MARGIN ON UNCLEARED SWAPS: a review of the key elements that will drive margining
With adherence to the Dodd-Frank Act and EMIR clearing requirements well underway, the attention of global regulators has turned to the non-centrally cleared over-the-counter (OTC) derivatives portion of the OTC sector. In 2011, the G20 agreed to add margin requirements for non-centrally cleared derivatives to the reform program. Subsequently, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) have been tasked with developing a set of key principles to ensure that appropriate margining practices are established for all non-centrally cleared OTC derivative transactions. Recently, the third and final iteration of the framework establishing the minimum standards was published. In this article, Manmeet Brar and Gordon McDermid review and evaluate three key elements of the requirements and explore the issues and challenges that they present.
New Margin Requirement Proposals
Published in September 2013 by the BCBS and IOSCO, the “Margin Requirements for Non-centrally Cleared Derivatives” is the final framework that will drive margin requirements going forward. This hotly anticipated framework comes after two previous consultation documents that drew broad and, in some cases, intensely debated responses from derivatives industry participants.
The importance of ensuring the uncleared margin framework worked for all industry participants cannot be underestimated. A significant portion of the derivatives market will not be cleared given a lack of standardization, liquidity and customization.
Progress to Date
The BCBS’s and IOSCO’s prior two consultation papers attracted widespread interest from many industry participants with over 180 comments from banks, buy-side institutions, trade associations and intermediaries. As a whole, the industry is broadly in favor of the paper’s main goals of strengthening systemic resiliency in the OTC derivatives market, promoting central clearing and preserving liquidity. However, there are some concerns as well, notably that the framework is disproportionate to the objectives and, while likely to reduce counterparty credit risk, will introduce new challenges, such as reduced collateral liquidity and increased funding risks. The scale of this risk is substantial, with the results from the Basel Committee’s 2012 Quantitative Impact Survey indicating that up to €600bn of initial margin would be required as a result of implementing the framework.
The Framework’s Eight Key Principles and Requirements
The margin requirements in the framework are presented as eight key principles or elements, which can be summarized as follows:
- Appropriate margining practices should be in place for all derivatives transactions that are not cleared by Central Counterparties (CCPs).
- All financial firms and systemically important non-financial entities, or “covered entities,” must exchange initial and variation margin as appropriate.
- The methodologies for calculating initial and variation margin should be consistent across covered entities and ensure that all counterparty risk exposures are addressed with a high degree of confidence.
- Assets collected as margin should be highly liquid and should be able to hold their value in a time of financial stress. (Examples include cash, government and central bank securities, corporate bonds, covered bonds, gold and equities).
- Gross initial margin should be exchanged by both parties and held in such a way as to ensure that the margin collected is immediately available to the collecting party in the event of the counterparty’s default, and the collected margin must be subject to arrangements that fully protect the posting party.
- Transactions between a firm and its affiliates should be subject to appropriate regulation and in a manner consistent with each jurisdiction’s legal and regulatory framework.
- Regulatory regimes should interact so that national entities can be harmonized so as to avoid duplicative mandates.
- Margin requirements should be phased in over an appropriate period of time, between December 2015 and December 2019, to ensure appropriate transition.
The main focus of this article includes the three key areas of concern, which are elements 2, 4, and 5. These are arguably the most discussed and debated areas of the framework, and they are most likely to have a substantial impact on the noncleared collateral market.
Three Key Areas of Concern
The three most intensely discussed themes are covered in Element 2, Element 4 and Element 5.
1 Element 2: Scope of Coverage—Scope of Applicability
A key element of the margin requirements is the scope of applicability. This identifies to which firms the requirements apply and what the requirements compel those impacted firms to do.
The framework confirms that financial firms and systemically important non-financial companies (NFCs) are subject to the margin rules if the firm has at least €8bn gross notional outstanding of non-centrally cleared derivatives. The following table identifies which entities are subject to the framework.
Firms that are in scope will need to adhere to the following new margin requirements:
- The full amount of variation margin to be collateralized on a regular basis (i.e., zero threshold and daily frequency)
- Initial margin with a threshold not to exceed €50m, applied at the consolidated group level of an entity
- Minimum transfer amounts not to exceed €500,000
- A minimum level of €8bn of derivatives activity necessary for covered entities to be subject to the margin requirements
The mandated two-way margining will create a number of challenges for impacted parties that will result in many OTC market participants making significant investments in their collateral infrastructure and capabilities. Given that two-way exchange of IM is not common market practice today, posting IM between counterparties that have never done so is likely to be complex and require significant legal and operational analysis.
Operationally, considerable analysis and operating model review and definition will need to be performed by those participants who currently do not have to post or receive margin. New processes and infrastructure will be required to support the framework. An investment in infrastructure covering margin calculation, account segregation, dispute management policy, procedures and reporting will be required to ensure the new requirements can be supported.
In terms of legal documentation, Credit Support Annexes (CSAs) will need to be renegotiated to support bilateral variation and initial margin requirements. Furthermore, revised legal opinions will need to be commissioned to validate the enforceability of netting and collateral—ensuring that the creation and perfection of legal rights over collateral is supported.
Finally, the liquidity and funding implications resulting from the need to collateralize considerably higher margin requirements than are currently required will be significant. Organizations will be forced to review their treasury and funding capabilities to support framework demands.
Easing of the IM Requirement
While the framework reduces the liquidity impact of bilateral initial margin through the provision of a €50m threshold, the fact that this is applied at the level of the consolidated group significantly limits its impact. For example, many large broker dealers trade derivatives through multiple legal entities that belong to the same bank holding company. In this instance, the relief will only be €50m across all the legal entities. Figure 1 outlines a typical scenario that organizations will experience.
In Figure 1, Bank Z trades with three entities under separate legally enforceable netting agreements. Initial margin requirement is €100m for each individual entity. Bank Z must collect at least €250m when dealing with the three entities. Exactly how the €50m threshold is allocated across the three entities is subject to agreement between Bank Z and the three Bank Holding Company A entities.
Total IM requirement across three entities €300m
IM threshold at consolidated level €50m
IM collectable by Bank Z €250m
Leveraging Industry Platforms to Attain Operational Efficiency and Lower Funding Costs
Industry platforms, such as TriOptima’s triResolve and AcadiaSoft’s MarginSphere, provide market participants with the tools to more efficiently reconcile their portfolios (material terms as well as valuations) and agree on their margin calls in a timely manner. In the new bilateral world, these tools may potentially assist with collateral optimization and funding exercises if margin calls are forecasted and agreed upon earlier in the operations timeline. An agreement on portfolio valuations and the resulting margin calls should significantly assist in attaining that efficiency.
2. Element 4: Eligible Collateral for Margin
The final framework recommends a list of eligible collateral based upon the high-level principle of good liquidity, along with limited exposure to credit, market and FX risk. Liquidity risk continues to be the main concern, with the framework designed to ensure that collateral used as initial and variation margin can be liquidated in a realistic amount of time to recognize the proceeds required to cover the exposure. While the list for recommended collateral is not intended to be exhaustive with the final framework ultimately leaving it to national supervisors to develop their own list of eligible collateral assets, the list below lays out the framework’s view on eligible collateral.
Eligible collateral under the framework includes:
- High-quality government and central bank securities
- High-quality corporate bonds
- High-quality covered bonds
- Equities included in major stock indices
The recommended collateral does not deviate significantly from the collateral in circulation to support non-centrally cleared derivatives. The graph below illustrates the percentage of collateral received against non-cleared OTC transactions. For a number of years, cash has been and continues to be the most popular type of eligible collateral.
Making the Case for Including Asset-Backed Securities AS ELIGIBLE COLLATERAL
As firms face the potential challenge of identifying sufficient eligible collateral to post as margin, senior ABS bonds are a significant omission from the published list of acceptable collateral, particularly those supported by residential mortgages, consumer assets and small and medium enterprise (SME) loans. The recent pronouncements from the European Central Bank and others recognizing the real economic benefits of securitization as an alternative source of liquidity and as an engine for growth has provoked many to reconsider the asset class as a mainstream investment. Some believe the ECB’s announcement that it is considering investing in ABS bonds and is encouraging EU agencies and other entities to do the same will lead to a renaissance of securitization and an upsurge in issuance. Such an active endorsement and likely expansion of issuance, including senior ABS bonds backed by retail assets, could help alleviate the collateral shortage famine and provide additional risk diversity.
The omission of ABS bonds appears out of step with the regulators’ approach. For example, the Bank for International Settlements (BIS) recently proposed that certain types of non-retained (or repackaged) liquid, low loan-to-value Retail Mortgage Backed Securities that are rated AA or better, can be included in the stock of eligible High Quality Liquid Assets (HQLA) included in Liquidity Coverage Ratio (LCR) calculations.
With the combination of investors looking for yield, the US housing market stabilizing and activity expanding globally, levels of new ABS deals backed by mortgage, consumer and SME assets are likely to reach levels not seen since the onset of the financial crisis. Many market commentators believe that the inclusion of ABS bonds on the BCBS/IOSCO eligible collateral list should be reconsidered given the many potential benefits accruing in both the collateral space and real economy.
3. Element 5: Treatment of Provided Initial Margin
Arguably the most contentious aspect of the margin framework has been the treatment of provided initial margin. BCBS and IOSCO felt that the exchange of IM on a net basis would be insufficient to protect two market participants with large, gross derivatives exposures from one another in the case of the failure of one of those firms. Furthermore, BSBC and IOSOC proposed that cash and non-cash collateral collected as IM should not be re-hypothecated, re-pledged or reused. Naturally, supporting these proposals would be a significant departure from current market practices and would have significant liquidity and funding implications for the entire market.
A Departure from Market Practices : the Reuse of Initial Margin
There has been some respite in the limitations to hypothecation. Unlike the proposal, the framework itself allows re-hypothecation of customer collateral, subject to restrictive conditions and only for the purpose of hedging customer positions. The definition of “customers” is limited to “buy-side” financial firms and non-financial entities, meaning that collateral collected by dealers or market makers in the interdealer market may not be re-hypothecated. Furthermore, the current text lacks sufficient detail to precisely interpret the definition of hedging, which will undoubtedly lead to additional questions for clarity.
Further stipulation of the framework requires that customer collateral collected as initial margin be segregated from the initial margin collector’s proprietary assets. The collector must also give its customer the option to have its initial margin individually segregated. In the event that the customer consents to re-hypothecation, the margin collector and the third party to which customer collateral is re-hypothecated would need to comply with the additional requirements, including:
- The re-hypothecation must be in connection with hedging positions arising out of transactions with customers (or where a customer’s collateral is individually segregated, hedging positions arising out of transactions with that specific customer)
- The collateral may be re-hypothecated, re-pledged or reused only once
- Collected collateral must be treated as customer assets and segregated from the initial margin collector’s proprietary assets until re-hypothecated to a thirdparty and, once re-hypothecated, the third-party must segregate the collateral from its own proprietary assets
- Collateral of customers who have consented to re-hypothecation must be segregated from customers who have not so consented
- Collateral must only be re-hypothecated to, and held by, an entity that is regulated under similar rules and that is not an affiliate of the customer
- The customer must provide express written consent to the re-hypothecation
- The level and volume of re-hypothecation must be disclosed to the authorities
Supporting these additional requirements will require organizations to review, evaluate and select global relationships with third-party custodians for ensuring the safe keeping of collateral assets. Firms will also need to monitor a likely increase in concentration risk and systemic risk, given that there are a limited number of tri-party providers globally. Further system functionality will need to be developed to support the hypothecation requirements, including identification, tracking and monitoring of the hypothecated collateral.
Treatment of IM under Basel III
Cash IM that is collected by banks and required to be segregated with no possibility of re-hypothecation would have the impact of grossing up the balance sheet for the purpose of calculating the Basel III leverage ratio. Since the frameworks seem to prohibit recycling the cash into a bank’s internal funding process, this is a pound-for-pound uplift. Banks are not permitted to net cash collateral with out-of-the money OTC positions for leverage ratio purposes, so there’s no permissible offset. Consequently, industry participants are lobbying that IM should be exempted from the leverage ratio calculation. Otherwise, the mandatory collection and segregation of IM (when the collateral provided is cash) would artificially restrict the maximum size of a bank’s balance sheet and consequently impact its funding capability.
Supporting the final framework will require organizations to make considerable investments in their collateral processes, infrastructure and technology. The liquidity, capital and balance sheet implications generated by the Initial Margin/ Independent Amount requirements will need to be understood, quantified and form part of the organization’s collateral strategies and decision making. Moving forward, organizations will need to conduct assessments of their collateral functions and infrastructure to ensure they comply—and ultimately take advantage of the new margining framework.