The Basel Committee on Banking Supervision and the International Organization of Securities Commissions have jointly issued a second consultative paper that they are calling their “near-final proposal” on margin requirements for non-centrally cleared derivatives. Welcome to the second half of AllAboutAlpha’s discussion of the salient points in that paper. Basel/IOSCO acknowledges that affected markets will face “operational and logistical challenges” due to the margin requirements, also known as the “collateral crunch,” and the proposal in its current form seeks to make those challenges manageable through a phase-in timeline and through some flexibility on the assets that may be provided for these purposes. At the same time, if anything other than “the most liquid, highest-quality assets” are employed, the “the potential volatility of such assets” is to be addressed “through application of appropriate haircuts.” Basel/IOSCO also asks for feedback on four issues: the treatment of physically-settled foreign exchange forwards and swaps; the ability to engage in limited re-hypothecation of collected initial margin; the proposed phase-in of the margin requirements; and the adequacy of a quantitative impact study conducted last year. My previous installment focused on forex and rehypothecation. I will speak below to the phase-in and to the QIS. The Phase-In The requirement to exchange variation margin becomes effective all at once at the start of 2015. The exchange of variation margin on contracts entered into before that “is subject to bilateral agreement.” The phase-in of the requirement to exchange two-way initial margin is to be based on computations made at month end of the last three months of 2014. In 2015, that is, every covered entity involved in non-centrally cleared derivative activity and belonging to a group whose aggregate month-end average notional amount of such activity in the last three months of 2014 exceeded €3.0 trillion will be subject to the margin requirements established in this paper when transacting with another entity that also meets that condition. Thereafter:
- In 2016, the last three months of 2015 shall be used for the same measurement and the coverage threshold will fall from €3.0 trillion to €2.25 trillion.
- In 2017, the last three months of 2016 shall be used for the same measurement and the coverage threshold will fall to €1.5 trillion.
- In 2018, the last three months of 2017 shall be used, and the coverage threshold will fall to €0.75.
- Finally, in 2019 and thereafter, the final three months of the previous year shall be employed to measure derivatives activity against a threshold of €8 billion.
Basel/IOSCO also expects global regulators to work together throughout the phase-in period “to ensure that there is sufficient transparency regarding which entities are and are not subject to the initial margin requirements.” The paper asks for comment on whether these arrangements are the best way to “trade off the systemic risk reduction and the incentive benefits [of margin requirements] with the liquidity, operational and transitions costs associated…?” The “near final” proposal as above only suggests the phase-in of initial margin. Variation margin is to come into effect in a single clump. But commenters are welcome to propose that variation margin, too, be phased in. The QIS The QIS on which much of this paper is founded includes data from 39 institutions, of which 33 were banks, and 19 (of those 33) were “large, internationally active derivative dealers.” The surveyed institutions are engaged in roughly three-quarters of the world’s non-centrally cleared derivative activity. On the basis of the QIS, the paper’s authors estimate that the central clearing mandate will cause roughly a 46 percent decline in the gross notional amount of non-centrally cleared derivatives activity. The largest decline will be found amongst the interest rate and equity derivatives, the smallest among the Forex and the indispensable “Other” category. QIS respondents were asked to estimate, for each broad asset class in the non-CCP derivatives world, the amount of initial margin that would be necessary were their entire bilateral portfolio to be centrally cleared, assuming a 10 day closeout period and a zero threshold. Roughly half of the sample completed that analysis. The answer as a stunning €846 billion on a total gross notional outstanding amount of €158 trillion. The authors of the Basel/IOSCO paper believe these numbers illustrate the benefits of multilateral netting, and thus of the central clearing mandate. But as they say, in the final words of the paper, they “seek comment on the accuracy and applicability of the QIS results discussed above.”