An estimated $2 trillion worth of liquid assets will have to be segregated in third-party custodial accounts under US proposals on margining for uncleared over-the-counter derivatives trades, according to one US prudential regulator. The proposals would compound the impact of other rules – on bank liquidity buffers and central clearing – which also require liquid assets to be locked away. In concert, the rules could generate a requirement for $6 trillion or more of similar assets.
The proposals for margining of uncleared derivatives lay out prescriptive requirements for the calculation, posting, collection and segregation of margin. Today, market participants have considerable freedom to negotiate their own margin agreements, and the posting of initial margin between banks is almost unheard of. Compelling the industry to start doing so, while also preventing rehypothecation, would have a huge impact, according to an impact analysis conducted by the Office of the Comptroller of the Currency (OCC), one of five prudential regulators responsible for the margin proposals.
Based on an annual average growth in notional swap amounts of $15 trillion, in addition to an unspecified proportion of renewal and replacement trades, the OCC estimates that initial margin in one year could total $2.56 trillion. However, assuming that 20% of trades are centrally cleared, the initial margin estimate would be $2.05 trillion – an impact the OCC claims would likely be reduced if dealers use internal margin models, which allow netting and hedging benefits within four risk categories.
But some dealers claim the regulators' estimate is on the conservative side. "The numbers are just incredible. Using one of the proposed initial margin models, we calculated that the total amount of margin we would be required to collect and segregate from our largest 34 counterparties would total $1.4 trillion. I just can't believe the regulators didn't take into account the liquidity impact of these proposals. We might as well just shut down the US financial system and go home," says one derivatives dealer at a large US bank in New York.
Concerns over the potential impact of segregation are widespread. "We made the case to regulators that initial margin in dealer-to-dealer trades would be ludicrous if we didn't have the ability to rehypothecate. By requiring that the assets be segregated, the regulators have created a liquidity vacuum," says another derivatives dealer.
The draft rules on margin requirements were published at the start of April and apply to swaps entities – a term from the Dodd-Frank Act that essentially means dealers and other active derivatives market participants. The majority of these entities are regulated by the five prudential regulators that co-authored the proposals, but a similar set of draft rules was also issued by the Commodity Futures Trading Commission, covering firms outside the prudential regulators' purview.
Both sets of rules require swaps entities to post and collect initial and variation margin from other swaps entities, and also require that initial margin be parked with a third-party custodian, with restrictions on rehypothecation. In addition, swaps entities must collect initial and variation margin from financial end-users in certain circumstances – a category that includes non-US sovereigns. The proposals would limit collateral to cash, US Treasury bonds and securities issued by certain government-sponsored entities.
The concern for market participants is that the proposals are the latest in a series of rules that use liquid assets as a credit or liquidity risk mitigant – potentially overwhelming the supply of those assets (Risk November 2010, pages 18-22).
First, under Basel III, banks will be required to hold enough liquid assets to see them through a one-month period of stress, a rule known as the liquidity coverage ratio. Second, derivatives clearing requirements will result in large amounts of liquid assets being hoovered up in the form of initial margin. Finally, insurance companies may be encouraged under Solvency II, the incoming European capital adequacy regime, to hold more government bonds.
In total, estimates of the demand generated by those three rules add up to $3 trillion–4 trillion in assets. With the impact of the US margin proposals on top, that figure could reach $6 trillion – with the potential to shoot far higher if other jurisdictions decide to copy the US rules.
Part of the problem with the US rules, dealers say, is the approach to initial margin calculation. The proposals sketch out two models: a standardised look-up table or an internal margining model, which would need to be approved by the relevant prudential regulator. The look-up approach sets initial margin as a percentage of the notional size of a trade, with no netting allowed.
Under the internal model approach, a limited amount of netting is permitted – but only within each of four regulator-defined asset classes – and the model has to be at least as conservative as the margin models used by derivatives central counterparties (CCPs). The proposal requires a minimum time horizon of 10 days to be used when calculating the possible price move – and, hence, the margin requirement. Typically, CCPs assume a horizon of three to five days.
Dealers also fear that inter-affiliate trades may be caught up in the rules, which would substantially increase the margin burden. "If my bank trades with another swaps entity, we both have to post margin to each other that will be locked away. But if I manage my risk through a different legal entity – bank B – I have to back-to-back the risk to bank B, which, given the lack of clarity in these proposals, might also be subject to initial margin requirements. The issue is compounded if bank B decides to hedge the risk with another swaps entity, which will also require initial margin to be posted and segregated. The numbers are going to be scary," says one New York-based lawyer at a US bank.