Surge Reported in Uncleared Swaps

Terry Flanagan

Spike in uncleared interest-rate swaps could spark tensions over margin rules.

A spike in the level of uncleared interest-rate swaps could exacerbate tensions between regulators and industry participants over whether and how margin requirements should be implemented.

The International Swaps and Derivatives Association (ISDA) reported that during the first half of 2011, the level of uncleared IRS increased by $28.2 trillion, to $143.9 trillion, the first increase in this figure since before 2007. Cleared IRS increased to $297.8 trillion, which accounts for over half of all IRS.

The notional amount of OTC derivatives outstanding increased 18 percent from $416.7 trillion at year-end 2010 to $491.3 trillion at June 30, 2011. This increase notional outstanding reverses declines in 2008, 2009, and 2010. From year-end 2007 through year-end 201, the OTC derivatives markets decreased in size by approximately 12 percent.

While the increased volumes of derivatives can be taken as a sign of increased demand for the instruments as hedging tools, the rise in levels of uncleared swaps could pose a conundrum as regulators seek to implement global reforms that are aimed at driving up the levels of cleared and centrally executed swaps.

In the United States, 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.

Under the CFTC’s proposed rules, a nonbank swap entity would be required to have credit support arrangements in place with all of its counterparties.

A great majority of end users don’t have ISDA Credit Support Annexes (CSAs) in place today. In a poll conducted by Reval, 68% of end users don’t have any kind of collateral arrangement with their swap dealers.

Thus, the rule would require extensive renegotiation of many existing agreements, even though non-financial entities would be exempt from posting margin.

As a point of reference, JP Morgan has in place over 4,000 agreements with non-financial entities that don’t have credit support arrangements. Requiring all of those agreements to be renegotiated will be “incredibly burdensome,” the bank said in a comment letter.

From the perspective of non-financial entities, the requirement to negotiate credit support arrangements will restrict hedging and risk management activities, JP Morgan said.

Many non-financial entities enter into agreements with multiple swap dealers so they can benefit from the transparency and pricing benefits of requiring multiple dealers to compete for their business. They would be required to renegotiate multiple agreements to add CSAs with multiple dealers.

For those that do have a CSA in place, the variation margin above the threshold is typically bilateral where either the swap dealer or the end user can post or collect collateral depending on the net position of the portfolio with respect to the threshold set in the CSA.

Therefore, all end users will incur costs for negotiating new or existing CSAs, the intent of which may be to have a high enough threshold that would never go into effect.

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