Margin Rules Assessed by Swaps Industry

Terry Flanagan

The margin rules for uncleared OTC derivatives which were released by the Basel Committee and the International Organization of Securities Commissions will have deep and lasting impact on the multi-trillion dollar swaps market.

Of particular note are the methods for calculating initial and variation margin, as well as a little-noticed rule that requires banks to take an additional eight percent haircut on any asset in which the currency of the derivatives obligation differs from that of the collateral asset.

The actual impact of margin requirements is subject to various factors and uncertainties, including the ratio of cleared to non-centrally cleared derivatives and changes in market volatility over time. Moreover, a number of the framework’s design elements could have impacts that may change over time depending on changes in market structure and market conditions.

“The long-awaited margin rules finally got published last week,” said Michael Clarke, managing director at Goldman Sachs, at the Isda North America conference on Thursday. “Variation margin will be universally required to be 100% mark-to-market value. Initial margin has two approaches: the first is to use standardized tables, and the second is to use an internal model which needs to be used by regulators.”

The impact of having to use standardized tables instead of internal models on the books of business of banks could be as high as $1 trillion, Clarke said.

“We agree with 90% of the content of the proposed rules,” said Stephen O’Connor, chairman of the International Swaps and Derivatives Association, at a press briefing. “Our main issue is with the calculation of initial margin, which requires a tradeoff between charging enough margin to ensure systemic resilience and the potential negative impacts on bank liquidity.”

The Basel Committee and Iosco will establish a monitoring group to evaluate the consistency of the margin standards with related regulatory initiatives such as changes to standardized approaches for trading book and counterparty credit risk capital, and capital requirements on centrally cleared derivatives that may develop alongside these requirements between now and 2014.

“We welcome the creation of this monitoring group, and will work with it to sasses the costs and benefits of the initial margin rules for uncleared derivatives,” O’Connor said.

As for the eight percent haircut on assets where the currencies of the derivatives obligation and the underlying collateral differ, Clarke said this could also pose a conundrum for banks.

“Current market practice is to collateralize on a net basis across the portfolio,” he said. “The decision we now face is whether to take the additional eight percent haircut on collateral, or hold collateral in the original currency of each contract, which could entail additional settlement risk.”

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