Regulatory Watch: ISDA Continues Fight against Initial Margin

ISDA, others continue inveighing against initial margin; claim it will have negative impacts on OTC derivative markets.

Initial margin will be a menace to OTC markets and should be reconsidered. That’s according to the International Swaps and Derivatives Association, which is ramping up its fight against initial margin (IM) in a letter to the International Organization of Securities Commissions (IOSCO) and the Basel Committee on Banking Supervision. In doing so, ISDA has also enlisted fellow industry organizations.

In its letter, ISDA, along with the Institute of International Finance (IIF) and Association for Financial Markets in Europe (AFME) said the they “completely support proposals for a robust Variation Margin (VM) framework,” the letter said. However, “we believe the Initial Margin (IM) component of the WGMR [Working Group on Margining Requirements] proposals will severely impact liquidity in the vital uncleared OTC derivative markets, and could increase rather than decrease systemic risk. Phasing-in of rules will not alter this outcome.”

The letter follows a study by ISDA from early November that showed how IM could increase risks as well as the fact that the level of IM required under current proposals is very high, ranging from $1.7 trillion to $10.2 trillion. The ISDA study also revealed that the increased amount of IM that would be required in stressed conditions could result in greatly increased demand for new funds at a time when market participants couldn’t afford it.

At the beginning of November, corporations got the long-sought-after confirmation they would get end-user exception to Dodd-Frank’s central clearing and trade execution mandate. However, margin remains a significant issue for corporations. The Commodity Futures Trading Commission (CFTC) has said that final margin requirements for uncleared swaps would be issued in January. But as of now the lack of guidance on margin and capital is hampering dealers’ attempts to set expectations for their clients and counterparties on terms, availability and pricing.

In its letter, ISDA, the IIF and AFME laid out seven misconceptions and falsehoods it feels could have a negative impact on any final rules. They include:

1. All OTC derivatives can and should be cleared. “Only sufficiently liquid and standardized OTC derivatives can be safely cleared…It does not make sense to push transactions into them that do not fit these characteristics,” the letter stated.”
2. If an OTC derivative can’t be cleared, then perhaps it is too risky, and it should not exist. “The clearing eligibility of an OTC derivative is not a proxy for its riskiness. Yet to some, the prevailing perception of uncleared derivatives is that they are all complex and risky; to others, uncleared derivatives should either be cleared or those markets should be eliminated.” The BCBS or IOSCO need to make sure this perception doesn’t enter into any final determinations, the letter said.
3. Market participants can easily find another alternative involving a standardized contract. Hedging is unique and specific to the risk. “If end-users have to hedge only with standardized derivatives, they would have an improper or imperfect hedge. The resulting financial risk exposures would lead to volatility and/or unmanaged losses in their financial results.”
4. Cleared OTC derivatives require IM, and we need to ensure a level playing field, so IM should also be required for uncleared OTC derivatives. This would increase capital requirements astronomically, the letter said. Instead, the letter writers believe the most effective way to address systemic risk is through a three pillar approach: (1) Mandatory clearing of sufficiently liquid and standardized OTC derivatives; (2)Robust VM for uncleared OTC derivatives that involves daily valuations and daily collateral exchanges; (3)An appropriate capital regime.
5. The problems related to IM requirements can be mitigated through an implementation transition and calibration process. …[A] phase-in approach would not alter the extremely deleterious impact the IM requirements would have on uncleared OTC derivatives. Nor, as we have noted above, would it enable market participants to transition to other alternatives,” the letter said.
6. If IM for uncleared OTC derivatives is high enough, then market participants will be incentivized to clear more. “If a transaction is not clearable, then no amount of IM can cause it to be cleared. If it is clearable, then legal mandates – and not punitive IM – should drive clearing.”
7. Segregated IM for uncleared OTC derivatives is a clean elimination of risk. “Banks and other entities which will be required to post IM will need to borrow cash or securities to fund the IM requirement” which will create exposures for investors and securities lenders. Rather than eliminating exposures and reducing risks, IM will just move risk to other parts of the market.

The industry groups acknowledged that there was a tight time line for implementation of the rules, so suggested to IOSCO and the BCBS that they continue on with their proposals relating to variable margin. That’s because the frequent exchange of the unrealized mark-to-value fluctuations between two parties is actually beneficial in reducing counterparty risk. Meantime, regulators should continue to study the impacts of IM and solicit further consultations from end users.