Another shoe drops: Basel Committee and IOSCO issue consultation paper on margin for non-cleared derivatives

In a long expected move, the Basel Committee on Banking Supervision and IOSCO have issued a joint consultation paper, “Margin requirements for non-centrally-cleared derivatives – consultative document.” The main idea is that regulators want banks out of the bilaterally cleared derivatives business as much as possible and that remaining derivatives should be well collateralized. Under Basel III, margin requirements for non-centrally cleared derivatives are supposed to be higher than the requirements for cleared derivatives as communicated by the G20 at its Sept 2009 Pittsburgh summit. This new consultation paper sets up the rules for exactly how that is supposed to happen.

Most of the seven key principals and proposed requirements in the document are no surprises: firms must exchange both initial and variation margin, collateral should be liquid, etc. Be sure to check out the appendices for suggested minimum initial margin and haircut requirements. The biggest curveball so far is that margin across bilateral arrangements should not be netted down and margin may not be rehypothecated. According to principal 5 of the document:

“Initial margin should be exchanged by both parties, without netting of amounts collected by each party (ie on a gross basis), and held in such a way as to ensure that (i) the margin collected is immediately available to the collecting party in the event of the counterparty’s default; and (ii) the collected margin must be subject to arrangements that fully protect the posting party in the event that the collecting party enters bankruptcy to the extent possible under applicable law.”

The question of whether FX Forwards and Swaps should be possibly exempted from non-cleared derivative margin requirements is a very dicey issue. In Finadium’s annual survey of asset managers coming out tomorrow, we identify collateralization for FX Forwards as the biggest issue that could ensnare mutual funds and insurance companies in collateral management. The Basel Committee and IOSCO have heard the arguments of the US SEC that FX derivatives should not be centrally cleared, but that does not mean that FX derivatives will be likewise exempt from non-cleared derivative requirements.

Two other issues getting some resolution is this document are the posting of margin on small contracts by non-significant, non-financial market participants, and the use of two-way initial and variation margin (“universal two-way margin”). Non-financials get exempted from posting margin on small non-cleared transactions: “There was broad consensus within the BCBS and IOSCO that the margin requirements need not apply to non-centrally-cleared derivatives to which non-financial entities that are not systemically-important are a party, given that (i) such transactions are viewed as posing little or no systemic risk and (ii) such transactions are exempt from central clearing mandates under most national regimes.”

Sovereigns get a free ride too, something that we do not agree with: “Similarly, the BCBS and IOSCO broadly supported not applying the margin requirements in a way that would require sovereigns or central banks to either collect or post margin.” We believe that sovereigns pose risk on their own and can themselves be Significant Financial Institutions. But, we suppose that the people writing the rules are giving themselves an out.

The paper goes into some detail about how universal two-way margin would get implemented, including setting potential minimum requirements and the impacts on liquidity. It appears that regulators are open to market comment on how the rules for two-way margining get written to accommodate the market. The paper concludes by saying that the Basel Committee and IOSCO will conduct a quantitative impact study (QIS) on the liquidity impact of the new rules.

While we are sure that the final rules will be different than the proposals in the consultation paper, it is to the benefit of the global financial community that these proposals for margin of non-cleared derivatives get spelled out. This is one of those things that in our opinion has been contributing to regulatory uncertainty and holding up decision making at many financial services firms. Whether and how FX Forwards and Swaps get included in the new rules will have substantial impacts on the global collateral management industry. Exemptions for non-financials and sovereigns will also clarify the costs for consumers and governments.

The consultation document is here.

The press release for Finadium’s 2012 survey of asset managers is here.

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