To ensure that systemic concerns arising from counterparty risks associated with uncleared derivatives are sufficiently managed through collateral, the G20 added margin requirements for such derivatives to the list of post credit crunch reforms in July 2011.

The rules are designed to reduce counterparty credit risk, limit contagion, and incentivize the central clearing of derivatives trades. The reliance on collateral rather than capital charges to achieve these goals ensures that the defaulting party bears the loss, rather than the performing counterparty. The uncleared over-the-counter space, however, will continue to be very sizeable given that many derivatives are ineligible for central clearing due to insufficient standardization or liquidity, or because of valuation challenges.

The rules, focusing on the bilateral exchange of margin, could potentially fuel negative outcomes such as regulatory arbitrage and put yet more pressure on sourcing good quality collateral, which could in turn create space for less-regulated entities to occupy. Further, the proposed new rules threaten to introduce new forms of legal uncertainty into the cross-border transactional environment, some of which are very significant indeed and not easy to mitigate.

International Initiatives

In September 2013, the Basel Committee on Banking Supervision and International Organization of Securities Commissions released their final framework for margin requirements for non-centrally cleared derivatives transactions.1 The framework sets out eight key principles and aims to ensure harmonization of their implementation across multiple jurisdictions. While the final framework is not binding on any regulatory authorities, it informs the approach of national regulators as they adopt their respective margin regimes.

In Europe, draft regulatory technical standards, closely following BCBS-IOSCO and implementing the relevant provisions of the European Market Infrastructure Regulation were published by the European Supervisory Authorities for comment in April 2014 and are expected to be finalized by the end of the year.

In September 2014, U.S. banking regulators and the Commodity Futures Trading Commission took steps to adopt revised rule proposals modeled closely on the BCBS-IOSCO framework that would apply to swap registrants under their respective remits. In the case of swap registrants subject to the jurisdiction of any of the U.S. banking regulators, the proposed rules would apply to all non-centrally cleared swap activity2 (i.e., swaps and security-based swaps) without reference to whether the registrant’s status relates to transactions in one or both swap product categories.3

The BCBS-IOSCO rules require the bilateral exchange of initial margin (IM) and the delivery by one party to the other of variation margin (VM) and apply to financial firms and systemically important non-financial entities (“covered entities”), the definitions for which are left to national regulation.

Key Aspects of the Margin Requirements

Impact

The introduction of the requirements presents significant commercial, operational, and legal challenges.

Availability of Collateral

There are concerns that stricter margin requirements may have a significant impact on market liquidity and the availability of collateral, particularly as IM must be posted gross and cannot be netted or offset between counterparties. Several quantitative impact studies have been conducted. An analysis conducted by the International Swaps and Derivatives Association estimates that the earlier versions of the BCBS-IOSCO framework could see IM requirements reach a peak of $10.2 trillion (c. €8.04 trillion) if internal models were not used to make IM calculations and no counterparty threshold applied. On the other hand, a study referenced by BCBS-IOSCO projects that model-based IM calculations could result in requirements of approximately €1.3 trillion where no counterparty threshold applies and nearly €600 billion if a counterparty threshold of €50 million applies. These estimations rise dramatically to €7.5 trillion and €6.2 trillion, respectively, where calculations are entirely based on a standardized margin schedule.

Rise in Shadow Banking Activity

Given the demand for eligible collateral, the cost of such collateral is likely to rise. Market participants will look to exchange non-qualifying securities for eligible collateral. This collateral transformation activity will increase repo and securities lending activity, which will partly be absorbed within the shadow banking sector. The CFTC has acknowledged that collateral transformation services might proliferate, but does not mention the potential risks that this might give rise to. Moreover, the traditional repo market is under pressure from Basel III reforms (notably the leverage ratio and the Net Stable Funding Ratio).

Regulators are taking steps to curb risk in the shadow banking arena. The Financial Stability Board recently published its final framework for haircuts on collateral in uncleared securities financing transactions, as a measure to thwart the rapid onset of margin calls. The framework is made up of qualitative standards for methodologies to calculate haircuts on collateral received and proposed numerical haircut floors in which financing against collateral other than certain government securities is provided to nonbanks. The proposed implementation date by national authorities is the end of 2017. There will be significant challenges in implementation, given that in the U.S. regulation is split among various regulatory agencies and more entity-based (for instance, by banks, broker-dealers, systemically important financial institutions, and asset managers) as opposed to activity-based as it is in Europe.

Infrastructure Needs

Robust systems for the calculation and notification of margin amounts will be required.8 In addition, new infrastructure and technology will need to be developed to facilitate the allocation and monitoring of the €50 million/$65 million threshold across legal entities. Likewise, it is imperative that the industry adopt and receive necessary regulatory approval of a common methodology for the calculation of IM requirements to promote consistency and minimize the risk of disputes.9 In the absence of a consistent model, the bespoke calculation of margin amounts by each counterparty to a trade could result in different amounts being paid, by counterparties, due to legitimate variations between models. To this end, ISDA is leading an initiative to develop a standard IM model (SIMM) for widespread use by the market. The advantages of this would include greater predictability in margin requirements.

Commercial Concerns

There have been a number of commercial concerns raised by market participants. Financial end-users with directional portfolios such as pension plans will not benefit from the limited permitted exposure netting within risk categories (see Calibration of Margin row in the table) resulting in higher IM for those end users. For pension plans, this may significantly affect fund performance and the funding of pension obligations.

Predictability of margin requirements is critical to the consistent pricing of transactions and discouragement of aggressive models to win business. There are also different views regarding margin funding costs, with some institutions pricing on the basis of the term of the transaction and others on an expected or average life assumption. Another potential area of inconsistency is the placement of transactions into risk categories, which has netting implications as described above. Under the U.S. proposals, each covered entity selects the risk category for netting purposes. This may lead to disparate results where two swap registrants are party to a trade.

The scope of the rules is wide and extends margin requirements to securitization vehicles, an arguably unnecessary reach of the rules given the priority swap counterparties have in securitization payment waterfalls over and above bond investors. (But it is likely that many securitizations would fall below the $3 billion threshold). This is yet another cost constraint on securitization structures and does not serve to encourage the asset-backed security market, which is an essential pillar for the full-scale rehabilitation and normalization of the commercial and retail banking market globally. Under the E.U. proposals, securitization issuers would also fall outside scope if the swap exposure of the issuer is less than the €8 billion threshold. There is also a specific exemption for covered bond issuers.

Finally, the U.S. regulators have acknowledged that there may be a discrepancy between the classification of a counterparty as a non-financial entity for purposes of determining eligibility for the mandatory clearing exemption and classification as a non-financial end-user for the uncleared margin requirements. The discrepancy does not arise in the E.U. context as the end-user exemption from clearing is aligned with the exemption from margin requirements. Under the U.S. proposals, the clearing exemption for end users could well become irrelevant given that margin for uncleared trades is likely to be higher than for the cleared counterparty, which in turn would steer those end users, falling within the clearing exemption but within the scope of the margin rules, to the cleared space. This outcome would not be aligned with the valid reasons justifying the end-user exemption from central clearing.

A separate significant issue facing U.S. covered entities is the absence of an exemption for intra-group transactions. E.U. entities benefit from such an exemption. The divergence increases the potential for arbitrage. This issue is entwined with resolution and recovery planning and has implications from a regulatory capital perspective.

Increased Legal Risk and Additional Documentation Requirements

There are certain legal risk issues that have not been sufficiently acknowledged or addressed in either of the proposed U.S. or E.U. rules. As mentioned, IM will have to be exchanged two-way and gross on a bankruptcy-remote basis, and be immediately available to the collateral taker. The U.S. proposals require the use of third-party custodial accounts for cash and securities, buttressed by a security interest or pledge in favor of the collateral taker. In the E.U., title transfer arrangements, which currently predominate in the market, will not meet the requirement that margin be held on a bankruptcy-remote basis. The margin will have to be held on a security interest basis and held either with the collateral provider or with a custodian. E.U. laws on security interest arrangements are not well developed and are inadequately harmonized across the E.U.

The E.U. requires collateral to be in the “possession or control” of the collateral taker to get full protection from normal insolvency law. The English courts interpret this as potentially prohibiting the collateral provider from automatically withdrawing collateral deemed no longer necessary. So U.S. arrangements where the collateral provider periodically takes back from the collateral account excess collateral can present issues in the E.U., which seeks to protect the collateral taker to a greater degree. The market will no doubt use the U.S. style arrangements globally if at all possible to avoid paying in IM for longer than required and to avoid having to wait for a collateral taker to release reimbursement.

To guard against the risk that their security may become void or unenforceable, counterparties will need to undertake an analysis of relevant local laws on security interests, and manage their practical arrangements carefully. This of course is likely to involve some uncertainties, difficult judgment calls (and the running of risk) and considerable expense. The E.U. proposals also require a legal opinion verifying that IM is adequately segregated and insulated from the bankruptcy risk of the collateral taker. Where IM is in the form of cash, the cash amount will need to be individually segregated per each collateral provider with a third party bank (to whose credit risk the provider is then exposed).

With respect to third party custodial arrangements, custody agreements and account control agreements will need to be negotiated and put in place with a large contingent of counterparties. Existing documentation will need to be modified to contemplate these third party arrangements. Documentation may also need to be amended to comply with proposed CFTC rules requiring that swap trading relationship documentation include a process for determining the value of each swap in compliance with the margin requirements.10 It remains to be seen what this disclosure requirement will mean in practice, especially with respect to proprietary risk based margin models. This rule, as is the case elsewhere, also requires that each swap registrant establish and maintain policies and procedures to resolve a valuation discrepancy, including as to how VM will be handled pending resolution of a dispute. Additionally, an institution may wish to put in place separate master netting agreements to avoid having the margin requirements apply to pre-effective date transactions since IM and VM requirements will apply to all transactions under a master netting agreement that governs post-effective date transactions.

From a risk perspective, while holding collateral with a custodian mitigates the risk associated with the collateral receiver’s bankruptcy, it does not eliminate all risk. In the event of an insolvency of counterparty (or other trigger for the release of collateral) it may well be that a custodian will not release the collateral to either party until directed to do so by a court with competent jurisdiction. It is also critical to keep in mind that in times of systemic stress, liquidity may be severely impaired. Additionally, upon any custodian insolvency, excluding cash collateral from the bankruptcy estate is very difficult. This requires the reinvestment of cash into securities on a daily sweep basis generally. In the E.U., or at least in the U.K., banks holding cash collateral could recognize the beneficial interest of the custodian’s client in the cash (strictly the custodian’s rights as depositor to the cash account). More broadly, as greater amounts of collateral are held in a limited number of custodian banks, this will concentrate risk in the financial system further.

Unless global regulators look again at permitting title transfer, the netting of IM payments, and expanding the list of eligible collateral, the effect of the rules for IM may simply be to swap counterparty risk for legal risk and uncertainty at an international level.

Extraterritorial Application

Another chief concern is the extraterritorial application of the regime for cross-border transactions, potentially leading to conflicts in the detailed application of the regime at a local level. A key principle included in the BCBS-IOSCO framework is that national regulatory regimes implementing the framework should not lead to conflicting, duplicative, or inconsistent requirements for participants; should limit regulatory arbitrage; and should maintain a level playing field. Both the E.U. and the U.S. proposed rules allow for substituted compliance, or compliance with home country requirements through compliance with local rules, provided that the relevant margin regime is found to be equivalent to their respective rules. Both sets of proposed rules also have extraterritorial reach, although the E.U. proposed rules are not as wide-reaching as the proposed U.S. rules. It remains to be seen how many equivalence or comparability determinations will be issued for the uncleared margin requirements. In the U.S., consensus has not been reached and much uncertainty remains as to the extraterritorial application of Title VII of Dodd Frank generally. This, combined with a lack of resources on the part of CFTC staff to conduct comparability assessments, does not give the market confidence that cross-border reconciliation of the uncleared margin requirements will be achieved. This is of immediate concern, especially given the rather short implementation date for the largest institutions—which generally have global businesses.

The timeframe for implementation of the final rules by market participants is tight, especially for VM. Lack of harmonization across jurisdictions will compound implementation anxieties, create uncertainty and increase legal risk.

As with many of the reforms in response to the recent financial crisis, there are unintended consequences to the introduction of the uncleared margin rules, some of which are immediately apparent and some of which will only become evident as industry begins its implementation. Unfortunately, these reforms may be pushed through too quickly without resolving the interpretational issues and legal uncertainties they create.