Margin Requirements For Non-Cleared OTC Derivatives: Too Much Collateral?

Much of the regulatory reform agenda for the global over-the-counter (OTC) derivatives industry to date has been focused on the clearing, trading, and reporting of standardised OTC derivative contracts.¹ Getting more OTC derivative contracts to be cleared through central counterparties (CCPs) will go a long way towards preventing a repeat of the build-up of risk that led to the financial crisis.

But what about derivative contracts that are not centrally cleared? The Basel Committee on Banking Supervision (BCBS) and the Board of the International Organization of Securities Commissions (IOSCO) recently launched a public consultation (the Consultative Document) to develop global standards for managing the risk associated with non-cleared derivative contracts, with particular regard to the posting of collateral² (see report in this issue). This international initiative may help ensure that the rules adopted by different jurisdictions, including the United States and the European Union, are consistent. At the same time, however, it raises important questions about the negative impact that increased collateral requirements could have on liquidity in the financial markets.

U.S. and EU Requirements for Non-Cleared Derivatives

CCPs step into the shoes of derivative counterparties, so that if one party fails, the other party can look to the CCP for payment. In this way, CCPs absorb the credit risk of a derivative transaction. How the CCPs manage this exposure — without themselves becoming a source of systemic risk — has been the subject of considerable rulemaking (and debate) in the United States and the European Union. Among other things, parties to a swap must post collateral with the CCP, which the CCP can use to cover defaults. Had AIG been required to post collateral with respect to its credit default swap trades, it would never have been able to amass such an unmanageable position, and the need for a bailout by the U.S. government could have been avoided.

Although a growing number of OTC derivative contracts — in particular interest rate derivatives — are centrally cleared, the majority of the U.S.$440 trillion market remains outside the clearing system.³ Under the U.S. and EU regulatory regimes, which are still evolving, only the most liquid and standardised contracts will need to be cleared through CCPs. Even after these requirements apply, a large portion of the OTC derivatives market will not be cleared by CCPs.⁴

In the United States, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank),⁵ which became law in 2010, includes some provision for this risk. Dodd-Frank amended the Commodity Exchange Act (CEA) and the Securities Exchange Act of 1934 to require swap dealers and major swap participants, and their security-based swap equivalents, to comply with minimum capital and margin requirements. The Commodity Futures Trading Commission (CFTC) proposed rules in April 2011 with respect to margin requirements for non-cleared swaps entered into by non-banks,⁶ and the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Federal Reserve Board, and other U.S. prudential regulators proposed rules in May 2011 with respect to margin requirements for prudentially regulated swap entities.⁷ The Securities and Exchange Commission (SEC) has yet to propose rules with respect to security-based swaps.

In the European Union, the Regulation on OTC Derivatives, Central Counterparties, and Trade Repositories (also known as the European Market Infrastructure Regulation, or “EMIR”)⁸ prescribes risk-mitigation techniques for non-cleared OTC derivatives, including capital requirements and the exchange of collateral (subject to intra-group exemptions) for financial and non-financial counterparties (see analysis by the author at WSLR, April 2012, page 24). The European Securities and Markets Authority (ESMA) is required to draft rules regarding the scope of the intra-group exemptions and the extraterritorial effect of the provisions. ESMA, together with the two other European Supervisory Authorities (ESAs) — the European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA) — are also required to draft rules regarding the collateral needed and various details of the intra-group exemptions. The draft rules will then be reviewed by the European Commission, which may make further changes before adopting them. ESMA published a consultation paper with proposed rules in June 2012.⁹ The ESAs published a joint discussion paper in March 2012 but have yet to produce draft rules.¹⁰

BCBS and IOSCO Recommendations

At their meeting in Cannes in November 2011, the G-20 leaders recognised the risks associated with uncleared OTC derivatives — and the need for a harmonised regulatory response to those risks — by calling on BCBS and IOSCO, in consultation with other organisations, to develop draft standards on margining by June 2012.¹¹ The Consultative Document is one step in this process.

According to the Consultative Document, there are two main reasons for implementing margin requirements for non-centrally cleared derivatives: decreasing systemic risk and encouraging central clearing. Subjecting non-centrally cleared derivatives to tougher margin requirements should incentivise market participants to use CCPs. At the same time, those requirements should be consistent across jurisdictions. Inconsistent standards could lead to regulatory arbitrage, which would reduce the efficacy of those requirements, and create an unlevel playing field, favouring some jurisdictions over others.

In order to achieve these objectives, BCBS and IOSCO have articulated their policy proposals in the form of seven key principles:

1. Margin requirements should apply to all non-centrally cleared derivative transactions, regardless of asset class

The Consultative Document refers specifically to the U.S. Treasury Secretary’s proposal to exclude foreign exchange swaps and forwards (FX) from the definition of “swap” under Dodd-Frank,¹² and seeks comment on whether it may be appropriate to exempt FX of less than a certain tenor from the margin requirements. Some commentators have argued that the clearing and collateral requirements should not apply to markets such as FX, where trades are mostly short-dated and the principal concern is settlement, not counterparty, risk.¹³ In the European Union, FX derivatives are included within the scope of EMIR, though ESMA may decide to exempt them from specific requirements.

2. All financial firms and systemically important non-financial firms should exchange initial and variation margin calibrated to the relevant risks

Initial margin refers to the amount of collateral exchanged at the outset of a transaction to protect the parties from potential future exposure, while variation margin refers to collateral exchanged during the course of a transaction to reflect the current exposure arising from changes in the value of the contract. BCBS and IOSCO recommend the mandatory exchange of initial and variation margin among transaction parties, or “universal two-way margin.” In order to address the impact on liquidity, the Consultative Document suggests that initial margin should be required only if it exceeds a threshold amount, depending on the risk profile of the counterparty. Non-financial firms that are not systemically important, and other types of participants such as sovereigns and central banks, should be exempt from the margin requirements altogether.

EMIR, like the Consultative Document, calls for the bilateral exchange of margin. In their discussion paper, the ESAs have expressed their view that, at a minimum, this should include variation margin, though they have requested comment as to whether initial margin should be required as well. Initial margin could be posted by all counterparties, or, alternatively, it could be collected only by prudentially regulated financial firms, subject to a minimum exposure threshold. In the United States, on the other hand, the CFTC and the U.S. prudential regulators would require only the collection of initial and variation margin by covered swap entities, subject to thresholds (though both have queried whether swap entities should be required to post margin as well).

The EU and U.S. treatment of non-financial and sovereign entities also differs. In the United States, non-financial entities that fall within the category of “major swap participant” must comply with the margin requirements. All other non-financial entities would be exempted under the CFTC proposals, though the prudential regulators would still require covered swap entities to collect margin from non-financial end users, albeit subject to thresholds. Both the CFTC and the prudential regulators would require covered swap entities to collect margin from financial entities that are not swap dealers or major swap participants, again subject to thresholds, and would specifically include non-U.S. sovereign entities within the category of financial entities that are subject to the margin requirements. In the European Union, on the other hand, non-financial entities would be subject to the margin requirements only if they exceed EMIR’s clearing threshold, and there is no reference to sovereign entities in EMIR or the EU rule proposals. EU central banks and similar bodies are exempt from EMIR generally, and third-country central banks would be exempt from the margin provisions as well.

3. Methodologies for calculating the minimum margin requirements should be consistent across entities and accurately reflect the relevant exposure with a high degree of confidence

The Consultative Document recommends that initial margin be calculated using an “extreme but plausible estimate” of an instrument’s increase in value reflecting a 99 percent confidence interval over a 10-day horizon, based on historical data that includes a period of “significant financial stress.” The amount can be determined by reference to an internal or third-party model. Derivatives that are subject to the same netting agreement may be considered on a portfolio basis. Hedging and risk offsets may be also taken into consideration with the approval of the relevant authority, but only within the same asset class. Alternatively, initial margin could be computed by reference to a standardised margin schedule. Variation margin should be calculated and collected with sufficient frequency (e.g., daily) pursuant to a single, legally enforceable netting agreement, and minimum transfer amounts should be set low enough to avoid exposure build-up.

The U.S. and EU proposals are broadly in line with these recommendations. The U.S. prudential regulators and the ESAs have both suggested that initial margin could be calculated using a standardised approach or an internal model, though neither contemplates the use of third-party models. The CFTC, on the other hand, would permit the use of third-party models but would not allow non-prudentially regulated swap entities to develop their own models because, unlike banks, they have not traditionally produced them, and the CFTC does not have the expertise or resources to review them. One danger of using internal models is that they may lack transparency and may differ from CCP requirements, which could result in an unlevel playing field. The CFTC would permit margin requirements to be determined by reference to similar cleared products, with some adjustments, while the ESAs would require any calculation methodology to take into account the requirements for CCPs.

4. Assets used as collateral should be highly liquid and able to maintain value during periods of financial stress, after applying an appropriate haircut

The range of assets that can be used as collateral is one of the most contentious elements of the margin proposals. In order to protect a firm from loss in the event of a counterparty’s default, the assets must be easily liquidated, especially during periods of financial stress. Restricting eligible collateral to securities such as cash and high-quality sovereign debt, however, would have a negative impact on overall liquidity. BCBS and IOSCO advocate permitting a broader range of assets, including highly liquid equity securities and corporate bonds, subject to appropriate risk-sensitive haircuts. U.S. regulators, on the other hand, have recommended a narrower range of assets, especially for variation margin, though the CFTC would permit non-financial entities to post other assets as long as the value can be ascertained on a periodic basis. The ESAs have preliminarily proposed either following the same criteria-based approach recommended by ESMA for determining what collateral is eligible for central clearing, or providing a list along the lines of what BCBS and IOSCO have proposed, derived from relevant prudential regulation.

The amount of haircut applied to an asset will vary depending on its level of risk. According to the Consultative Document, haircuts could be based on internal or third-party models or a standardised schedule, which is similar to the approach suggested by the ESAs. A proposed schedule is annexed to the Consultative Document, derived from the standard supervisory haircuts included in the Basel Accord.¹⁴ Like margin schedules, standardised haircuts provide greater transparency, and they also limit procyclicality. However, they may lack flexibility to reflect changes in market conditions. In the United States, both the CFTC and the prudential regulators have proposed specific haircuts for different asset types depending on duration, which are based on haircuts used by prudential regulators in other contexts.

5. Initial margin should be exchanged without netting, immediately available in the event of a party’s default, and protected in the event of a party’s bankruptcy

The netting and commingling of assets can eliminate the protection provided by collateral in the event of a counterparty’s default. The Consultative Document therefore recommends the gross exchange and segregation or similar protection of initial margin. In the United States, assets used as initial margin need to be segregated with an independent third party only at the counterparty’s request, while in the European Union, the ESAs have preliminarily recommended that initial margin should be segregated when exchanged by both parties, but when only one party posts collateral, segregation would be required only at the request of that party. Whether those assets will be protected in the event of a party’s bankruptcy will depend on local law. The CFTC and the U.S. prudential regulators have proposed that initial margin collected or posted by swap entities be held by unaffiliated custodians subject to the same insolvency regime. For purposes of the U.S. Bankruptcy Code, securities held in a portfolio margining account that is a futures account will be treated as customer assets. In the European Union, the treatment of margin assets will vary depending on the insolvency laws of the relevant Member State.

According to the Consultative Document, initial margin should not be re-used or re-hypothecated, in order to ensure that it will be available to counterparties when needed. The CFTC and U.S. prudential regulators would not allow custodians to re-hypothecate assets or re-invest them in assets that are not permitted forms of margin,¹⁵ while under the ESA proposals, re-use of collateral would not be permitted. The SEC, however, has suggested in comments to BCBS and IOSCO that re-use and re-hypothecation should be permitted in limited circumstances, provided the margin is sufficiently protected. According to the SEC, differences in regulatory capital treatment could mean that U.S. registered broker-dealers are disproportionately affected by these restrictions compared to banks.

6. Intra-group transactions should be subject to appropriate variation margin arrangements

Currently, margin is not typically exchanged in non-cleared derivative transactions among affiliated entities. As BCBS and IOSCO point out, however, affiliate transactions can pose systemic risks, especially in the cross-border context. In light of liquidity concerns and differences of approach among jurisdictions, the Consultative Document proposes a compromise position whereby variation margin would be required in intra-group transactions, but initial margin requirements would be left to national discretion. Initial margin requirements for intra-group transactions could create additional liquidity demands for firms, but, because variation margin is simply being shifted from one affiliate to another, it should not have a liquidity impact at the net consolidated level.

EMIR provides that the collateral requirements (including initial and variation margin) will not apply to intra-group transactions where all counterparties are from the same Member State, subject to certain conditions. Intra-group transactions involving parties from different Member States may also be wholly or partially exempt. There is currently no intra-group exemption in Dodd-Frank, though legislation has been proposed that would exempt transactions among affiliated entities from the margin requirements. The bill was passed by the U.S. House of Representatives in March 2012 and has gone to the Senate for consideration.¹⁶ If this bill becomes law, both the U.S. and the EU regimes would be inconsistent with the BCBS/IOSCO recommendations.

7. Jurisdictions should co-ordinate to ensure that margin requirements are consistent and non-duplicative

The OTC derivatives market is international in scope, and cross-border transactions are common. The Consultative Document recommends that firms, including local subsidiaries of foreign companies, collect initial and variation margin in accordance with the laws of the jurisdiction in which they are established. Local branches of foreign companies would be governed by the law of the foreign country. Provided the host country complies with the global standards developed by BCBS/IOSCO, the home country should allow a covered entity to comply with the host country’s regime. If there is a conflict between the two sets of rules, a subsidiary or branch should comply with the stricter requirements.

Both the amended CEA and EMIR contain language that would make their respective margin requirements for non-cleared derivatives applicable to third-country entities in certain circumstances. The rule proposals of the U.S. prudential regulators include provisions on the treatment of non-U.S. entities that differ from the Consultative Document in several key respects. For example, foreign subsidiaries of U.S. entities, and U.S. branches of non-U.S. entities, would be subject to U.S. margin requirements, and foreign covered swap entities would be required to collect margin from U.S. counterparties. On July 12, 2012, the CFTC published a proposed rule concerning the cross-border application of these and other provisions of the CEA, which purports to be guided by principles of international comity, but which also would require non-U.S. entities to comply with U.S. margin rules in some cases.¹⁷ ESMA recently indicated that it intends to publish a consultation paper on similar issues in the near future.

The need for harmonised rules is generally recognised. On the topic of FX, Steven Maijoor, the chairman of ESMA, remarked in February 2012 that “[t]he problem of international inconsistency and regulatory arbitrage is much more serious on margins for contracts that are not centrally cleared than on the clearing obligation,” and emphasised the importance of global co-operation.¹⁸ As the foregoing analysis makes clear, however, the U.S. and EU proposals differ in important ways from each other and from the BCBS/IOSCO recommendations.

On the same day that it published its proposed rule on the cross-border application of certain swaps provisions of the CEA, the CFTC decided to reopen the comment period on its proposed rules on margin requirements for non-cleared derivatives.¹⁹ Chairman Gary Gensler said in a statement that this decision was taken “in light of work being done to internationally harmonize an approach to margin.” In Gensler’s opinion, it is “essential” that these requirements are aligned globally.²⁰ In the European Union, the joint discussion paper published by the ESAs refers to the alignment of international standards as “crucial,” and states that the proposals of BCBS and IOSCO will be taken into account in the rulemaking process.²¹ ESMA and the other ESAs recently announced that the September 2012 deadline for draft rules to be submitted to the European Commission had been extended so that the rules can reflect the ongoing work on international standards by BCBS and IOSCO.²² These developments hopefully suggest that the U.S. and EU regulators will endeavor to adopt a co-ordinated position not just on FX but also on other aspects of the margin requirements, including their extraterritorial application.

Too Much Collateral?

To date, whether or not initial and variation margin is required has been a matter of negotiation for the parties to a transaction. Currently, the majority of interest rate swap transactions are subject to both initial and variation margins, with the terms of collateralisation governed by the Credit Support Annex to the ISDA Master Agreement.²³ However, commentators are concerned that new regulations mandating the collection, posting, and segregation of margin for non-cleared derivatives transactions, without the multilateral netting benefits that clearing provides, will result in vast quantities of assets being locked up rather than used productively. According to ISDA, estimates of the collateral needed to satisfy the new requirements range from $0.5 trillion to $2.7 trillion.²⁴ This comes at a time when the demand for collateral from other sources is also growing, as cash-strapped banks scramble to secure central bank funding. The increased capital charges required by Basel III for uncleared OTC derivatives transactions, which are intended to encourage the use of CCPs, will put further strains on liquidity, as not all derivatives are suitable for clearing.²⁵

Regulators have acknowledged that the segregation requirements and limitations on the re-use of margin could have a significant adverse impact on liquidity and require derivative transaction counterparties to seek other sources of funding. As ISDA puts it, “the real elephant in the room is whether the marketplace will come up with the all the collateral that is required, and if it does, what the liquidity implications for the real economy will be.”²⁶ The result, in their words, could be a “collateral shock.”²⁷ In their quest to reduce systemic risk through collateralisation, regulators could be creating new sources of risk for the global economy.

Christopher Bernard is a Legal Analyst with Bloomberg Law, London.