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.

No Margin for Error

On Friday, ISDA submitted its response to the BCBS/IOSCO proposal on Margin Requirements for Non-Centrally Cleared Derivatives. This is one of the most important issues today in financial regulation. It is not hyperbole to suggest that the future of OTC markets depends on getting it right. Less apparent, but equally true, is that the resiliency of the financial system does too.

Broadly speaking, the BCBS/IOSCO proposal aims to reduce counterparty risk, a goal ISDA shares. But they seek to do it by imposing a universal two-way initial margin (IM) requirement on all covered entities. Covered entities are defined as all OTC derivatives participants except for non-systemically important corporates, sovereigns and central banks. The proposals also call for variation margin (VM) exchange by all covered entities. And if the above were not enough, the proposals call for collateral exchanged to remain segregated and not be re-hypothecated.

It is obvious that the BCBS/IOSCO proposal aims to replicate the mechanics found in the context of clearing. CCPs seek to completely insulate themselves through the imposition of VM (which settles unrealized gains/losses), and IM (meant to provide a cushion to absorb losses that may materialize in trying to cover its risk if a counterparty defaults). By doing so, CCPs effectively neutralize (to a 99% confidence interval) counterparty risk.

And there lies the rub.

In the context of a CCP, such a minimization of counterparty risk is appropriate and the utilization of VM and IM are tools (along with their default funds) used to accomplish this objective. CCPs are not supposed to take credit risk themselves, but to pass through the benefits associated with multi-lateral clearing. However, extending these concepts to the bilateral context is inappropriate, because the parties involved are typically creditworthy entities on their own, and back their creditworthiness with their own capital as well as the proper use of credit mitigants.

So, imposing mandatory margin requirements on bilateral trades would be tantamount to insuring for the same risk twice.

We can understand – and in fact, we fully agree with – the 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 very beneficial in terms of reducing counterparty risk. It helps avoid the build-up of large unrealized positions that could become destabilizing in periods of market stress. This is a widely adopted practice among practitioners in the OTC derivatives markets. Had this practice been followed by AIG and certain monolines in the US, counterparty risk would probably not have become such a big issue.

While the requirement for VM exchange alone would be more than enough to address counterparty risk concerns, the BCBS/IOSCO proposal goes a step further. In order to further reduce counterparty risk in the eventuality that one of the parties in a bilateral trade defaults, they call for IM to establish a buffer. The buffer – the IM – is meant to absorb any losses realized during the time (10 days) when the non-defaulting party is closing out or replacing the risk it had with the defaulting party. This innocuous step has huge unintended consequences.

In addition to being unnecessary (as this exposure is typically covered by other risk mitigants that the two parties typically agree among them), this arrangement is inefficient. That’s because BOTH parties are required to post IM – but only one defaults. It would also require all covered entities to create new set ups to meet these requirements (be they in the form of new operational processes, cash and collateral and custodian management needs, new agreements etc.). All of this implies higher costs for derivatives users as they will bear the increased cost of doing business, irrespective of whether they are covered entities or not.

Unfortunately, the detrimental effects of this proposal do not stop here. While one cannot argue with the intentions of the regulators to reduce counterparty risk, it seems that the potential implications of this proposal have been grossly underestimated. The combination of requiring the posting of an across-the board two-way IM – which has to be segregated and cannot be re-hypothecated – leads to some very large collateral requirements.

ISDA has performed some preliminary analysis to gauge the potential demand for collateral that this proposal could generate. If this were to be implemented on the existing portfolio of non-cleared OTC derivatives outstanding, incremental collateral demand could run as high as $15.7 trillion.

Now $15.7 trillion may sound like a very large number. It is! But for all practical purpose, any number above a couple of trillion would make the cost of meeting such requirements prohibitive – even if it is feasible at all to locate so much collateral. Collateral demand in such amounts is likely to cause irreparable damage both to the OTC derivatives market, but also to the general economy.

So, once again we have come full circle. Risk does not disappear. It just changes form. Regulators have initiated margin proposals to enhance systemic resiliency by reducing counterparty risk. But in the process of doing so, they are about to decrease systemic resiliency by introducing healthy amounts of liquidity risk (caused by the shortage of collateral) and economic risk (caused either by the shortage of liquidity and/or by all the economic risks that are likely to remain unhedged).

Is There a Better Way?

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.

Do the Sums Add Up?

Earlier this month, ISDA published a short paper entitled Counterparty Credit Risk Management in the US Over-the-Counter (OTC) Derivatives Market. The paper used data prepared by the Office of the Comptroller of the Currency (OCC) to examine the extent of losses related to counterparty defaults from 2007 through the first quarter of 2011. During that entire period, the US banking system sustained losses of $2.7 billion on counterparty defaults on OTC derivative contracts. This includes nearly $850 million of losses in the fourth quarter of 2008, which is when we believe losses associated with Lehman were recognized. This leaves less than $2 billion of counterparty losses not related to Lehman.

We were surprised at these relatively small figures as we remembered large synthetic CDOs inflicting very large losses on financial institutions. The OCC data covered just banks so we looked harder. We found very substantial counterparty losses in non-bank affiliates of banks and broker-dealers outside the banking system. These losses were related to mortgage products and they verified our understanding of the market. We were, though, still surprised by the very small counterparty losses sustained by the banking system.

We then decided to model how these exposures and losses might be impacted by the clearing and margining regulations stemming from the Dodd-Frank Act. A portion of the losses were due to corporations that defaulted amid the troubles that followed 2008. These users will be exempt from clearing under most sets of proposed regulation. Another portion must have come from entities, such as hedge funds, that defaulted on mortgage and other complex products that could not be cleared.

The balance of counterparty losses were caused, most likely, by defaults of financial entities that will be required to clear their transactions under the new regulations, and the defaults occurred on these very same transactions. If these transactions had been cleared, then it stands to reason that counterparty losses by US banks would have been lower. This raises an interesting question:  how beneficial would clearing and initial margining have been for US banks?

The reason we ask this question is the pure cost of initial margin related to clearing. ISDA estimates that initial margin will amount to anywhere from $200 billion to $500 billion of collateral once clearing is complete. The “cost” of this collateral might be 50 basis points; it might be 100 basis points. That’s a minimum of $1 billion per year and a maximum of $5 billion per year. These estimates are global costs. Perhaps the cost to customers of US banks is $250 million to $2 billion per year. These costs need to be considered when contemplating the benefits of clearing and the need for initial margin.
So let’s consider what this means in light of the counterparty loss experience of US banks. As noted, we have a firm upper bound of $2 billion of costs (the counterparty losses not related to Lehman) that could be attributed to the absence of initial margin. But let’s make some assumptions. First, let’s assume half the losses were attributed to defaults by corporations. That reduces the losses caused by financial institutions to $1 billion. These losses were caused by a combination of:

  • no variation margin on clearing eligible products;
  • no or insufficient margin on products not clearing eligible; and
  • variation margin but no initial margin or insufficient initial margin on clearing eligible products.

It is impossible to quantify these respective losses but common sense indicates that a large majority came from lack of variation margin or from products that are not clearing eligible. We will hazard a guess and say those two causes accounted for 80% of the $1 billion of losses from the defaults of entities that would now be subject to clearing. That leaves $200 million as the benefit of initial margin over a period of four and a quarter years. Our numbers and analysis don’t have to be exact. We shake our heads and wonder: we spend hundreds of millions a year and save tens of millions?

Readers: are we missing something?