By Dwight Cass
Bilateral derivatives counterparties can use more types of collateral and some limited rehypothecation.
The Basel Committee on Banking Supervision (BCBS) and International Organization of Securities Committees (IOSCO) released their final collateral rules for bilateral derivatives transactions on September 2.
The rules address some of the derivatives market’s main concerns, containing carve outs for some cash-settled FX, more types of eligible collateral and more flexibility with regard to rehypothecation. However, despite conducting several Quantitative Impact Studies, what the actual effect of the rules will be on the cost of hedging for nonfinancial corporates remains anyone’s guess.
Demise overstated
It has been some time since bank analysts predicted that the world economy would grind to a halt when the collateral rules kicked in and took $1-3 trillion of liquid assets out of circulation. The migration of plain vanilla swaps to CCPs has proceeded apace without disaster striking, although many buy side entities failed to prepare for the transition in time (see “Capital Markets: Buy Side Comments on Central Clearing: “Doh!,” September 20, 2013) and corporates had to make some difficult decisions in September regarding whether to pursue the end user exemption, clear swaps through FCMs, or both. The main provisions of the new collateral rules, as summarized in a report by Guy C. Dempsey Jr. of the law firm Katten Muchin Rosenman LLP, are as follows:
- Variation margining will commence December 1, 2015. Initial margining will be phased in starting on that date for the largest market participants, with full initial margining coming into effect on December 1, 2019.
- Initial margin can be calculated using percentages from a standard schedule or an approved model.
- Initial margin must be exchanged on a gross basis and must generally be held at an independent custodian.
- National regulators will determine eligible collateral based on general guidance from BIS and IOSCO.
- Collateral haircuts can be set by reference to percentages from a standard schedule or an approved model.
- Variation margin must be exchanged on a zero threshold basis; initial margin can have a threshold of up to €50 million applied on a consolidated basis across all entities in the same corporate family.
- Rehypothecation is permitted for variation margin but not for initial margin (except under limited circumstances).
- Variation margin calculations can take into account legally enforceable netting arrangements.
Taking Stock
One aspect of the new rules that has raised some eyebrows is the inclusion of equity in the list of acceptable collateral. The regulators decided against allowing only high-quality, liquid fixed income instruments in favor of a more flexible roster including corporate bonds and equities.
The inclusion of equity in the list of acceptable collateral has raised eyebrows.
The regulators decided to deal with the additional volatility of these instruments by requiring larger haircuts (see figure below). BCBS and IOSCO hope that this will reduce the potential liquidity impact of the margin requirements, and better align them with central clearing practices, in which CCPs frequently accept a broader array of collateral, subject to collateral haircuts.
The regulators set some difficult-to-meet criteria for the collateral. In principle:
1) Eligible collateral must have good liquidity even in down markets.
2) Eligible collateral should not be exposed to excessive credit, market and FX risk (including through differences between the currency of the collateral asset and the currency of settlement).
3) The value of the collateral should not exhibit a significant correlation with the creditworthiness of the counterparty or the value of the underlying non-centrally cleared derivatives portfolio in such a way that would undermine the effectiveness of the protection offered by the margin collected (so-called “wrong way risk”).
4) Securities issued by the counterparty or its related entities should not be accepted as collateral.
5) Accepted collateral should also be reasonably diversified. Examples of collateral that meet these criteria are:
- Cash;
- High-quality government and central bank securities;
- High-quality corporate bonds;
- High-quality covered bonds;
- Equities included in major stock indices; and
- Gold.
Clearing’s 12 Basis Point Advantage
The Macroeconomic Assessment Group on Derivatives, part of the Bank for International Settle-ments, issued a report in August in which it concluded that the move to central clearing would have a benefit of 12 basis points of GDP per year. Here is the reasoning behind that figure, drawn from the report (“Macroeconomic impact assessment of OTC derivatives regulatory reforms,” MAGD, August 2013):
“The main benefit of the reforms arises from reducing counterparty exposures, both through netting as central clearing becomes more widespread and through more comprehensive collateralization. The Group estimates that in the central scenario this lowers the annual probability of a financial crisis propagated by OTC derivatives by 0.26 percentage points. With the present value of a typical crisis estimated to cost 60 percent of one year’s GDP, this means that the reforms help avoid losses equal to (0.26 x 60 percent =) 0.16 percent of GDP per year. The benefit is balanced against the costs to derivatives users of holding more capital and collateral.
Counterparties can either use their own quantitative models to determine the collateral haircuts or use a standardized schedule included in the report. The standardized schedule applies its harshest haircuts—15 percent—to equities and gold, and runs all the way down to 0 percent for cash and 0.5 percent for high-quality government and central bank securities with residual maturity less than one year.
The BCBS has been upfront about the fact that its motivations in devising these rules, apart from reducing systemic risk, include providing an incentive for swap users to use the CCPs.
While the final rules bend more toward the wishes of the derivatives-using community, the economic distortion created by that non-market incentive could have some deleterious effects on the market nonetheless.