Will the IOSCO margin rules for uncleared swaps put derivatives investors active in that market on a collision course with their broker/dealers? Requirements for higher initial margin are almost certainly coming down the pike and the cost of an uncleared swap will rise. Using 10 day liquidation assumptions will be more onerous than many investors would otherwise face and certainly higher than cleared swaps. But is there a better way?
A June 23, 2013 article in IFR by Christopher Whittall “Dealers losing battle over uncleared swaps” had the usual complaints about how higher initial margin will raise costs, especially for one-way investors like pension funds.
“…The head of global markets at a major bank sounded a similar warning. ‘If the proposed initial margin requirements are implemented, then the cost to trade more illiquid derivatives like long-dated inflation swaps will be so huge will that it will be very difficult for dealers to stay in this business,’ he said…” and “…’More significantly, it will become very difficult for clients to hedge, especially those with large, one-way exposures like UK pension funds’, he added…”
And the “pro-cyclical” card has been played too. The article quoted Fred Janbon, global head of fixed income at BNP Paribas:
“…There is a danger the initial margin rules could be very pro-cyclical. As you enter a crisis and markets get more volatile, initial margin posting will increase massively: US$1trn could quickly turn into US$3tr…. This will force deal unwinds, which in itself could precipitate a crisis.”
Initial margin, like repo haircuts, have always been pro-cyclical. More volatile markets result in bank credit officers requiring more cushion. Starting out with higher initial margin when a swap is uncleared and, by definition, less liquid, seems difficult to argue against. Forced unwinds will create havoc, but won’t higher IM mean the banks stand a chance to have less exposure should they come? Is the logical next step of the argument not to collect higher initial margin (or VM) when volatility is higher? We hope not.
But is there a way to make everyone happy? Christopher Whittall buried the lead when he wrote at the very end of the article:
“…Perhaps more significantly, industry insiders point to preliminary work on a concept known as “net initial margin risk”. This would involve building an institution similar to a central clearing house for collateral for uncleared swaps.
This means that if Firm X entered an uncleared swap with Firm Y, which then did an offsetting trade with Firm Z, collateral could be posted to a central hub that would allow the exposures to be netted down rather than all three firms having to post collateral on a gross basis.
“It’s very early days on this concept of net initial margin risk, but it could be very important,” said one derivatives industry professional. “It has not been fully fleshed out yet, and it would probably be a three-year undertaking to build such an institution…””
If there is a way to net margin requirement outside of a CCP environment, it could take a lot of pressure off. There are lots of unanswered questions. How are prices determined to mark the derivatives to market, which then flow down to margin surplus or deficit? If these were easily available / transparent prices, wouldn’t the derivatives probably be cleared? How would liquidation work in a default environment? Who gets what & when is hard enough in a CCP – but a margin clearing house, presumably without guaranty funds and risk waterfalls will be very tricky. Many of the uncleared derivatives investors are one-way risk: pension funds, insurance companies, etc. A margin clearing entity may not give them much in the way of netting offsets. Finally, everyone has to agree on what constitutes eligible collateral. Getting that agreement in place will be like herding cats. Fundamentally it is an interesting idea and while we have our doubts, are encouraged by some out of the box thinking.
A link to the IFR article is here.