On the (broken) record…

Last Monday, ISDA submitted its response to the second BIS/IOSCO consultation on “Margin requirements for non-centrally cleared derivatives”. The second consultation asked market participants to comment on two specific areas: the treatment of physically-settled FX transactions, and the question of re-hypothecation. At the same time, it asked for comments on the newly proposed phase-in of initial margin (IM) requirements, and the accuracy and applicability of the results from the Quantitative Impact Study (QIS) conducted as part of the first consultation.

Here are some of the broad themes that emerge from the second consultation:

First, the regulators’ stance towards IM requirements remains unchanged. The IM proposals contained in the second consultation are in line with those of the first consultation, calling for imposing a universal two-way initial margin (IM) requirement on all covered entities (all OTC derivatives participants except for sovereigns, supranationals, central banks and non-systemically important corporates). However, the second consultation excludes entities with aggregate notional amounts of less than €8 billion notional outstanding during the last three months of the preceding year.

Second, while the regulators seem to acknowledge the potential impact of the IM requirements on liquidity, they attempt to mitigate these negative effects by:

  • Phasing in and gradually applying the requirements starting in 2015 with the largest entities (those with more than €3 trillion notional during the last three months of the preceding year), and gradually capturing all covered entities by 2018;
  • Allowing limited netting to be used in connection with the standardized table method;
  • Contemplating (and asking participants about) the possibility of some form of re-hypothecation.

Third, the published QIS results confirm ISDA’s estimates as to the quantum of the proposed IM requirements. If nothing else, the QIS results indicate even higher quantities of required collateral to meet the IM obligations (from $1.7 to roughly $2.2 trillion, if all covered entities use internal models – and from $0.8 to $0.9 trillion – and a potentially higher number, depending on how the €50 million threshold is applied1).

Indeed, reflecting the regulators’ anxiety as to the quantum of the IM proposals, there are some encouraging morsels in the stew, such as the effort to exempt a number of smaller entities. Unfortunately, even in this case, the metric used is notional amounts. Since that is not risk sensitive, it is inconsistent with the overall objective of reducing systemic risk. It would make more sense if the metric used was risk sensitive and, as we suggest in our response, took into account the hedging activities of the entity.

Most importantly, if one takes all of the above into account, the thrust of the consultation and the industry’s response remain more or less unchanged. If the proposed IM requirements go ahead as proposed, the sheer quantum of them is likely to cause irreparable damage to market liquidity and to the general economy. We have repeatedly listed these arguments before in various shapes and forms; in our March paper Non-Cleared OTC Derivatives: Their Importance to the Global Economy; in last November’s presentation Initial Margin For Non-Centrally Cleared Swaps: Understanding the Systemic Implications; and also in a shorter take in a media.comment post from January.

Moreover, as our research in the collateral space expands, so does our anxiety as to the potential effects of the IM proposals to the general economy. Collateral serves a fundamental function in the secured financing market and is a source of liquidity as it is a substitute for money/credit. Removing trillions from the collateral market, however phased-in such requirements are, undoubtedly will have a negative effect on the economy.

And if those adverse effects are not enough, there’s another factor to consider: the IM requirements are highly pro-cyclical, hitting participants at the worst possible time when everyone is on a quest for liquidity. In an effort to enhance systemic resiliency by reducing counterparty risk, we may be introducing other risks, such as liquidity and economic risk, that may make it harder to achieve a more resilient system.

So, for the record, that’s where ISDA stands on the IM issue. If the record sounds a little broken because we have been playing it a lot recently, that’s because we have. These are important issues and it’s clear that their impact needs to be fully assessed before they are finalized and implemented.


1 The new consultation seeks to apply the €50 million threshold on a consolidated basis, potentially neutralizing the benefit this exemption, as the threshold gets divided by the number of entities belonging in the consolidated group.

IM getting serious

Click to open ISDA’s new Initial Margin For Non-Centrally Cleared Swaps Analysis

A key recommendation of the G20 2009 Pittsburgh Communique was to enhance systemic resiliency by reducing bilateral counterparty risk and mandating central clearing of “standardized” OTC derivatives. ISDA and market participants are fully supportive of the G20’s clearing initiatives. Today, more than half the market is cleared and more clearing is on the way.

However, most industry estimates expect that 20 percent or more of the notional value of OTC derivatives cannot be and will not be clearable. Such swaps play an important economic role for the global economy, ranging from housing to corporate financing. Policymakers are hoping to eliminate counterparty risk of these unclearable trades by proposing margin requirements – both initial (IM) and variation margin (VM) – for them.

We fully support mandatory exchange of VM among covered entities. Experience (good and bad) has demonstrated that the practice of frequently exchanging the unrealized mark-to-value fluctuations between two parties is beneficial in reducing counterparty risk. It avoids the build-up of large unrealized positions that could become destabilizing in periods of market stress. This is a widely adopted practice in the OTC derivatives marketplace. And, had this practice been followed – which was NOT the case with AIG and certain monolines in the US – counterparty risk would not be the issue it has become today for the OTC derivatives industry. So, the requirement for VM exchange alone would be more than enough to address counterparty risk concerns.

However, while we support the use of VM, the same can not be said for imposing mandatory IM on counterparties. A rudimentary risk/benefit exercise reveals that the approach is flawed. We see minimal benefits in terms of incremental risk reduction – above and in excess of what is already provided by capital requirements.

Instead, we see huge risks in the making. The outright quantum of margin required under these proposals, even in “normal” market conditions, is significant.

Take, for example, the data that is coming out of the QIS study that the BCBS/IOSCO is conducting. The numbers are revealing. Even if we take the most optimistic scenario (where ALL market participants use some form of internal model to maximize netting benefits), we still estimate incremental margin requirements of approximately $800 billion. This is an amount of incremental collateral which, even under normal circumstances, is challenging to raise.

What’s worse: we know that IM requirements in stressed conditions could go up by at least three times, raising potential requirements at a time when liquidity will be most needed. This is a clear recipe for disaster, only exacerbating systemic risk. And as to the proposed use of thresholds to alleviate the IM impact, at times of crisis, they just make the problem worse. It’s a message we plan to share with supervisors and regulators around the world. (ISDA’s recent analysis of data regarding IM estimates and their impact is here.)

In short, ISDA believes that mandatory, risk sensitive IM will not achieve its purported goals. We instead advocate a three pillar framework for ensuring systemic resiliency: a robust variation margin framework, mandatory clearing for liquid, standardized products and appropriate capital standards.

When It Comes to Sovereign CDS, Collateral is King

We have talked a lot about sovereign CDS exposures being largely collateralized. What exactly do we mean by that? And why is it so important to understand how collateral works?

Exposures between two counterparties under an ISDA Master Agreement are typically subject to one of ISDA’s credit support annexes. Our margin survey indicates that over 70% of derivatives exposure is subject to these arrangements. But some of the entities that are users of other types of derivatives ‒ sovereigns, supranationals and corporates ‒ are not active in CDS. As a result, well over 90% of CDS are subject to collateral arrangements, and these arrangements are virtually all two-way (i.e., either party could post collateral to the other based on the mark-to-market value of trades between them).

With the standardization of CDS contracts resulting from the 2009 Big Bang Protocol, there are now two standard coupons on CDS, 100 basis points for investment grade credits and 500 basis points for high yield names. An upfront payment is made by one party to the other to reflect the present value of the difference between the market rate for buying protection and the standard coupon. Where the reference entity is distressed, a significant amount is paid by the buyer of protection upfront because the market rate for buying protection greatly exceeds the coupon.

This upfront payment feature of the CDS market is distinct from other derivatives markets. But once the upfront payment is made, the collateral practice is the same. The trade is marked to market and collateral is posted. For a distressed reference entity, the protection seller would have to post collateral, but the amount of that collateral would, at least initially, be more or less equivalent to the upfront payment. In effect, the upfront payment from the buyer to the seller becomes the collateral that the seller posts with the buyer. Subsequent, incremental fluctuations in market value will lead to more collateral being posted or some collateral being returned.

To understand the implications of collateral arrangements, let’s take a simple example involving Greek CDS. Let’s assume that Bank A is a net seller of five-year protection and that all of its Greek CDS trades are with one other bank, Bank B.  In this case, Bank A would have posted collateral, primarily cash, to Bank B in an amount equal to the mark-to-market value of the CDS trades. 

As the likelihood of default increases, the value of the contract will increase as well and more collateral will need to be posted, a process that happens daily. So based upon current prices for five-year Greek CDS, Bank A will be posting 62% or so of notional against the Greek protection it has sold. Each day, assuming conditions get worse, the amount of collateral increases. The risk for Bank B is that either Bank A defaults on one of the daily incremental collateral calls or a Greek default occurs and the price of the CDS increases greatly. However, this latter event would hardly constitute an extreme “jump to default” situation, such as where an otherwise creditworthy entity defaults out of the blue, generating a collateral call of 50% or more. So Bank A’s daily collateral requirement will be relatively modest and the replacement cost to Bank B will be modest if, indeed, Bank A should default for whatever reason.

Counterparty risk management for CDS involves assessing the exposure that could arise between one counterparty and another due to a jump to default by a reference entity or a counterparty default on the CDS. How much does it cost to replace the defaulted positions as well as the shortfall in collateral? There is no unsecured exposure before the default. In Bank A’s case, it already has posted 62% against its sold Greek protection.

Collateral management between two dealers is more complex, of course, because all their OTC derivatives contracts are covered by one collateral arrangement. But the principle is the same: how much collateral was not delivered and how much will it cost to replace the positions? Collateral arrangements between dealers are also very efficient due to netting arrangements that enable in the money positions to offset out of the money positions across asset classes.

One final note: Consider what happens when, as is far more likely than not, Bank A performs its obligations under the Greek CDS. When Bank A performs its obligations on the Greek CDS the balance on its collateral arrangements with Bank B will be altered. After payment on the Greek CDS, the net mark-to-market position shifts. Because the Greek CDS trades are settled, Bank A will be able to demand collateral to be returned to it by Bank B.

Collateral is an incredibly powerful and dynamic tool and understanding how it works should, we believe, provide a great deal of comfort to both experienced and casual observers of the sovereign CDS product.