Navigating the labyrinth
04 November 2014
Etienne Ravex of Murex outlines how BCBS/IOSCO’s final framework for
non-cleared derivatives has created a new risk management paradigm
Image: Shutterstock
While most of the focus on derivatives reform has been on cleared trades, changes are also coming to bilateral, non-cleared derivatives starting in 2015. These important shifts are directing market participants to reevaluate how they manage risk in this space. There are major changes ahead and risk and collateral managers have choices to make in the new environment.
Regulators have used the powers at their disposal to make centrally cleared trades more economically attractive than bilateral. Despite the extra costs and complexity, shifting to an exclusively cleared derivatives environment is not possible. Bilateral trades will remain an important part of the market. To be sure, some trades that are currently bilateral but can be cleared will migrate over time, but many trades are not suitable for central clearing. Certain trade types or clients have been exempted. Those that remain non-cleared will suffer through a complex labyrinth of rules and regulations.
Background
In 2009 when the G20 leaders met in Pittsburgh to hash out the direction of derivatives market, the final communiqué stated: “Non-centrally cleared contracts should be subject to higher capital requirements.” Since then, regulations have changed: centrally cleared trades are preferred to bilateral and regulations should influence the market in that direction.
After much debate, Margin Requirements for Non-Centrally Cleared Derivatives, published by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) in September 2013, presented the final framework on how market participants will manage risk and collateral for non-cleared derivatives.
A new framework for non-cleared derivatives and collateral
Bilateral trades between a derivatives dealer and a client are governed by an International Swaps and Derivatives Association (ISDA agreement, typically with a Credit Support Annex (CSA) that outlines collateral arrangements. Historically, many CSAs did not require highly rated counterparties to post initial margin (IM)—dealers absorbed the exposure as a cost of doing business. Looking back at lessons learned from AIG, regulators saw this lack of margin as a source of systemic risk and have been working on a fix. The objective is to move the market from a ‘survivor pays’ model to ‘defaulter pays’ by collecting sufficient IM upfront to absorb adverse price movements in the case of a counterparty default.
Rules released by BCBS/IOSCO for non-cleared derivatives trades will make bilateral derivatives more complicated and more expensive. Included are higher capital costs relative to cleared trades, funding valuation adjustment (FVA) and credit valuation adjustment (CVA) charges, complex margining processes, and higher initial margins. Today, between 34—40 percent of derivatives trades are non-cleared and ISDA expects a substantial percentage of the market to remain that way. This will leave a sizeable portion of the derivatives market subject to a broader set of rules and higher costs.
Currently the largest segment of non-clearable swaps are swaptions and cross-currency swaps (roughly $30 trillion each). Other non-clearable derivatives include clearable products in non-clearable currencies (eg, Korean won, Brazilian real, and Mexican peso).
The first rule to take effect will be IM on 1 December 2015, and then only for derivatives books with more than €3 trillion in notional. Over time, the threshold will fall, when on 1 December 2019 the IM requirement will affect applicable derivatives portfolios above €8 billion. The schedule is (notional is determined by calculating the average notional of non-centrally cleared derivatives for June, July, and August month-ends):
1 December 2015 to 30 November 2016: €3 trillion
1 December 2016 to 30 November 2017: €2.25 trillion
1 December 2017 to 30 November 2018: €1.5 trillion
1 December 2018 to 30 November 2019: €750 billion
1 December 2019: €8 billion
Variation margin (VM) will be mandatory on trades executed on or after 1 December 2015.
Participants and exclusions
The new regulations are intended to affect financial institutions and systemically important non-financials. Systemically, important non-financials is a poorly defined term and few derivatives players would fall under this category. Sovereigns and supra-nationals are exempted, although some, including Germany, are voluntarily deciding to post collateral as a risk management and cost improvement tool. Physically settled foreign exchange transactions associated with the exchange of principal, notably including cross-currency swaps, are also partly exempted from the new rules.
As a practical matter, phase-ins periods and IM thresholds mean that only the largest derivatives market participants should worry about current changes. But those large players will see substantial complexity added in the way they manage their bilateral trades.
While collecting VM is a common market practice, the BCBS/IOSCO rules make it somewhat more complicated. Only cumulative IM above €50 million with any counterparty, calculated on a consolidated basis, need be collected by any derivatives dealer. By using a €50 million threshold, BCBS/IOSCO says there will be substantial savings for those otherwise obliged to post IM. They estimate that the amount of margin needed with a zero threshold is more than double compared to the higher threshold.
In addition, no IM will be required when there is no counterparty risk. For example, when a client buys a European option from a dealer for a premium, the option buyer is now exempt from posting IM as the option seller has no credit exposure to it. The risk is only that the dealer makes good should the option value come into the money. The seller of the option has no counterparty risk exposure.
Which margining model to use?
One area of controversy is what the IM and VM models will look like. BCBS/IOSCO will allow the use of either internal or standardised margin models. Internal models must be approved by regulators, much like capital models.
However, market participants must incorporate a 99 percent confidence 10-day margin period when calculating IM amounts. This is more onerous than centrally cleared trades (which typically use a five-day margin period) or exchange cleared derivatives (that often use a one day margin period). As a result, IMs will be higher on a bilateral trade versus similar risk in other forms.
BCBS/IOSCO has mandated that trades be divided by type, suggesting a breakdown by currency/rates, equity, credit or commodities. Margin would be collected on a gross basis for each trade risk type. Netting would only be applied within risk buckets. This could make overall IM requirements higher by not taking into consideration negatively correlated cross-bucket transactions.
Models will be calibrated using historical prices that intentionally include periods of market stress. BCBS/IOSCO requires this analysis to be further divided by trade type: “[T]he period of financial stress used for calibration should be identified and applied separately for each broad asset class for which portfolio margining is allowed.”
The BCBS/IOSCO rules allow for a standardised model but make it more expensive to follow this route than relying on an internal model. For example, the standardised model uses set haircuts on collateral in contrast to internal models that are calculated by each firm. For internal models, there is no specific register of acceptable collateral although BCBS/IOSCO has suggested a list that includes cash, government bonds, high quality corporates, high quality covered bonds, equities included in major stock indices, and gold.
Derivatives dealers will be responsible for maintaining best practices, including diversification, credit quality, liquidity, and avoiding correlation or wrong way risk. BCBS/IOSCO has estimated that standardised model IM could be as much as 11.1 times higher versus internal models. ISDA has estimated that IM under the standardised model could be as a high as €8 trillion, even with a €50 million threshold.
In the standardised model, there is an 8 percent haircut on collateral when there is an FX mismatch (on top of the normal asset haircuts). For IM, this creates a two-level exposure netting process with four asset class buckets on one level, rolling up to a currency level above, at which allocation of eligible collateral will be performed. This makes it particularly complex to monitor portfolios that go across currencies. Cross-currency collateral creates an additional layer of operational and timing risk (also known as Herstatt risk).
The European Banking Authority (EBA) has clarified the regulatory subtlety concerning the application of an FX mismatch to both VM and IM. Catering for constraints, while a feature of capital calculation systems for years, is new to collateral systems. The schedule-based haircuts are designed to encourage internal models.
ISDA and the standard initial margin model
ISDA has advocated that a market-wide internal model be established: the standard initial margin model (SIMM). A single model is more transparent to the entire marketplace than each firm supporting its own internal model. It puts each derivatives dealer on a level playing field, preventing investors from shopping for the most advantageous model for a given trade. Another benefit is to avoid each dealer having its own black box, which would complicate replication of results and make dispute resolution significantly easier.
On the negative side, it will be a challenge for dealers to arrive at a consensus for a single market-wide model, much less regulators. There is also the potential for systemic risk created when every participant is using the same model.
ISDA has also argued that the idea of bucketing trades by type (eg, currency/rates, equity, credit or commodities) is not appropriate. Many trades, according to ISDA, cannot be cleanly split by risk type and are often some hybrid of risks. ISDA has suggested a model that decomposes trades into specific risk factors, then aggregates, taking into account risk factor offsets.
Rehypothecation rules
BCBS/IOSCO has incorporated a new process to control rehypothecation of collateral held for non-centrally cleared derivatives trades. Addressing the fear that long collateral chains of rehypothecated collateral would introduce systemic risk, regulators have mandated a shortening of the chains by limiting rehypothecation to a single turnover.
This ‘one and done’ approach limits the collateral movement to trades that hedge the dealer’s position. In addition, the recipient of the collateral must protect the original customer’s rights in the collateral and agree not to rehypothecate the collateral further. Precisely how this can work with cash, given its fungibility, is not clear. Perhaps the currency can be invested in triparty repo with one agreement per original customer.
But, given the intermediate position of the derivatives dealer and the potential for being caught up in a complicated chain that protects the original customer should the derivatives dealer go bankrupt, it may not be worth the effort. The rule does not apply to bilateral trades with other derivatives dealers. Interestingly, within Europe, rehypothecation of IM collateral has been banned outright by the EBA.
Complexity and technology
The complexity introduced by the BCBS/IOSCO regulations will be a challenge to manage and requires world-class technology. Non-cleared derivatives sit on top of an already intricate series of rules that collateral management systems must apply and optimise.
The systems environment that supports this activity needs to understand not only the constraints placed by the regulatory and business environment, but also the idiosyncratic preferences and needs of each user. Equally as important, systems must work flawlessly with upstream and downstream technology.
At Murex, we adapt our systems to fit client business models, not the other way around. This comes from deep expertise in the evolving regulatory environment, a keen understanding and respect for client needs.
Murex brings decades of building ground breaking technology solutions for a variety of client profiles including the largest and most sophisticated capital markets institutions in the world.
MX.3 is the culmination of the massive investment necessary to bring an end-to-end platform that can make a difference to how effectively clients can execute their strategy. That investment will not stop any time soon. Murex will constantly refine and improve its risk and collateral management platforms in order to keep a step ahead.
Regulators have used the powers at their disposal to make centrally cleared trades more economically attractive than bilateral. Despite the extra costs and complexity, shifting to an exclusively cleared derivatives environment is not possible. Bilateral trades will remain an important part of the market. To be sure, some trades that are currently bilateral but can be cleared will migrate over time, but many trades are not suitable for central clearing. Certain trade types or clients have been exempted. Those that remain non-cleared will suffer through a complex labyrinth of rules and regulations.
Background
In 2009 when the G20 leaders met in Pittsburgh to hash out the direction of derivatives market, the final communiqué stated: “Non-centrally cleared contracts should be subject to higher capital requirements.” Since then, regulations have changed: centrally cleared trades are preferred to bilateral and regulations should influence the market in that direction.
After much debate, Margin Requirements for Non-Centrally Cleared Derivatives, published by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) in September 2013, presented the final framework on how market participants will manage risk and collateral for non-cleared derivatives.
A new framework for non-cleared derivatives and collateral
Bilateral trades between a derivatives dealer and a client are governed by an International Swaps and Derivatives Association (ISDA agreement, typically with a Credit Support Annex (CSA) that outlines collateral arrangements. Historically, many CSAs did not require highly rated counterparties to post initial margin (IM)—dealers absorbed the exposure as a cost of doing business. Looking back at lessons learned from AIG, regulators saw this lack of margin as a source of systemic risk and have been working on a fix. The objective is to move the market from a ‘survivor pays’ model to ‘defaulter pays’ by collecting sufficient IM upfront to absorb adverse price movements in the case of a counterparty default.
Rules released by BCBS/IOSCO for non-cleared derivatives trades will make bilateral derivatives more complicated and more expensive. Included are higher capital costs relative to cleared trades, funding valuation adjustment (FVA) and credit valuation adjustment (CVA) charges, complex margining processes, and higher initial margins. Today, between 34—40 percent of derivatives trades are non-cleared and ISDA expects a substantial percentage of the market to remain that way. This will leave a sizeable portion of the derivatives market subject to a broader set of rules and higher costs.
Currently the largest segment of non-clearable swaps are swaptions and cross-currency swaps (roughly $30 trillion each). Other non-clearable derivatives include clearable products in non-clearable currencies (eg, Korean won, Brazilian real, and Mexican peso).
The first rule to take effect will be IM on 1 December 2015, and then only for derivatives books with more than €3 trillion in notional. Over time, the threshold will fall, when on 1 December 2019 the IM requirement will affect applicable derivatives portfolios above €8 billion. The schedule is (notional is determined by calculating the average notional of non-centrally cleared derivatives for June, July, and August month-ends):
1 December 2015 to 30 November 2016: €3 trillion
1 December 2016 to 30 November 2017: €2.25 trillion
1 December 2017 to 30 November 2018: €1.5 trillion
1 December 2018 to 30 November 2019: €750 billion
1 December 2019: €8 billion
Variation margin (VM) will be mandatory on trades executed on or after 1 December 2015.
Participants and exclusions
The new regulations are intended to affect financial institutions and systemically important non-financials. Systemically, important non-financials is a poorly defined term and few derivatives players would fall under this category. Sovereigns and supra-nationals are exempted, although some, including Germany, are voluntarily deciding to post collateral as a risk management and cost improvement tool. Physically settled foreign exchange transactions associated with the exchange of principal, notably including cross-currency swaps, are also partly exempted from the new rules.
As a practical matter, phase-ins periods and IM thresholds mean that only the largest derivatives market participants should worry about current changes. But those large players will see substantial complexity added in the way they manage their bilateral trades.
While collecting VM is a common market practice, the BCBS/IOSCO rules make it somewhat more complicated. Only cumulative IM above €50 million with any counterparty, calculated on a consolidated basis, need be collected by any derivatives dealer. By using a €50 million threshold, BCBS/IOSCO says there will be substantial savings for those otherwise obliged to post IM. They estimate that the amount of margin needed with a zero threshold is more than double compared to the higher threshold.
In addition, no IM will be required when there is no counterparty risk. For example, when a client buys a European option from a dealer for a premium, the option buyer is now exempt from posting IM as the option seller has no credit exposure to it. The risk is only that the dealer makes good should the option value come into the money. The seller of the option has no counterparty risk exposure.
Which margining model to use?
One area of controversy is what the IM and VM models will look like. BCBS/IOSCO will allow the use of either internal or standardised margin models. Internal models must be approved by regulators, much like capital models.
However, market participants must incorporate a 99 percent confidence 10-day margin period when calculating IM amounts. This is more onerous than centrally cleared trades (which typically use a five-day margin period) or exchange cleared derivatives (that often use a one day margin period). As a result, IMs will be higher on a bilateral trade versus similar risk in other forms.
BCBS/IOSCO has mandated that trades be divided by type, suggesting a breakdown by currency/rates, equity, credit or commodities. Margin would be collected on a gross basis for each trade risk type. Netting would only be applied within risk buckets. This could make overall IM requirements higher by not taking into consideration negatively correlated cross-bucket transactions.
Models will be calibrated using historical prices that intentionally include periods of market stress. BCBS/IOSCO requires this analysis to be further divided by trade type: “[T]he period of financial stress used for calibration should be identified and applied separately for each broad asset class for which portfolio margining is allowed.”
The BCBS/IOSCO rules allow for a standardised model but make it more expensive to follow this route than relying on an internal model. For example, the standardised model uses set haircuts on collateral in contrast to internal models that are calculated by each firm. For internal models, there is no specific register of acceptable collateral although BCBS/IOSCO has suggested a list that includes cash, government bonds, high quality corporates, high quality covered bonds, equities included in major stock indices, and gold.
Derivatives dealers will be responsible for maintaining best practices, including diversification, credit quality, liquidity, and avoiding correlation or wrong way risk. BCBS/IOSCO has estimated that standardised model IM could be as much as 11.1 times higher versus internal models. ISDA has estimated that IM under the standardised model could be as a high as €8 trillion, even with a €50 million threshold.
In the standardised model, there is an 8 percent haircut on collateral when there is an FX mismatch (on top of the normal asset haircuts). For IM, this creates a two-level exposure netting process with four asset class buckets on one level, rolling up to a currency level above, at which allocation of eligible collateral will be performed. This makes it particularly complex to monitor portfolios that go across currencies. Cross-currency collateral creates an additional layer of operational and timing risk (also known as Herstatt risk).
The European Banking Authority (EBA) has clarified the regulatory subtlety concerning the application of an FX mismatch to both VM and IM. Catering for constraints, while a feature of capital calculation systems for years, is new to collateral systems. The schedule-based haircuts are designed to encourage internal models.
ISDA and the standard initial margin model
ISDA has advocated that a market-wide internal model be established: the standard initial margin model (SIMM). A single model is more transparent to the entire marketplace than each firm supporting its own internal model. It puts each derivatives dealer on a level playing field, preventing investors from shopping for the most advantageous model for a given trade. Another benefit is to avoid each dealer having its own black box, which would complicate replication of results and make dispute resolution significantly easier.
On the negative side, it will be a challenge for dealers to arrive at a consensus for a single market-wide model, much less regulators. There is also the potential for systemic risk created when every participant is using the same model.
ISDA has also argued that the idea of bucketing trades by type (eg, currency/rates, equity, credit or commodities) is not appropriate. Many trades, according to ISDA, cannot be cleanly split by risk type and are often some hybrid of risks. ISDA has suggested a model that decomposes trades into specific risk factors, then aggregates, taking into account risk factor offsets.
Rehypothecation rules
BCBS/IOSCO has incorporated a new process to control rehypothecation of collateral held for non-centrally cleared derivatives trades. Addressing the fear that long collateral chains of rehypothecated collateral would introduce systemic risk, regulators have mandated a shortening of the chains by limiting rehypothecation to a single turnover.
This ‘one and done’ approach limits the collateral movement to trades that hedge the dealer’s position. In addition, the recipient of the collateral must protect the original customer’s rights in the collateral and agree not to rehypothecate the collateral further. Precisely how this can work with cash, given its fungibility, is not clear. Perhaps the currency can be invested in triparty repo with one agreement per original customer.
But, given the intermediate position of the derivatives dealer and the potential for being caught up in a complicated chain that protects the original customer should the derivatives dealer go bankrupt, it may not be worth the effort. The rule does not apply to bilateral trades with other derivatives dealers. Interestingly, within Europe, rehypothecation of IM collateral has been banned outright by the EBA.
Complexity and technology
The complexity introduced by the BCBS/IOSCO regulations will be a challenge to manage and requires world-class technology. Non-cleared derivatives sit on top of an already intricate series of rules that collateral management systems must apply and optimise.
The systems environment that supports this activity needs to understand not only the constraints placed by the regulatory and business environment, but also the idiosyncratic preferences and needs of each user. Equally as important, systems must work flawlessly with upstream and downstream technology.
At Murex, we adapt our systems to fit client business models, not the other way around. This comes from deep expertise in the evolving regulatory environment, a keen understanding and respect for client needs.
Murex brings decades of building ground breaking technology solutions for a variety of client profiles including the largest and most sophisticated capital markets institutions in the world.
MX.3 is the culmination of the massive investment necessary to bring an end-to-end platform that can make a difference to how effectively clients can execute their strategy. That investment will not stop any time soon. Murex will constantly refine and improve its risk and collateral management platforms in order to keep a step ahead.
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