When the inherent weaknesses and cracks in the OTC (over-the-counter) derivative market’s operating model became so perceptible in the aftermath of the financial crisis, there was one thing global regulators could collectively agree on, namely that CCPs (central counterparty clearing houses) had performed their role indomitably. This was illustrated perfectly by the actions at LCH, which not only successfully unwound Lehman Brothers’ $9 trillion interest rate swap portfolio, but did so using up only one third of its initial margin.
As a result, legislators across the world mandated financial institutions centrally clear their vanilla OTC transactions through CCPs. These policies have had their intended effects. Nowadays, 55% of outstanding credit default swaps (CDS) are centrally cleared, as are 72% of interest rate derivatives denominated in euros. Nonetheless, of the $594.8 trillion in notional outstanding OTC contracts, a decent sized percentage continues to be uncleared and traded bilaterally, as they are considered too risky or adventurous for CCPs to process.
In response, the Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commissions (IOSCO) published their “Final Framework on Margin Requirements for non-centrally cleared Derivatives”, calling for global standards to be applied on bilateral OTC contracts. The document endorsed the phasing in of margining requirements for non-cleared OTCs in order to offset the risk of these transactions becoming under-collateralised, a problem which could have systemic consequences.
In the EU, initial margining requirements for bilateral OTCs began to apply in September 2016 as part of the European Market Infrastructure Regulation (EMIR). It initially impacted any financial institution with an average aggregate notional amount in excess of ¤3 trillion in OTC contracts, although this was reduced to ¤1.5 trillion in September 2018. As of September 2019, that threshold will drop down to ¤750 billion before settling on ¤8 billion in 2020, an amount which is broadly synchronised with other major markets.
“The latest batch of clients being impacted by the rules are taking action to comply far sooner than we have seen in previous years,” says Dominick Falco, head of collateral segregation at BNY Mellon. “During the first three phases of initial margining for bilateral OTC derivatives, clients gave us collateral management mandates in and around Q1 of the compliance year. Ahead of phase four in September 2019, clients were already awarding us mandates in Q3 and Q4 of 2018. Even now, we are receiving RFPs from customers preparing for phase five in 2020,” he added.
First hurdle: Brexit
While many industries are still starring down the barrel, unsure how their businesses will cope with the potential disruption Brexit will bring, those trading OTC derivatives bilaterally have been given something of a temporary lifeline.
In November 2018, the European Banking Authority, the European Insurance and Occupational Pensions Authority (EIOPA) and ESMA together with the European Supervisory Authorities (ESA) published draft regulatory technical standards (RTS) on the risk mitigation techniques for uncleared OTCs under EMIR post-Brexit.
A number of EU financial institutions with UK counterparties were alarmed that under a no-deal, their bilateral OTC trades could be subject to mandatory clearing, adding tremendous costs to their operations. However, the RTS has helped soothe the market albeit temporarily.
The RTS states that in the event of no-deal, the EU will introduce a limited exemption to facilitate novation of certain OTC contracts to EU counterparties for a brief period exempting firms from having to clear their trades. “In the event of a no-deal Brexit, ESMA is introducing a one-year grandfathering period of collateral exchange to facilitate novation in the EU27 area for OTC contracts dealt with UK counterparties that were not subject to the collateral exchange obligation when dealt in the UK,” says Francois Baratte, senior industry affairs advisor at ALFI (Association of the Luxembourg Fund Industry).
Thresholds come under fire
Despite the regulation’s positive intentions, the initial margin thresholds have not been immune from controversy. The International Swaps and Derivatives Association (ISDA) along with other industry bodies including the Securities Industry and Financial Markets Association (SIFMA), the American Bankers Association (ABA), the Global Foreign Exchange Division of the Global Financial Markets Association (GFMA) and the Institute of International Bankers (IIB) have called for a recalibration of the proposed final initial margin thresholds, asking that they be raised from EUR/USD 8 billion to EUR/USD 100 billion.
Karen Stretch, a senior associate specialising in derivatives at international law firm Dechert in London, acknowledges global regulators were facing pushback on the low initial margin thresholds from the industry. “The sentiment is that the EUR/USD 8 billion threshold – currently proposed by regulators – will impact a lot of financial institutions and counterparties yielding very limited overall benefits. In both Europe and the US, there is now widespread discussion and calls by groups such as ISDA and other market participants to increase the threshold,” she explains.
ALFI has also been vocal on the initial margining requirements. “When meeting with the Basel Committee, ALFI provided support to the survey issued by ISDA in September 2018. Firstly, the gross notional threshold for phase five should indeed be raised to EUR/USD 100 billion, as the current EUR/USD 8 billion is far too burdensome and counterproductive an obligation for the smaller firms,” adds Baratte.
As these reforms take hold, the pool of firms who will be expected to margin their bilateral OTCs is expected to dramatically widen. To preserve the integrity of the bilateral OTC market, those counterparties will need to post creditworthy securities – such as cash or highly rated government bonds – as margin. While some experts have said firms are adequately prepared for these new requirements, others are not so optimistic. “Among Category five (firms) – the readiness – as assessed by ISMA (International Securities Markets Association) and SIFMA – is limited,” comments Sarj Panesar, global head of business development – asset managers, Societe Generale Securities Services (SGSS).
With more financial institutions now under an obligation to margin, there are concerns a shortage of eligible collateral could materialise leading to potential inefficiencies in the OTC market. Such fears are not novel. Prior to the first migration of OTCs into clearing, experts predicted collateral would become scarce making it difficult for market participants to trade or hedge risk. While obtaining collateral is not always a smooth exercise for OTC users, the collateral shortfall risk has been wildly over-hyped in some quarters, mainly because financial institutions are now posting different assets as collateral to counterparties.
BNY Mellon’s Falco acknowledges that financial institutions are looking beyond just AAA-rated government bonds and posting money market funds as collateral on some transactions. This should certainly help contain any shortfalls arising. Baratte advocates for an enlargement of eligible and accepted collateral. “Under the current observed practices, cash is – most of the time – the only underlying accepted. Other types of assets like HQLA (high-quality liquid assets) securities and liquid ETFs (exchange traded funds) should be considered as eligible collateral,” he says.
While there is arguably plenty of collateral available to meet all of the incoming margining requirements, identifying where it is located may not be as simple as many people think. Firstly, the repo market has declined sharply over the last few years, as the flight by banks and large institutional investors to HQLA has been perpetuated by regulations such as Basel III and Solvency II, both of which are designed to shore up the balance sheet strength at systemically important financial institutions (SIFIs).
However, banks have found innovative solutions though enabling buy-side clients to fulfil their newfound margining needs. Collateral transformations, for example, turn equities into eligible collateral such as government bonds and are offered by a number of broker-dealers and prime brokers to fund manager clients. These transactions not only help investment firms margin their OTCs, but it allows banks to lend out those same equities to borrow HQLAs in order to meet their Liquidity Coverage Ratio (LCR) obligations.
Meanwhile, tri-party collateral management, a service provided by a number of custodian banks and international central securities depositories (ICSDs) is a growing business too. This service enables managers to outsource their collateral management activities to third-parties, whose technology, automation and scalability helps firms optimise their collateral movements in a more cost-effective manner than if they were performing the role in-house.
The OTC derivatives machine did not clog up when the first rounds of compulsory clearing went live. While a number of market participants are undeniably irritated by the low initial margin thresholds, one expert – who did not want to be named – said it was too difficult to predict whether the regulators would increase the current ceiling. Consequentially, it would be wrong for impacted firms to hold off preparing for the rules.