Cost Hikes to Bilateral Swaps Envisioned

Terry Flanagan

Rules establish margin requirements for uncleared swaps.

Derivatives users will need to cough up additional collateral and change the way they deal with their counterparties as regulatory reforms such as the Dodd-Frank Act go into effect.

The Commodity Futures Trading Commission has proposed a rule under Dodd-Frank that would establish margin requirements for uncleared swaps for swap dealers and major swap participants that are not banks.

Under the proposed rules, both the CFTC and the prudential regulators would permit swap entities to use models approved by the applicable regulator in calculating the amount of initial variation margin required to be collected from their counterparties.

Both the CFTC and prudential regulators would require the models to cover 99% of price changes over a 10-day liquidation window, as opposed to the typical three to five day requirement used by swap clearinghouses.

“The calculation methodology applied by the new rule ignores industry norms for structuring collateral requirements,” Luke Zubrod, director at Chatham Financial, told Markets Media.

On order for pre-existing trades to be exempt from new requirements, financial and non-financial end users will need to place new trades under new ISDA credit support annexes (CSAs). “In this way, the proposed rule will create an administrative burden for virtually all end users, excluding the small subset of non-financial end users under the CFTC’s rule for non-bank swap dealers,” Zubrod said.

Whereas today, some borrowers post an “independent amount”, or upfront collateral, and post collateral when the variation margin exceeds a threshold, the new margin requirement substitutes an “initial margin” requirement for the normal independent amount concept.

The initial margin amounts in some cases are themselves subject to a threshold, an approach not contemplated by existing credit support annexes (CSAs). Also, the calculation methodology for initial margin is largely prescribed by the regulators.

“This will create a technology development burden for market participants and will require new documents,” said Zubrod.

The International Swaps and Derivatives Association’s (ISDA) launch of a standard credit support annex (SCSA) is intended to promote the adoption of overnight index swap (OIS) discounting for derivatives, and to align the mechanics and economics of collateralization between the bilateral and cleared OTC derivative markets

An overnight index swap (OIS) is an interest rate swap where the periodic floating rate of the swap is equal to the geometric average of an overnight index (i.e., a published interest rate which is also called Overnight Rate) over every day of the payment period. The index is typically an interest rate considered less risky than the corresponding interbank rate (LIBOR).

“Firms should begin planning their approach to the SCSA and particularly its impact on existing document storage, data capture and collateral systems as soon as possible,” said Michael Beaton, managing director of Document Risk Solutions.

The SCSA supports the move to OIS discounting by grouping derivatives into separate buckets or “silos,” based on currency. Each currency silo is evaluated independently to generate a required movement of collateral in the relevant currency.

This aligns bilateral collateral structures to be more consistent with the LCH and other CCPs that adopt consistent margin approaches, ISDA said.

An OIS-based standard CSA substantially consistent with the LCH would facilitate the novation of OTC derivatives to CCPs, according to ISDA.

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