The relief felt by treasurers last month when the Commodity Futures Trading Commission finally approved the end user exemption to central clearing of derivatives may have been premature. The Basel Committee on Banking Supervision and the International Organization of Securities Commissioners recently issued a proposal that would impose significant operational costs on exempt organizations that trade OTC derivatives.
Barry Schachter, chief risk officer at Woodbine Capital Advisors and an acknowledged expert on risk management and regulation, wrote a piece for Bloomberg last month arguing that the proposal “will impose significant new compliance, record-keeping and risk measurement infrastructure costs on most parties to such transactions and creates significant disincentives to use non-cleared OTC derivatives.”
The BCBS and IOSCO are accepting comments on the consultative document, “Margin requirements for non-centrally-cleared derivatives,” until September 28.
The organizations propose two methods for end users to employ to calculate their margins. They can either use internal quantitative risk models, with 10-day, 99 percent confidence VaR or similar tools. Or, they can use a schedule that regulators will publish.
The key principal in the determination of margin, according to BCBS/IOSCO, is: “The methodologies for calculating initial and variation margin that must serve as the baseline for margin that is collected from a counterparty should (i) be consistent across entities covered by the proposed requirements and reflect the potential future exposure (initial margin) and current exposure (variation margin) associated with the portfolio of non-centrally-cleared derivatives at issue and (ii) ensure that all exposures are covered fully with a high degree of confidence.”
OTC users may be pleased to hear that the regulators decided to allow a “broader set” of eligible collateral beyond just cash, Treasuries and similar instruments. The paper notes that potential advantages of this 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.”
The regulators are not sanguine about the fallout from these rules. They write, “based on preliminary analysis, the BCBS and IOSCO believe that the liquidity impact of any variation of the margin requirements contemplated above will be both material and significant.” For that reason they are conducting a QIS and gathering further data on how various aspects of the rules – allowing rehypothecation or not, for example – would affect the market’s liquidity.