By Fanni Koszeg
Agency rulemaking pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) has brought many controversial rules. In particular, the Commodity Futures Trading Commission (CFTC) receives much criticism from market participants for being overly aggressive in exercising its new authority to regulate the previously largely unregulated $600 trillion-dollar over-the-counter (OTC) derivatives markets.1 In the almost three years since Dodd-Frank's adoption, some final rules have been successfully challenged in court and a number of proposals evoking lots of heated discussion have yet to be finalized. One important, controversial and still pending area of rulemaking is the Dodd-Frank requirement that the CFTC, the Securities and Exchange Commission (SEC), and a group of prudential regulators (Prudential Regulators) impose capital and margin (i.e. collateral) rules for swaps that are not cleared through a registered derivatives clearing organization. How big will this segment of the derivatives market be once mandatory clearing of standardized derivatives is in force? In a recent speech, a Federal Reserve Vice-Chairman quoted International Monetary Fund (IMF) estimates that “one-third of interest rate and credit derivatives and two-thirds of equity, commodity, and foreign exchange derivatives will not be suited to standardization and will remain non-centrally cleared.”2 Accordingly, these derivatives will continue to comprise a substantial portion of the derivatives marketplace and “it will be important to remain vigilant in managing the risks from non-centrally-cleared derivatives exposures.”3
The CFTC and Prudential Regulators issued proposals on margin for non-cleared derivatives in the spring of 2011 and the SEC followed suit late last year for security-based swaps.4 Meanwhile, regulators in the European Union have also proposed new rules and the Basel Committee on Banking Supervision (BIS) and the International Organization of Securities Commissions (IOSCO) published an in-depth consultative study (BIS/IOSCO Study) on the subject.5 The diverse group of regulators involved coupled with strong opposition from affected market participants has made it difficult for regulators to finalize the new rules.6
Most market participants contend that they largely support the intent of new regulations to make derivatives markets more transparent, primarily through mandatory clearing and reporting of standardized derivatives. Nonetheless, many maintain that derivatives markets need flexibility to be efficient and thousands of pages of complex and sometimes contradictory regulations cause uncertainty that may ultimately hamper the flow of credit in the global financial system. According to the International Swaps and Derivatives Association (ISDA), the Prudential Regulators' uncleared margin proposal (PR Proposal) would “severely impact liquidity in the uncleared swap market” and “[ISDA] believe[s] that severely constraining the uncleared swap market would have serious negative economic consequences.”7 On the other hand, while central clearing of derivatives involves holding collateral with a central counterparty (making events of default less disruptive), uncleared derivatives do not benefit from such transparent collateral arrangements and could “pose the same type of systemic contagion and spillover risks that materialised in the recent financial crisis.”8 Better Markets, Inc. (Better Markets), an independent industry organization, argued in its comment letter on the CFTC's margin proposal (CFTC Proposal) that a strict margining system was necessary to avoid a financial crisis similar to 2008 when “large [swap dealers’] excessive uncollateralized derivatives positions plunged the system into turmoil.”9 From this latter perspective, imposing higher collateral requirements on uncleared swap dealing would make markets less risky and would advance Dodd-Frank's policy goals, albeit at the cost of shrinking the volume of such trading.
In the aftermath of the 2008 financial crisis, the tension between preserving market liquidity and reducing systemic risk underlies much of the financial reform debates. Discussions of margin rules, capital requirements, and other rules will continue through 2013, likely longer. This article presents the most contentious aspects of the margin proposals and analyzes the main arguments for and against strict regulation of uncleared derivatives.
Dodd-Frank split the authority to establish margin requirements for uncleared derivatives in three, based on which regulator supervises the entity that is entering into the uncleared derivative transaction:
The PR Proposal and the CFTC Proposal were released almost two years ago, generating considerable negative reaction from market participants. The comment period was re-opened for both proposals after the BIS/IOSCO Study came out last year.10 The SEC drafted and released its own version (SEC Proposal) late last year taking into account the international input. ISDA has been very critical of the PR Proposal and the CFTC Proposal alike, but found the SEC's approach somewhat more sensible. Others, like Better Markets, argued that none of the proposals goes far enough in establishing strict collateral requirements for uncleared swaps. All U.S. regulators as well as the BIS/IOSCO Study support aligning the rules across global markets, but, in practice, this may be the hardest goal to achieve.
Dodd-Frank added section 4s(e) to the Commodity Exchange Act (CEA) to address capital and margin requirements for Swap Entities. The plain text of the law requires that margin rules for uncleared derivatives should be established across the board. The BIS/IOSCO Study's presumption is also that “margin requirements apply to all non-centrally-cleared derivatives.” However, there is some room for regulators to exempt certain types of entities from the regulations. The CFTC Proposal and the SEC Proposal would exempt commercial end-users assumed to be hedging their commercial risk, but the PR Proposal, in its original form, would not. The BIS/IOSCO Study stated that “the margin requirements need not apply to non-centrally-cleared derivatives to which non-financial entities that are not systemically-important are a party, given that (i) such transactions are viewed as posing little or no systemic risk and (ii) such transactions are exempt from central clearing mandates under most national regimes.”11
Defining the parameters of what entity should qualify as an end-user has been a much-discussed aspect of a number of rules, including rules on reporting, clearing, and trading. The CFTC adopted a final rule exempting end-users from clearing and provided general guidance on how to interpret the rule, but refused to provide specific examples of entities that would qualify for the exemptions.12 Qualifying for the exemption would significantly lower the cost of entering into uncleared derivatives, which matters greatly to market participants of all stripes. For example, ISDA has argued for going beyond what the CFTC has proposed and suggested that uncleared derivatives transactions entered into by end-users, special purpose vehicles (SPVs), and state and municipal governments should not be covered because those do not contribute to systemic risk.13 The Alternative Investment Management Association (AIMA), an industry group representing hedge funds (entities that generally would not be considered Swap Entities) also submitted comments to the CFTC. AIMA suggested that in addition to non-financial end-users and low-risk financial end-users, all “financially sound” financial end-users, such as hedge funds, should be able to benefit from the provision that under a certain threshold they would not have to post initial margin.14 In AIMA's opinion, margin requirements should be tailored more closely to the creditworthiness of the counterparties.
A key principle in the BIS/IOSCO Study is that “[a]ll financial firms and systemically-important non-financial entities (”covered entities“) that engage in non-centrally-cleared derivatives must exchange initial and variation margin as appropriate to the risks posed by such transactions.”15 The text of the CEA also requires that “the prudential regulators, in consultation with the [CFTC] and the Securities and Exchange Commission, shall jointly adopt rules for swap dealers and major swap participants, with respect to their activities as a swap dealer or major swap participant, for which there is a prudential regulator imposing—
(i) capital requirements; and
(ii) both initial and variation margin [emphasis added] requirements on all swaps that are not cleared by a registered derivatives clearing organization.“16
Initial margin is an amount of collateral parties are required to provide to each other at the inception of a transaction to account for the potential consequences of default. This is usually determined based on the market value of the contract, the type and riskiness of the collateral, and counterparty risk, among others. Variation margin is a periodic adjustment of the margin depending on changes in the value of the contract. Both the CFTC Proposal and the PR Proposal impose initial margin requirements and allow Swap Entities to use internal models to calculate this amount (subject to approval by the relevant regulator prior to use).
How to calculate initial margin and whether it is at all necessary has been one of the most contested aspects of the proposals. ISDA has argued in its comment letters and elsewhere that the proposed initial margin requirements are “exceptionally burdensome” and “the amount required would vastly exceed the amount that the market could post.”17Instead, ISDA proposes to reduce systemic risk by imposing robust variation margin requirements with daily collection and zero thresholds. This is the approach market participants generally already have in place and would accordingly require far less of an additional investment in market infrastructure and systems. Better Markets, on the other hand, argued that initial margin and variation margin are two essential pieces in ensuring there is sufficient collateral available in an event of default. Better Markets quoted swap clearing house LCH.Clearnet's description of variation margin to support the argument that variation margin, on its own, would be insufficient:
Better Markets, on the other hand, has argued that regulators should not consider widening the list of eligible collateral much beyond cash and government securities because “in a stressed market situation, liquidity mismatches are often fatal.”21 In such a situation, market participants start demanding cash collateral, which is more difficult to obtain when assets normally provided as collateral are relatively illiquid. In addition, allowing a company's public securities to serve as collateral can have significant negative effects on those securities if swap counterparties start liquidating the securities in large volumes to respond to cash collateral demands from other parties. These sorts of problems transpired during the financial crisis of 2008 and in Better Markets' estimation are best avoided going forward by limiting eligible collateral to the most highly liquid assets.
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