WGMR margin rules borrow heavily from US proposals

The development of a global set of margin requirements for uncleared derivatives trades took a step closer last week, when a working group comprising four different international regulators published its initial consultation paper. It leans heavily on margin rules proposed by US prudential regulators in April 2011, which may mean US banks are able to compete overseas on a level playing field, but could also create huge extra demand for collateral – as regulators acknowledge.

US regulators pressed their global counterparts to form the working group last year after it became clear the country was alone in plans to require its banks to collect initial and variation margin not only from domestic clients but also from counterparties overseas. The provision was designed to ensure banks did not shift their uncleared business to other jurisdictions, but would have meant US dealers finding it difficult to compete against foreign banks not subject to the same regime.

The result was the Working Group on Margining Requirements (WGMR), which was established in October last year and is run jointly by the International Organization of Securities Commissions, the Basel Committee on Banking Supervision, the Committee on Payment and Settlement Systems and the Committee on the Global Financial System.

The WGMR calls for financial firms and big non-financials to post variation and initial margin to each other. That is a dramatic break with tradition for over-the-counter derivatives markets, where collateralisation has been a matter for bilateral negotiation, and the posting of initial margin is rare. In many respects, the proposal is similar to the US draft rule – but goes further by requiring all covered counterparties to exchange initial margin. In contrast, the US rules only require swap dealers to collect initial margin. Trades between dealers and sovereign counterparties, like debt management offices and central banks, as well as corporate end-users, are excluded from the requirements.

The consultation gives market participants two methodologies to calculate initial margin: a standardised approach, or value-at-risk models that are subject to regulatory-defined parameters borrowed from the US proposals. The internal models would have to be approved by a supervisor and are allowed to recognise netting and offsets – but only within asset class silos. The standardised approach is based on a simple table that computes margin based on the asset class and notional of the trade. The table is lifted verbatim from the US margin proposals.

But collateral demands calculated using the standardised look-up table are potentially explosive. In April last year, the Office of the Comptroller of the Currency published an impact study on the US margin proposals for uncleared trades, which estimated approximately $2 trillion would be locked away in third-party custodial accounts in the first year after the new rules had been implemented. Earlier this year, Risk used the same methodology to estimate the impact globally, using figures from the most recent survey from the Bank for International Settlements. The result was $7.61 trillion of collateral, or $6.67 trillion if foreign exchange swaps and forwards are exempt.

These kinds of numbers have industry participants worried. "If you take the liquid assets that are required by Basel III's liquidity coverage ratio, central counterparties and potentially strict initial margin requirements on uncleared trades, there is no doubt that all these rules taken together will cause a collateral shock. The competing demands will inevitably cause collateral to become an increasingly scarce and expensive commodity," says Peter Sime, head of risk and research at the International Swaps and Derivatives Association in London.

While dealers will most likely use internal models to calculate margin requirements and therefore benefit from some netting efficiencies, the margin numbers will still be large – and the WGMR has indicated it is concerned by the potential liquidity black hole. As well as conducting a quantitative impact study on liquid assets later this year, the working group may implement initial margin thresholds, which are intended to lessen the amount of margin that will need to be posted. The thresholds will be determined by the class of counterparties to the trade – but the details have yet to be decided.

The margin working group also hopes to reduce the liquidity impact by broadening the scope of eligible collateral. While the US rules are restricted to cash, US Treasury debt and certain agency issued bonds, the WGMR consultation includes cash, high-quality government and central bank securities, high-quality corporate and covered bonds, equities included in major stock indexes, and gold. But the collateral will be subject to various haircuts, which will either be determined by models or a standardised haircut schedule.

The consultation also requires inter-affiliate trades to be collateralised with variation margin. It is proposed that local supervisors be given the flexibility to require initial margin on those trades as well. Meanwhile, the paper recognises that national supervisors may wish to alter margin requirements to achieve macro-prudential outcomes – for instance, limiting expansion of balance sheets. One option may be for the relevant authority to impose a macro-prudential 'add-on' to margin levels, but no conclusion has been reached on this issue.