront costs for small trades represents an impressive victory for the derivatives industry, some commentators argue that the devil still remains in the detail.
“To the extent that upfront costs have been reduced for some, and implementation moved to a phased-in approach, the banks got part of what they wanted from global regulators,” says Stu Taylor, founder and CEO of Algomi, a London-based technology and consulting firm focused on the banking sector.
“However, more clarity is needed with respect to key details like definitions of entities covered by the rules, and whether the ISDA CSA [International Swaps and Derivatives Association’s credit support annex] becomes the de facto documentation template for non-cleared trades.”
Although the phased-in approach avoids a potentially chaotic regulatory big bang for non-cleared trades in aggregate, not all participants will benefit from the extended implementation schedule.
For example, organizations with a monthly total notional amount of non-cleared derivative exposures greater than €3 trillion, margin requirements will become effective in 2015, while groups with €2.25 trillion or more of exposure will have to comply by 2016 and so on. Groups with less than €8 billion of exposure will avoid the initial margin rules altogether.
Looking at the OTC derivatives market in the US, it is clear that the proposed threshold levels are more focused on medium and small banks, and the buy-side than the global dealers. According to the Office of the Comptroller of the Currency (OCC) in Washington DC, the five banks with the most derivatives activity – JPMorgan, Bank of America, Citi, Goldman Sachs and HSBC – hold 96% of all derivatives, equivalent to a total exposure of more than $220 trillion. JPMorgan’s total derivative exposure at the end of December 2011 was $70 trillion alone, according to OCC data.
“If you are a high-volume counterparty, the initial margin requirement deadline is essentially 2015,” says Taylor. “Institutions in this space have to start the operational side of preparing for the new rules now, if they haven’t already.”
Furthermore, regulators still have a lot of work to do on definitions with respect to clarifying which organizations are covered by the new margin proposal, and face a harmonization challenge in making the new rules consistent with the Dodd-Frank in the US and EMIR in Europe.
“These requirements are new and interact with a large number of existing regulatory initiatives that, over time, should be reviewed and harmonized as appropriate,” the regulators recognize in their latest announcement.
Moreover, the new regulatory framework appears to rely on the ISDA CSA to become the de facto governing document for the non-cleared market. While the ISDA CSA has historically served a similar function for most participants, it is not clear what new demands its new regulatory role will make of the CSA, or how it should change to fulfil its new mandatory role.
“There will be lots of practical issues around CSA extension, which will require participants to go back and amend existing agreements,” says Taylor.
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| Manmohan Singh, senior |
Despite these regulatory concessions, it is inescapable that the non-cleared derivatives market is going to come under intense economic pressure, especially for the five dealers that control more than 95% of the reported market. Margin rules, counterparty definitions, documentary requirements and increased regulatory capital charges will likely lead to a drastic pull back from the market, at least in the short term. Indeed, while the regulatory push to reduce systemic risk by pooling credit risk on centralized clearing counterparties makes intuitive sense, it is still not clear that regulators are sure of what the macro-prudential objective of the non-cleared market is, other than closing down OTC markets.
Manmohan Singh, senior economist at the IMF in Washington DC, and leading shadow-banking expert, draws a sobering conclusion. “If we acknowledge that banks and CCPs are both systemically important financial institutions, and the taxpayer is on the hook anyway in the case that either fails, then moving OTCD to CCPs only creates ‘deadweight loss’ from lost netting that presently happens on banks’ books,” he says.
“Of course, this move to CCPs reduces the political cost of a future bailout, which is lower for a CCP than a bank bailout.”