European regulators recently re-proposed rules to establish margin requirements for uncleared swaps that exempt most nonfinancial corporates, diverging from the path US regulators are anticipated to follow. Still, margin requirements will impact corporates downstream.
Issued by the Joint Committee of the European Supervisory Authorities (ESA) and seeking comments by July 14, the “consultation paper” resembles the original proposal issued more than a year ago and describes a framework for posting initial and variation margin for uncleared derivative transactions.
The proposal describes the minimum amount of initial and variation margin that must be posted and collected, and how those amounts are to be calculated. For initial margin, which would be a new requirement for many derivative end-users, counterparties can choose between a standard, pre-defined schedule based on the notional value of the contracts, and an internal modeling approach determined by modeling the exposures.
The proposal also describes the assets that are eligible to use as collateral, covering a broad range including sovereign securities, covered bonds, certain securitizations, corporate bonds, gold and equities. And in addition to establishing collateral diversification requirements and haircuts to mitigate market and foreign-exchange volatility, the prescribed proposal would impose documentation requirements and other operational procedures.
The proposal exempts corporate derivative end-users, except those with more than $3 billion in speculative derivative exposures or other derivatives that do not qualify as hedges—most likely impacting energy companies and others that frequently trade derivatives.
Nevertheless, said Luke Zubrod, director of risk and regulatory advisory at Chatham Financial, the rules would likely raise costs for exempted corporate end-users. A bank counterparty to a corporate end-user may not have to hold margin against that transaction, but banks typically hedge such swaps with subsequent transactions for which they probably will have to post collateral, tying up their capital and causing them to raise transaction prices in order to be compensated for the low return on margined funds.
Mr. Zubrod noted that ESA’s proposal largely follows recommendations published in September by the Working Group on Margining Requirements (WGMR), run jointly by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions. He added that one notable difference is the treatment of re-hypothecated collateral, in which a bank receiving collateral proceeds to post it as margin on a separate transaction.
The WGMR paper outlined a complicated approach to limit a bank’s reuse of collateral to one time if it meets prescribed requirements, in an effort to reduce the need for banks to set aside capital for subsequent transactions.
“The benefit of WGMR’s approach is that this could have reduced funding charges,” Mr. Zubrod said, adding, “The Europeans set that whole scheme aside, saying it was too complicated, so the result is that banks will have higher costs to pass on to customers.”
US prudential regulators are anticipated to re-propose an outstanding proposal as well, perhaps in the next month. Like the earlier proposal, it’s anticipated to deviate significantly from the WGMR recommendations by requiring banks to impose margin on corporate end-users after they exceed a swap-exposure threshold determined by the bank.
The lack of exemption for corporate end-users stems from US regulators’ interpretation that Dodd-Frank requires them to impose margin on all market participants. Mr. Zubrod noted, however, that those officials have indicated support for legislation rescinding those margin requirements.
“So it’s not because they believe it’s good policy to impose margin on end-users, but rather it’s because they believe Dodd-Frank requires them to impose margin on end-users,” Mr. Zubrod said.