By Dwight Cass
Margin and collateral requirements still missing as rule implementation dates approach.
Gary Gensler, the chairman of the Commodity Futures Trading Commission, said last month that final margin requirements for uncleared swaps would be issued in January, nearly four months after they were expected. With the CFTC hoping to start interest-rate swap and credit default index product clearing in January, 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.
“The saving grace here is ZIRP on the short end,” said an interest-rate swap trader. “If rates were in flux we’d be hard pressed” to prepare for implementation. As it is, the new listed futures contracts designed to replace OTC interest-rate swaps will have a reasonably stable market in which to find their footing. New products in commodity derivatives markets, with their higher level of volatility, are facing a more serious challenge, he added, although clearing for commodities and energy will be phased in after the rates and credit swap markets.
No consensus
One reason for the delay is the difficulty getting an international regulatory consensus on the rules. The US Financial Stability Board, in its semiannual derivatives regulation progress report on October 31, said, “Jurisdictions are working together, both bilaterally and multilaterally, to identify and address cross-border issues. However, progress to date in cross-border discussions has been slow. This risks delaying the full and timely implementation of the G20 objectives.”
The FSB acknowledged that the lack of guidance on margin and capital was making compliance difficult for financial institutions:
“Regulatory uncertainty remains the most significant impediment to further progress and to comprehensive use of market infrastructure. Jurisdictions should put in place their legislation and regulation promptly and in a form flexible enough to respond to cross-border consistency and other issues that may arise. Regulators need to act by end-2012 to identify conflicts, inconsistencies and gaps in their respective national frameworks, including in the cross-border application of rules.
In the first week of November, regulators from the EU, the US Securities and Exchange Commission and the CFTC met to attempt to hammer out differences in the US and European regulatory regimes, including differences over collateral requirements for uncleared swaps. The prospects for these talks were darkened somewhat by the revelation in the Wall Street Journal that French, UK, Japanese and EU finance ministers had written to Gensler in mid-October to complain about the proposed CFTC rules’ extraterritoriality, in particular, their requirement that non-US dealers register with US authorities. According to the Journal, the finance ministers wrote: “At a time of highly fragile economic growth, we believe that it is critical to avoid taking steps that risk a withdrawal from global financial markets into inevitably less-efficient regional or national markets.”
Financial Buggy Whips
Many dealers anticipate that the additional capital and collateral they will need for uncleared derivatives transactions will force them to raise the cost of those transactions to the point where they become uneconomical for corporate end users, despite the corporate exemption.
Large, bespoke swaps used to lock in a funding cost as part of a bond offering could become so expensive that they no longer work. Likewise, portfolio duration management using OTC interest rate swaps could become uneconomical. Large-scale transactions like these would be difficult to execute in the futures markets too, so corporates may end up with a smaller toolkit with which to hedge, optimize funding and tailor portfolios.
Making matters worse, dealers received a shock last month when Davis Polk, the counsel for SIFMA, determined that dealers would have to start ponying up collateral during the transition to central clearing. Previously, dealers thought they had up to nine months before they needed the additional money. According to Bloomberg, starting earlier could sop up another $50bn in cash and Treasuries.
Expect the Unexpected
Many banks seem to be at a loss regarding how to respond to the massive change in the OTC derivatives business. However, some of the largest dealers have taken a two-step approach to protect their corporate derivatives franchises. First, they have invested in clearing platforms that are sophisticated enough to provide some of the advantages of OTC transactions. These are principally designed for prime brokerage clients, but relationship bankers say they can be tweaked for use by corporates as well. Typically, these clearing systems have:
1) A risk management and/or portfolio analysis functionality; 2) A transaction search function that finds the most cost-advantageous way to execute a financing or hedging need; 3) A margin and collateral optimization function.
Essentially, this provides a corporate client (like a hedge fund or other buy-side client) with the ability to manage their margin on a net basis across several different clearinghouses and different asset classes. While this won’t eliminate the additional cost of using cleared derivatives, it makes them somewhat less onerous. The problem for a corporate client is the stickiness of these systems. Once a company has begun netting its margin through a specific dealer, it will be cumbersome to shift to another dealer’s system.
Clearly, this is not an ideal solution. Some bankers talk about establishing the modern-day equivalents of “Swapcos”— the triple-A rated bank subsidiaries used in the early days of the derivatives markets to transact deals. But regulators have made it clear that any such entities would have to be consolidated and would contribute to regulatory capital, making such a move moot.
Rather, bankers think that many corporates will be faced with transacting rates business through exchanges, perhaps via swap futures and similar instruments, with margin minimized to whatever extent possible via netting. However, until the final margin and collateral rules emerge in January, the specifics remain anybody’s guess.