By Dwight Cass
The US implementation of Basel III and regulators’ guidelines on margin calculations were a blow for hedgers who hoped for business as usual.
There was much for corporate hedgers to complain about in 2013. In particular, the commercial end-user exemption from central clearing requirements that they so vigorously lobbied for in Dodd-Frank was eviscerated by the US implementation of Basel III, which provides no similar relief. And the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissioners issued guidelines for margin calculation that even the authors conceded will have a liquidity impact that will be “both material and significant.”
The margin guidelines offer two methods that end users can use to calculate initial margin. 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.
BCBS and IOSCO issue guidelines for margin calculation that even the authors conceded will have a liquidity impact that will be “both material and significant.”
The International Swaps and Derivatives Association believes most derivatives market participants will use internal models because the schedules will be “punitive.” ISDA estimates that approximately 20 percent of notional OTC derivatives outstanding are unclearable.
Based on this estimate, ISDA concluded that total IM in the global system would range from $1.7 trillion to $10.2 trillion if the BCBS/IOSCO proposals were put into effect. ISDA believes that over EUR4 trillion in collateral will be demanded of the major dealers by their clients if no changes are made. If dealers were allowed to skip initial margin on transactions below a certain threshold, that figure could be reduced to $800 billion.
This massive liquidity drain is leavened somewhat by the regulators’ decision to allow a “broader set” of eligible collateral beyond just cash, Treasuries and similar instruments. The BCBS/IOSCO IM paper says 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 key principle 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.”
Extraterritorial Reach
Even if corporates can do business in swap-friendly jurisdictions outside the US, they may not find themselves off the hook.
In November, the Commodity Futures Trading Commission issued an advisory saying that swaps between registered non-US dealers and non-US counterparties, if they are handled by personnel in the US, will be subject to mandatory clearing, along with the margin, reporting and transaction requirements mandated by Dodd-Frank.
The decision caught the market by surprise because the CFTC had previously said that it would defer to foreign regulators in such cases. The derivatives dealer community complained about the decision through its lobbyists, but the CFTC has not changed its mind or issued further clarifications.
DFA Gives, Basel Takes
Under the Dodd-Frank exemption from central clearing, corporates were hoping to avoid being forced to use standardized cleared instruments.
But the US released its implementation rules for Basel III in July, and notably refused to give corporate end users an exemption on the credit valuation adjustment charge, unlike European regulators, who exempted commercial hedging.
The CVA charge is expected to make hedging significantly more expensive, obviating the benefit of uncleared OTC derivatives and pushing more corporates to either give up hedging, pay exorbitant rates to hedge as usual or to begin to use standardized, cleared instruments, despite their many drawbacks.
Going into 2014, end users are facing great uncertainty over how their dealers will conform to the new rules, whether there will be opportunities to arbitrage the regulatory differences over CVA between the US and the Eurozone, and whether they can make a go of hedging with exchange traded, cleared instruments. With bank capital still under pressure, they should plan for the worst.