Last week we wrote about the recent ISDA margin survey and the rehypothecation of collateral. We noted that 99% of the cash & 85% of government securities received as margin on non-cleared swaps was eligible for rehypothecation and that 87% and 45%, respectively, was actually used. There is more to the story, as explained in an April 19th post from the Harvard Law School Forum on Corporate Governance and Financial Regulation “Segregation of Initial Margin Posted in Connection with Uncleared Swaps”.
The post comes from from Ropes & Grey LLP attorneys Leigh R. Fraser, Isabel K.R. Dische and Molly Moore. A link to the Ropes & Grey piece is here.
Dodd Frank and CFTC rules 23.702 and 23.704 require swaps dealers to notify their customers that they can have their initial margin held in a segregated account.
From the post:
“… The swap dealer is required to identify one or more independent custodians that the counterparty may select to hold initial margin, and to provide pricing information…”
From an ISDA FAQ published on March 27, 2014:
“…The notice issued by the SD must also identify one or more acceptable independent custodians to hold IM (one of which must be a creditworthy non-affiliate) and provide information regarding the price of IM segregation to the extent that the SD has such information…”
This will be a tri-party agreement. From the ISDA FAQ:
“…If a counterparty elects to require IM segregation in accordance with the CFTC IM Segregation Regime, the counterparty and SD must put in place a triparty custodial agreement that meets the requirements of the CFTC IM Segregation Regime (as described further in FAQ #5 above) with an eligible custodian…”
The election will apply only to new swaps executed after May 5, 2014 (when the underlying swaps agreement was entered into after January 6, 2014) and November 3, 2014 for agreements in place before January 6, 2014.
From the ISDA FAQ on how cash can be invested:
“…The CFTC IM Segregation Regime also provides that segregated IM can only be invested consistent with CFTC regulation 1.25 (which is the same standard that applies to the investment of customer funds posted in respect of exchange-traded futures and cleared swaps)…”
So will there be a rush for the buy-side to ask for segregation and sign tri-party agreements to hold initial margin? We have not sensing much enthusiasm for this (well, outside of the tri-party custodians who probably see this as a source of new business). The extra cost of using tri-party was one reason we heard although others have said it is pretty cheap. A lack of stress in the financial system that might impact swaps dealers was another reason for staying put.
What we have not heard much about is the impact of segregation on trade economics. As the ISDA margin survey said, the majority of cash and nearly a majority of the securities taken as margin are rehypothecated. The liquidity generated with the cash or converting securities into cash via repo has value for the swaps dealer. Without the ability to generate that income (paper or cash sitting in tri-party will not generate the same kind of value) the pricing of those derivatives will change, the cost of the lost liquidity folded back in. It will be hard to know how much swaps pricing may change as a result of the changed economics and even harder to know before the buy side has to make their elections.
NOTE: We just saw this very relevant post from Reed Smith’s The Swaps Report “CFTC Collateral Segregation Rules — Q&A on Upcoming Collateral Segregation Notices” (April 25, 2014) and thought it was worth taking a look at.