The amount of collateral held against OTC trades, and the operational complexity of moving and segregating margin, are both expected to increase sharply. Virtually all experts predict that costs will rise, and many expect a resulting drop in volumes, unless firms can optimise how they provide collateral for such transactions.
The impact of these changes on the buyside has received wide media attention given that mandatory clearing of swaps and initial margin are both new requirements that will affect pension funds, asset managers and other institutions trading derivatives.
According to Mike Reece and Jason Paltrowitz, J.P. Morgan market executives for banks and broker-dealers for Europe and the Americas respectively, the impact to banks, broker-dealers and clearinghouses is equally significant. “These institutions cannot risk being caught off guard by the systemic changes to trading and collateralising OTC derivatives,” they note.
Expected regulation covering cleared trades
While the definitive regulations remain pending under both the DFA and EMIR, approximately two-thirds to three-quarters of the current bilateral trade volume is forecast to migrate to various central counterparties (CCPs).
Cleared OTC derivatives transactions will attract both variation margin (VM) and initial margin (IM) obligations in line with the risk models of CCPs. The increased use of CCPs and the mandatory use of IM are forecast to significantly increase the overall value of collateral held against OTC derivative transactions.
In addition, CCPs will accept only high grade collateral, which will put pressure on supply as demand for this limited pool of collateral continues to increase. The influx of cash resulting from mandatory IM and VM is likely to prove challenging for the CCPs who have few options for managing that cash.
Expected regulation covering non-cleared trades
Certain OTC derivative instruments will not be accepted by CCPs, principally due to a lack of liquidity, and will thus be exempted from central clearing. Trades where one of the counterparties is not a financial entity and is using swaps to hedge or mitigate commercial risk are likely to be exempted (for example, an airline hedging against the price of fuel) from clearing, as well as any margin requirements.
US agencies previously put forward proposals for the remainder of the market:
• Trades between significant users of swaps (banks, hedge funds etc) generating significant positions: Counterparties must collect IM and VM, which should be held with an independent third-party custodian and may not be rehypothecated.
• Trades between significant users of swaps and other low risk financial end users: Swap entities would have to collect both VM and IM subject to certain thresholds.
However, most jurisdictions, including the US, are likely to wait until year end for new global principles on margining rules for non-cleared transactions before deciding upon their approach.
DFA and EMIR currently diverge in their treatment of certain entities, most notably the temporary exemptions from clearing for pension funds. That said, whilst EMIR is approximately one year behind DFA, the two are ultimately expected to be very closely aligned. Any major long term divergence might result in regulatory arbitrage, which is something that all regulators are seeking to avoid.
According to Reece, the sheer breadth and depth of new regulation creates significant challenges for banks, brokerdealers and other major participants in the global derivatives markets. As DFA and EMIR intersect with Basel III and a raft of other complex and broad-ranging reforms, it is exceptionally difficult for firms to achieve a holistic understanding of the new market reality.
Financial institutions are being asked to make major strategic decisions with uncertain inputs. That said, Paltrowitz also notes that there are some areas where the likely impact of new regulation is clear:
1. More collateral will be needed. The imposition of mandatory IM payments for both cleared and noncleared transactions, in addition to charges imposed by Basel III for non-collateralisation, is forecast to increase the value of collateral held against all OTC derivatives by multiple trillions of dollars.
2. High grade collateral will be in short supply. Collateral eligibility standards will be tightened under the proposed regulations. Demand will significantly increase for the same high quality collateral called for by Basel III, for example. While it is difficult to accurately predict the impact on supply and demand, the consensus is that there could be a significant reduction in availability allied with a commensurate increase in cost. Options for transforming collateral will play a key role in helping institutions to meet the more rigorous eligibility requirements set forth by the CCPs.
3. Operational complexity will increase. The introduction of central clearing, coupled with the substantial remaining volume of bilateral trading, will require that two market processes be put in place by virtually all market participants.
4. Collateral optimisation will become a strategic priority. As the cost of collateral increases, collateral management and optimisation will become the new battleground for efficiency. Those that can efficiently manage margin across cleared and non-cleared derivatives will enjoy a significant competitive advantage.
Finally, and not insignificantly, CCPs requiring IM and VM face challenges in managing that cash and collateral effectively. The amount of margin to be held with CCPs will increase substantially, representing a challenge for those institutions as they seek to reinvest cash. The current mechanisms for managing collateral are neither sufficient to meet the expected volume nor able to cope with the operational and asset servicing complexities that will ensue.
For counterparties, J.P. Morgan’s collateral agency services can mitigate the operational complexity of a bifurcated market model while providing security with segregated accounts and rigorous reporting. J.P. Morgan clients benefit from end-to-end support for both bilateral and CCP-cleared derivatives transactions to address the rapidly increasing demand for higher volumes, higher values and higher quality collateral. For CCPs, J.P. Morgan is also developing or adapting solutions to meet their emerging business challenges, including more efficient systems to manage their collateral and expanded options for cash reinvestment.
Although some of the finer detail remains unclear, DFA and EMIR (along with Basel III) will soon become the new reality. Though the rule-making continues, banks and broker-dealers cannot delay their preparation. Managing the interrelation between the new and existing regulatory demands is critical to achieving a favourable outcome for any firm—more critical, in fact, than the demands of any single new reform.
In this context, all the new regulations represent both risk and opportunity. The banks and broker-dealers that adopt and implement the right approach will enjoy a substantially enhanced competitive advantage. As a major player in both the cash management and securities servicing markets and an expert collateral agent, J.P. Morgan is uniquely positioned to work closely with all industry participants and bodies to understand the regulations, assess the holistic impact of the changes and devise/propose solutions.
John Rivett, J.P. Morgan business executive for collateral management notes that “through J.P. Morgan’s engagement with regulators, CCPs, clearing members and end clients, we are able to offer a comprehensive range of solutions designed to facilitate the continued use of OTC derivatives while reducing the associated costs of collateral and effectively managing risk.”
Ultimately, whether it is OTC derivatives collateral, exchange-traded derivatives collateral, repo collateral, stock loan collateral or any other collateral, Rivett says that firms are taking an enterprise-wide view of collateral. “Increasingly, institutions are looking at this collectively as ‘collateral’ in order to be truly efficient in their balance sheet usage.”
A recent ISDA paper (derivatiViews, September 6, 2011) found that mandatory clearing called for by the Dodd-Frank Act would increase variation margin by $30-50bn among US banks. Clearing requires payment of initial margin as well. The US Office of the Comptroller of the Currency estimated that initial margin requirements could total over $2trn globally under certain circumstances. Other estimates of initial margin start at the hundreds of billions of dollars of new collateral needed.