ISDA has published studies recently that give us a better understanding of the functioning of the OTC derivatives market leading up to and during the financial crisis. A recent paper on the US banking system found relatively modest losses arising out of counterparty defaults of plain vanilla derivatives.
The paper also found that mandatory clearing called for by the Dodd-Frank Act would increase variation margin by $30 to $50 billion among US banks, again a relatively small sum in a $14 trillion economy. Clearing, of course, requires payment of initial margin as well. The Office of the Comptroller of the Currency (OCC) estimated in a paper that initial margin requirements could total over $2 trillion globally under certain circumstances, a truly staggering sum. Other estimates of initial margin start at the hundreds of billions of dollars of new collateral needed. What this means is that the new regulations may require over a trillion dollars in initial margining to protect against incremental exposures whose current mark-to-market value is perhaps $50 billion. We have not seen any cost benefit analysis of clearing and initial margins that justifies this approach.
How did we get here? During the financial crisis, global regulators were unsure how the market would handle defaults of major participants. OTC derivatives contracts amounted to hundreds of trillions of dollars of notional amounts with thousands of participants. It was not clear how many were subject to collateral requirements nor was there uniformity in collateral practices. Some had initial margin and daily margining. Others only had variation margin after a threshold exposure was reached. Furthermore, regulators did not know if another mortgage problem existed through a single entity such as AIG FP or through widespread risk-taking by many participants. Out of this grew the requirement for mandatory clearing and trade reporting.
The requirement is leading to a host of clearinghouses around the world. As they are created and used, they reduce the benefits of bilateral netting (which we discussed in a previous derivatiViews). In some cases, the benefits of risk reduction from clearing will be exceeded by the additional risk created by losing netting benefits. That’s even before considering the costs of clearing.
As noted, the clearing requirement was not subject to analysis nor were other alternatives. ISDA would like comments from readers on the following approach:
- First, we do agree that interdealer contracts for standardized products should be cleared. For very active participants, initial margining is quite efficient.
- Second, all financial entities (subject to de minimis exceptions) should have two-way collateral arrangements for variation margin. This would include AIG and all the monolines that wrote CDS on mortgage CDOs. These arrangements should be completely standardized – no exposure thresholds and margin posted daily. The collateral process could be overseen by an independent third party.
- Third, the parties can decide for themselves the amount and extent of initial margin required.
- Finally, trade and counterparty reporting should be put in place to reveal risks taken both by individual counterparties as well as by many participants together.
Our proposal will not eliminate losses due to the absence of initial margin. But it will reduce the excess costs of initial margins for creditworthy counterparties. And it will also give regulators the transparency they need. With initial margin running anywhere from the hundreds of billions to the OCC’s estimate of $2 trillion or more, perhaps the benefits of our proposal exceed the alternative “one size fits all” approach that we are unfortunately moving toward.