Does mandatory margining of non-cleared swaps make sense for Asia?

The Asian banking community is anxiously following the debate around the BCBS/IOSCO proposed mandatory margining of non-cleared swaps that began with the publication of Margin Requirements for Non-Centrally Cleared Derivatives in July 2012 and has been followed up by a near final “Second Consultative Paper on Margin Requirements for Non-Centrally Cleared Derivatives”, published in February 2013.

Mandatory margining of non-cleared swaps is one of the G20 regulatory agenda items. Though the rules have not been finalized, they will clearly increase the cost of doing business with a very high likelihood that this increased cost will be acutely felt in Asian financial markets.

BCBS/IOSCO proposals start from the conceptual premise that OTC derivatives trades that are not cleared should face higher costs than cleared trades in order to provide incentive to move them to clearing.

This misses the important fact that not all OTC derivatives trades can be cleared and that many of the non-clearable products are quite important risk mitigation tools in the real economy.

Also missing was recognition that the regulatory objective of providing incentive for clearing had already been achieved through Basel III, which requires banks to take significantly higher regulatory capital charges on bilateral trades than on cleared OTC derivatives trades.

The new margin framework proposed by regulators consists of two elements: variation margin and initial margin. Variation margin is a mechanism that is used to avoid the build-up of unsecured risk exposures between counterparties and is widely used by market participants.

ISDA research¹ reveals that more than 70% of all OTC derivatives transactions — including 84% of those executed by large dealers — are subject to variation margin arrangements.

The case for initial margin, on the other hand, is problematic. Initial margin is a safety cushion designed to cover the replacement costs if a counterpart defaults. It is an extra payment made between parties in excess of amounts owed. Initial margin does improve the situation of the non-defaulting party and reduces the risk of default contagion across the system.

However, initial margin comes with some very significant cost. It has the potential to significantly strain the liquidity and financial resources of the posting party. As such, it introduces a potentially large amount of risk into the system due to its pro cyclicality. Lack of variation margin played a significant role in AIG’s default, but lack of initial margin was never an issue.

Upwards of 70 percent of global OTC derivatives activities are likely to be cleared eventually. The residual non-cleared segment of the OTC derivatives market remains critical to Asian economic growth.

These products are used extensively by corporations, investment and pension funds, governments and financial institutions to run their operations and to manage risk. They include the majority of interest rate swaptions (US$28.4 trillion notional principal outstanding² and options (e.g. caps, floors and collars) (US$12.3 trillion notional principal outstanding), cross-currency swaps (US$16.9 trillion notional principal outstanding), single-name credit default swaps and various types of equity and commodity swaps.,

They will likely remain non-cleared, as they do not fit the eligibility requirements of clearinghouses (CCPs). Lack of liquidity will also mean that otherwise clearable interest rate swaps will remain un-cleared. These include several of the Asian currency denominations as well as products with unique maturities or underlying reference rates.

Subjecting these products to mandatory initial margining – even if limited to financial counterparties - will tie up a tremendous amount of capital (see ISDA’s study: https://www2.isda.org/functional-areas/risk-management/).

The cost of this collateral will eventually flow through to the pricing of the products to Asian end users. The concern is that the increased cost will make hedging less attractive with the result that end users stop hedging real business risks.

The rules have not been finalized yet and there does not appear to be a clear consensus amongst either global regulators or market participants on whether variation margin, initial margin, neither or both should apply to FX products, including cross currency swaps. The final decision on this will matter to Asia’s real economy.

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¹ ISDA Margin Survey 2012.

² DTCC Global Trade Repository Reports