ISDA Chief Executive Officer Scott O’Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA’s long-held commitment to making the market safer and more efficient.

By the end of this year, the first prong of the Securities and Exchange Commission’s (SEC) Treasury clearing mandate will come into force. This is part of a regulatory effort to make the financial system more robust, but it will also come with added costs – which is why recent proposals from the Commodity Futures Trading Commission (CFTC) and the SEC to allow an existing cross-margining arrangement offered by the Fixed Income Clearing Corporation (FICC) and CME Group to be extended to clients is so important to ensuring Treasury clearing can be implemented efficiently.

Once implemented, a much wider universe of market participants will be able to take advantage of risk offsets that exist when clearing a portfolio of Treasury securities and Treasury futures, reducing the initial margin (IM) customers need to post by aligning the amount of margin more closely with actual risk. This will not only reduce costs for market participants – it will also make clearing more efficient as the clearing mandate is rolled out.

Up until now, only clearing members could take advantage of the risk offsets between FICC-cleared US Treasury cash and repo transactions and CME-cleared futures. Under the CFTC and SEC proposals, clients of those clearing members will also be able to benefit, while maintaining existing strong customer protections and legal certainty.

As we pointed out in our responses to the CFTC and SEC, we strongly support the proposals, but it’s critical the agencies finalize the changes well in advance of the clearing mandate, which comes into force for certain cash transactions from December 31, with repos following six months later. Market participants need sufficient time to complete account setup, documentation, legal arrangements and end-to-end testing and to operationalize client cross-margining before mandatory clearing requirements take effect – this cannot be achieved in days or weeks.

Extending cross-margining arrangements to clients is an important step to enabling the smooth implementation of mandatory Treasury clearing, but it’s not the only one. US prudential regulators also need to ensure the US capital rules are modified to recognize the risk-reducing benefits of netting across products, including cleared repos and futures, under the standardized approach to counterparty credit risk (SA-CCR).

This lack of recognition is particularly problematic in the context of the Treasury clearing mandate. While cross-margining arrangements will allow clients to benefit from reduced IM amounts that reflect the actual risk of a portfolio of trades, banks could face a hefty increase in capital requirements due to the current design of SA-CCR. Unnecessarily high capital requirements would reduce bank balance sheet capacity to facilitate the clearing of client transactions at a time when volumes of cleared trades will increase significantly.

As US prudential regulators are preparing to release their revised Basel III endgame proposals, we urge them to ensure this important issue is addressed. With the US Treasury market at more than $30 trillion, it’s critical the regulatory framework does not hamper market efficiency and liquidity and prevent the ability of banks to provide the intermediation services so vital to the smooth functioning of this market. The CFTC and SEC have taken a very important step – we hope changes to the capital rules will follow.

Source: ISDA