Last week the BCBS and IOSCO released their second consultative document “Margin requirements for non-centrally cleared derivatives”. It describes their thinking on what the final proposal will be for non-cleared swaps. We review the highlights.
The BCBS and IOSCO are sensitive to the connection between margin requirements and collateral liquidity. “…it is important to recognise ongoing and parallel regulatory initiatives that will also have significant liquidity impacts; examples of such initiatives include the BCBS’s Liquidity Coverage Ratio (LCR), Net Stable Funding Ratio (NSFR) and global mandates for central clearing of standardised derivatives….” But what will they do about it?
Who won’t be subject to margin on non-cleared derivatives? “…The BCBS and IOSCO believe that the margin requirements need not apply to noncentrally cleared derivatives to which non-financial entities that are not systemically-important are a party…Similarly, the BCBS and IOSCO support not applying the margin requirements in a way that would require sovereigns, central banks, multilateral development banks, or the Bank for International Settlements, to either collect or post margin…” There are some sovereigns that probably should be posting margin based on their credit ratings. In any event, absent margin, dealers are going to manage their CVA on those shaky sovereign by buying credit protection. The result is to push up sovereign spreads.
The paper advocated the use of margin thresholds. This is already the practice in many CSAs and reflects a dealer’s credit appetite for a client. The margin threshold is applied on a group basis to avoid proliferating subsidiaries to skirt under thresholds. “…All covered entities must exchange, on a bilateral basis, initial margin with a threshold not to exceed €50 million. The threshold is applied at the level of the consolidated group to which the threshold is being extended and is based on all non-centrally cleared derivatives between the two consolidated groups…”
How much initial margin will be collected? “…For purposes of informing the initial margin baseline, the potential future exposure of a non-centrally cleared derivative should reflect an extreme but plausible estimate of an increase in the value of the instrument that is consistent with a one-tailed 99 percent confidence interval over a 10-day horizon, based on historical data that incorporates a period of significant financial stress…” Granted that non-cleared derivatives are likely more complicated to unwind than cleared deals, but cleared deals use a 5-day horizon. Swaps futures are pressing for a 1-day horizon. In a survey that accompanies the paper, the average horizon for the banks in the survey was 8.1 and a confidence interval of 96.2%.
In looking at netting, the paper made it clear that netting only worked when risks within a portfolio of trades that had offsetting risk within the same asset class, otherwise margin is calculated on a gross level. “…inter-relationships between derivatives in distinct asset classes, such as equities and commodities, are difficult to model and validate. Moreover, these sorts of relationships are prone to instability and may be more likely to break down in a period of financial stress. Accordingly, initial margin models may account for diversification, hedging and risk offsets within well-defined asset classes such as currency/rates, equity, credit, or commodities, but not across such asset classes…” This will be a blow to non-cleared derivatives margin costs and may encourage investors who still post margin to look at venues that allow cross-asset class margining.
On collateral eligibility, the BCBS and IOSCO made their opinion pretty clear. They are for broad collateral eligibility guidelines.
“…Accordingly, the BCBS and IOSCO have considered the types of collateral that should be deemed eligible for use in meeting the margin requirements, evaluating several different approaches. One approach would be to limit eligible collateral to only the most liquid, highest-quality assets, such as cash and high-quality sovereign debt, on the grounds that doing so would best ensure the value of collateral held as margin could be fully realised in a period of financial stress. Another approach would be to permit a broader set of eligible collateral, including assets like liquid equity securities and corporate bonds, and address the potential volatility of such assets through application of appropriate haircuts to their valuation for margin purposes. Potential advantages of the latter approach would include (i) a reduction of the potential liquidity impact of the margin requirements by permitting firms to use a broader array of assets to meet margin requirements and (ii) better alignment with central clearing practices, in which CCPs frequently accept a broader array of collateral, subject to collateral haircuts. After evaluating each of these alternatives, the BCBS and IOSCO have opted for the second approach (broader eligible collateral)…”
But they also said that appropriate haircuts should be applied and local regulators should develop their own list of eligible collateral, taking into consideration local market conditions. Given the episodic liquidity of some asset classes – corporates come to mind – there will certainly be much debate on this. But the wind is clearly blowing in the direction of broader collateral eligibility.
In addressing the ability to lend out collateral received as IM, the BCBS and IOSCO said “…Initial margin should be exchanged on a gross basis and held in a manner consistent with the key principle above. Cash and non-cash collateral collected as initial margin should not be re-hypothecated, re-pledged or re-used…” This will create liquidity issues insofar that derivatives dealers use the cash they raise from lending out IM to fund themselves. This discussion is far from over.
A link to the BCBS/IOSCO paper is here.