A new research report from the Bank for International Settlements says that banks have enough unencumbered assets to meet initial margin on newly cleared OTC derivatives but may need to raise cash to meet variation margin calls. In “Collateral requirements for mandatory central clearing of over-the-counter derivatives,” authors Daniel Heller and Nicholas Vause model out how much collateral centrally cleared OTC derivatives will demand from dealers. Their conclusions suggest that dealers have little to worry about. It’s a nice idea and we like the overall model the authors have built, but we think that some of their assumptions need adjustment in order to more accurately meet the real world. This may in turn break down one of their core conclusions.
Our main concern about the paper is the amount of capital that the authors assume is posted for initial margin or will be in a new world order. As noted in SFM’s post yesterday on Legally Segregrated/Operationally Commingled clearing accounts, a movement away from legally commingled collateral accounts increases collateral requirements for the rest of the risk pool. LSOC could drive collateral requirements up by 63%, according to Chris Edmonds, the President of ICE Trust, and the option is gaining in popularity with institutional investors. This sharp an increase in initial margin requirements for all market participants would blow the initial margin assumption that the authors used in the BIS working paper out of the water. Ka-boom.
This initial margin issue is dangerous stuff and will continue to be dicey as the rules of engagement with CCPs become better defined. From repo to CSDs to interest rate swaps, each new adjustment to initial and variation margin requirements dramatically complicates the exercise of modeling how much capital dealers really need for newly centrally cleared anything, let alone OTC derivatives. For this reason we are very wary of the authors conclusions on this point.
On a lighter note, the paper concludes with the finding that while dealers have enough capital for dealing with multiple CCPs, one CCP would lessen collateral requirements even further without sacrificing risk management or the stability of the CCP. Market practitioners have been aware of this for some time but regulatory jurisdictions prevent cross-margining across borders, at least for now. Finadium also found in a March 2011 report that only two out of 14 CCPs were clearing more than one product and none were cross-border. While the BIS working paper is still a couple of guys kicking around ideas, the fact that it comes out of the BIS may suggest that official thinking is warming up to the idea of cross-border, cross-product and cross-margin CCPs. That development will be fun to watch.
The BIS working paper is here.