12.08.2011
By Terry Flanagan

Margin Requirements Rattle Buy Side

End users chafe at rules requiring cash collateral on swaps.

Buy side participants who don’t have the option to engage in the cleared swaps market are chafing at proposed rules on margin requirements for uncleared swaps, saying it would pose a financial burden.

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. Prudential banking regulators have proposed a similar rule that would apply to dealers and MSPs that are 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.

“There is a significant difference between the impact on financial and non-financial end users, and between the CFTC’s and prudential regulators proposed rules,” Luke Zubrod, director at Chatham Financial, told Markets Media.  “Both rules treat financial end user’s similarly, but diverge in their approach to non-financial end users.”

One of the more controversial issues has been margin requirements for non-financial end users, i.e., a counterparty that’s not a swap entity or a financial end user.

The CFTC rule (which applies to non-bank swap dealers) does not impose margin requirements on transactions executed by non-financial end users.  There is a significant difference in the approach taken by prudential regulators (their rule applies to bank swap dealers), however.

“Their rule creates a legal obligation for non-financial end users to post cash or cash equivalents when the market value of their trades exceeds a certain threshold,” said Zubrod.

Today, some end users agree with their banks to enter into such arrangements.  However, many have never posted cash or cash equivalent collateral and the new rule will place a particularly acute burden on them, he said.

Property companies and those that finance infrastructure investments (e.g., power plants) in project subsidiaries are among those that will feel this burden the most.  These companies hold physical assets in subsidiaries, finance the assets in those same subsidiaries, and hedge the risk associated with the financing.

“These subsidiaries have limited or no liquid resources,” Zubrod said.  “For them, a contingent margin requirement could amount to a time bomb in their financing structure.  Such a requirement would likely be unworkable for such entities, and would force them to significantly alter their risk management and financing structure in ways that add cost and risk, and reduce flexibility.”

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