Buy-side hit with surprise initial margin levels on CDS right before mandatory clearing starts

A rule on cross-margining released just a couple days before the March 11th start of mandatory clearing for derivatives caught the attention of a lot of people. It came from the SEC and impacted single name CDS and CDS indexes — and could have far ranging impact on collateral.

Most attention is paid to the CFTC and the margin requirements of CCPs imposed on the sell-side. We are guilty of that too. The SEC also regulates derivatives with a mandate for security base swaps. This includes single name CDS contracts. The CFTC regulates pretty much everything else. Sell-side firms are now able to take advantage of CDS cross margining (across CDS indexes — the responsibility of the CTFC — and single name CDS, which are the SEC’s world). Without the regulator’s approval, the margin buckets at the CCP would be totally separate and no cross-margining allowed. In this case, ICE Clear has the lion’s share of the clearing market. But buy-side cross margining, while approved by the SEC, included the caveat that margin methodology has to be approved by the SEC. The SEC had not approved any margin schemes by the start of mandatory clearing, so they issued a temporary rule.

The stopgap measure said that buy-side customers would have to pay 150% of the margin that clearing members/FCMs would – provided that they were rated AA or AAA. All others pay 200%. That pretty much means everyone is at 200%. The other alternative was that the clearing member could charge the same amount of margin that they pay, but would have to take a direct hit to capital for the remaining 50% or 100%. No takers there, we are sure.

One thing that did not get a lot of press is that ICE changed their CDS model methodology (“the Decomp Model”). The new model allowed ICE to decompose CDS indexes into their components, looking at them like a series of individual name CDS. The SEC wrote in their Feb. 20 ruling, “…A fundamental aspect of the Decomp Model is the recognition that index CDS instruments cleared by ICE Clear Europe are essentially a composition of specific single-name CDS… “

With a consistent methodology across single name and indexes, the regulators put aside territoriality and were satisfied to allow cross margining. But among other things that the new model did was push collateral from the CDS guaranty fund to initial margin. In the SEC ruling that approved cross margining, they said,

“…ICE Clear Europe notes that the decrease in the CDS Guaranty Fund and the increase in initial margin requirements are not equivalent in terms of magnitudes. Instead, based on current portfolios, it is expected that for every $1 decrease in the CDS Guaranty Fund requirement there will be a corresponding increase of approximately $5 in initial margin requirements….”

We wonder if the increased reliance of IM put the SEC in the frame of mind to hike up buy-side margin requirements by so much? Or maybe it was seen as less than perfect, but a whole lot better than prohibiting buy-side cross margining altogether.

When thinking about collateral and if there is going to be a shortage, we haven’t focused much on buy side clients being subject to higher margin requirements than the sell-side. It was always in the background but until mandatory clearing kicked in, it never made it to the headlines. That has changed. Its hard to know exactly how much more collateral will get taken out of the market here. The single name CDS market, in the scheme of the derivatives market as a whole, is not huge. But it is considered volatile with its embedded “jump to default” risk and IM higher. According to the BIS, single name notional CDS outstanding globally, as of June 2012, was $15.566 trillion, 2/3rds of which were attributed to “Reporting dealers”.  The increase in IM for the buy-side could be large – it’s hard to tell. But at a minimum,  it certainly was a shock.

A link to the BIS data is here.

A link to the SEC ruling allowing cross-margining is here.

A link to a press release from ICE is here.

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