Final framework requirements for non-centrally cleared derivatives

After much deliberation and a lot of lobbying, the final framework requirements for non-centrally cleared derivatives have been released by The Basel Committee on Banking Supervision and the International Organisation of Securities Commissions.

There had been much lobbying in the derivatives industry, led by ISDA (International Swaps and Derivatives Association) for the proposed regulations to be watered down amid fears that they would harm a lot of crucial hedging activity. The Committee has pressed ahead regardless, and has also moved to assuage fears concerning a potential liquidity drain by proposing that a wide range of collateral be accepted to satisfy these margin requirements.

The report says, of its approach to collateral: “One approach would be to restrict eligible collateral to the most liquid top-quality assets, such as cash and high-quality sovereign debt, on the grounds that doing so would best ensure that the value of collateral held as margin could be fully realised in a period of financial stress. Another approach would be to permit a broader set of eligible collateral, including assets such as liquid equity securities and corporate bonds, and address the potential volatility of such assets through the application of appropriate haircuts to their valuation for margin purposes. Potential advantages of the latter approach would include (i) a reduction of the potential liquidity impact of the margin requirements by permitting firms to use a broader array of assets to meet margin requirements and (ii) better alignment with central clearing practices, in which CCPs frequently accept a broader array of collateral, subject to collateral haircuts. After evaluating each of these alternatives, the BCBS and IOSCO have opted for the second approach (broader eligible collateral).”

Collateral requirements are a key concern in the derivatives markets, with the previously unsung department of the market now taking a leading role with increased collateral requirements coming thick and fast with the regulatory reforms moving towards central clearing. George Handjinicolaou, deputy chief executive officer and head of Europe, Middle East and Africa, at ISDA, expressed his fears of a collateral shortage to us. “There is, globally, around US$70-$80 trillion in collateral, identifiable from IMF statistics that calculate all of the government debt, all of the higher quality debt, depending upon where you draw the line in terms of quality, all of the corporate, mortgage and agency bonds and there is $70-$80 trillion. The next question is how much of this collateral is actually available to the market? A lot isn’t, for a number of reasons. Some people simply don’t like to lend their holdings, they like to keep them locked up in their vault and they sleep well at night. They don’t deem the return from lending out their securities worthwhile in relation to the risk.

“Some entities are strictly prohibited from lending. Some people are not even aware that they have the option to lend out their collateral. For all these reasons, you are not left with an available pool of eligible collateral worth $80 trillion. From what we hear, the amount of available collateral is much nearer to $10-$11 trillion. I have been involved in the markets for many years and collateral was always an afterthought. You’d do a deal and then it would go into the back office to be dealt with. In the new world, everything will revolve around collateral. I’m fascinated by what is happening in this area and it is still little understood, even by policy makers.”

These new initial margin requirements won’t have done much to ease the view of ISDA. The final say in the type of collateral that is acceptable will be made the relevant local regulators.

These initial margin requirements exclude FX transactions, on the basis that there are so many such transactions that they would be impossible to margin. The reforms will also be phased in and there is no immediate rush, a fact that will surely give hope to some market participants that the rules will be watered down prior to their final implementation.

Phase one of the implementation will pick up firms with a month-end average notional amount of uncleared derivatives exceeding €3tr. They will need to comply with the new regulations as of December 2015. Phase two will gather those firms with a month-end average notional amount of uncleared derivatives exceeding €8bn. Those firms have until December 2019 to be compliant.

You can read the final report, in full, here: http://www.bis.org/publ/bcbs261.pdf

Tags: BISISDAOTC Derivatives