04.02.2013
By Terry Flanagan

Buy Side Ambivalent on Margin Requirements

Institutional investment firms who use derivatives for hedging interest rate and currency exposures are caught between a rock and a hard place when it comes to reforms for OTC instruments that would make centralized clearing mandatory for “vanilla’, e.g., non-customizable, instruments.

While they support the overall objectives of greater transparency and reduced systemic risk in financial markets that the Dodd-Frank Act, Emir and similar regulatory initiatives will bring, they are worried that regulators are attempting to shoehorn an exchange-based model from the world of futures and commodities onto what is essentially a bilateral, contractual obligation between counterparties, and that this “futurization” of the swaps market will force them to incur added expenses in the form of increased margin for instruments that are not cleared.

“In its capacity as an investment manager, Pimco broadly supports improvements in risk management for derivatives transactions,” said Douglas Hodge, chief operating officer at Pimco, in a comment letter. “This includes the goals of moving OTC derivatives to CCPs and establishing margin requirements, both of which, if properly implemented, will reduce systemic risk.”

While Pimco is prepared to transition as many of its OTC derivatives positions to a clearing environment, a significant portion of the security-based (SB) swap market may not be eligible for clearing.

SB swaps are swaps that are based on a single name or a narrow index, such as an ETF, and are regulated by the SEC under FinReg. Swaps that are based on interest rates or commodities are regulated by the CFTC.

The SEC has promulgated rules for determining margin for cleared and uncleared SB swaps, which stipulate that margins for uncleared swaps be higher than for cleared swaps because of the perceived higher risk associated with uncleared swaps.

“We are especially concerned about the punitive nature and associated unintended consequences associated with this proposal on those end users who must rely on the non-cleared SB swaps market for risk management,” Hodge said.

Futures exchanges offer “swap futures” that they say are the economic equivalent to OTC swaps, with some added benefits.

“Swap futures are designed to allow firms cheaper access to interest-rate hedges without needing to register as major swap participants or swap dealers, as there is no notional threshold for swap futures,” said Ben Larah, manager at Sapient Global Markets. “They also offer lower initial margin requirements [the holding period for calculating initial margin for cleared swaps is five to seven days depending on the clearing house, compared to one to two days for futures], and eliminate the need to report to swap data repositories, which is required for swaps. Furthermore, firms trading swap futures benefit from more established trading mechanisms, which allow for faster and more transparent trade execution and settlement.”

However, these advantages are somewhat artificial, arising as a direct result of regulatory preference for futures over swaps, as opposed to fundamental economic differences between the contracts — which are, to all intents and purposes, the same, Larah said.

Meanwhile, the interest rate swaps market “is in no danger of dying because end users will still need their flexibility to customize payments to match their risk exposures, and swap-dealers will want to retain this business as long as possible,” Larah said. “But as a percentage of interest rate positions outstanding, it will certainly decrease as swap futures become more and more liquid and their volume grows.”

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