Margin requirements for non-centrally-cleared derivatives - consultative document
BIS, July 2012
The G20 Leaders agreed in 2011 to add margin requirements on non-centrally-cleared derivatives to the reform programme for over-the-counter (OTC) derivatives markets. Margin requirements can further mitigate systemic risk in the derivatives markets. In addition, they can encourage standardisation and promote central clearing of derivatives by reflecting the generally higher risk of non-centrally-cleared derivatives. The consultative paper published today lays out a set of high-level principles on margining practices and treatment of collateral, and proposes margin requirements for non-centrally-cleared derivatives.
These policy proposals are articulated through a set of key principles that primarily seek to ensure that appropriate margining practices will be established for all non-centrally-cleared OTC derivative transactions. These principles will apply to all transactions that involve either financial firms or systemically important non-financial entities.
The Basel Committee and IOSCO would like to solicit feedback from the public on questions related to the scope, feasibility and impact of the margin requirements. Responses to the public consultation, together with the QIS results, will be considered in formulating a final joint proposal on margin requirements on non-centrally-cleared derivatives by year-end.
Objectives of margin requirements for non-centrally-cleared derivatives
Margin requirements for non-centrally-cleared derivatives have two main benefits:
Reduction of systemic risk. Only standardised derivatives are suitable for central clearing. A substantial fraction of derivatives are not standardised and will not be able to be cleared.4 These non-centrally-cleared derivatives, which total hundreds of trillions of dollars of notional amounts,5 will pose the same type of systemic contagion and spillover risks that materialised in the recent financial crisis. Margin requirements for non-centrally-cleared derivatives would be expected to reduce contagion and spillover effects by ensuring that collateral are available to offset losses caused by the default of a derivatives counterparty. Margin requirements can also have broader macroprudential benefits, by reducing the financial system’s vulnerability to potentially de-stabilising procyclicality and limiting the build-up of uncollateralised exposures within the financial system.
Promotion of central clearing. In many jurisdictions central clearing will be mandatory for most standardised derivatives. But clearing imposes costs, in part because CCPs require margin to be posted. Margin requirements on non-centrally-cleared derivatives, by reflecting the generally higher risk associated with these derivatives, will promote central clearing, making the G20’s original 2009 reform program more effective. This could, in turn, contribute to the reduction of systemic risk.
The effectiveness of margin requirements could be undermined if the requirements were not consistent internationally. Activity could move to locations with lower margin requirements, raising two concerns:
The effectiveness of the margin requirements could be undermined (ie regulatory arbitrage).
Financial institutions that operate in the low-margin locations could gain a competitive advantage (ie unlevel playing field).
Margin and capital
Both capital and margin perform important risk mitigation functions but are distinct in a number of ways. First, margin is “defaulter-pay”. In the event of a counterparty default, margin protects the surviving party by absorbing losses using the collateral provided by the defaulting entity. In contrast, capital adds loss absorbency to the system, because it is “survivor-pay”, using capital to meet such losses consumes the surviving entity’s own financial resources. Second, margin is more “targeted” and dynamic, with each portfolio having its own designated margin for absorbing the potential losses in relation to that particular portfolio, and with such margin being adjusted over time to reflect changes in the risk of that portfolio. In contrast, capital is shared collectively by all the entity’s activities and may thus be more easily depleted at a time of stress, and is difficult to rapidly adjust to reflect changing risk exposures. Capital requirements against each exposure are not designed to be sufficient to cover the loss on the default of the counterparty but rather the probability weighted loss given such default. For these reasons, margin can be seen as offering enhanced protection against counterparty credit risk where it is effectively implemented. In order for margin to act as an effective risk mitigant, that margin must be (i) accessible at the time of need and (ii) in a form that can be liquidated rapidly in a period of financial stress at a predictable price.
The interaction between capital and margin, however, is complex and is an area in which the full range of interactions needs further careful consideration. When calibrating the application of capital and margin, consideration must be given to factors such as: (i) differences in capital requirements across different types of entities; (ii) the effect certain margin requirements may have on the capital calculations of different types of regulated entities subject to differing capital requirements; and (iii) the current asymmetrical treatment of collateral in many regulatory capital frameworks where benefit is given for collateral received, but no cost is incurred for the (encumbrance) risks of collateral posted.
Impact of margin requirements on liquidity
The potential benefits of margin requirements must be weighed against the liquidity impact that would result from derivative counterparties’ need to provide liquid, high-quality collateral to meet those requirements, including potential changes to market functioning as result of an increasing demand for such collateral in the aggregate. Financial institutions may need to obtain and deploy additional liquidity resources to meet margin requirements that exceed current practices. Moreover, the liquidity impact of margin requirements cannot be considered in isolation. Rather, it is important to recognise ongoing and parallel regulatory initiatives that will also have significant liquidity impacts; examples of such initiatives include the BCBS’s Liquidity Coverage Ratio (LCR), Net Stable Funding Ratio (NSFR) and global mandates for central clearing of standardised derivatives.
The US SEC has pointed out that the proposed margin requirements could have a much greater impact on securities firms regulated under net capital rules. Under such rules, securities firms are required to maintain at all times a minimum level of ‘net capital” (meaning highly liquid capital) in excess of all subordinated liabilities. When calculating the “net capital”, the firm must deduct all assets that cannot be readily convertible into cash, and adjust the value of liquid assets by appropriate haircuts. As such, in computing “net capital”, assets that are delivered by the firm to another party as margin collateral are treated as unsecured receivables from the party holding the collateral and are thus deducted in full when calculating net capital.
As discussed in Part C of this consultative paper, the BCBS and IOSCO plan to conduct a quantitative impact study (QIS) in order to gauge the impact of the margin proposals. In particular, the QIS will assess the amount of margin required on non-centrally-cleared derivatives as well as the amount of available collateral that could be used to satisfy these requirements. The QIS will be conducted during the consultation period, and its results will inform the BCBS’s and IOSCO’s joint final proposal.
The BCBS and IOSCO also note that national supervisors may wish to establish margin requirements for non-centrally-cleared derivatives that, in addition to achieving the two principal benefits noted above, also create other desirable macroprudential outcomes. Further work by the relevant authorities is likely required to consider the details of how such outcomes might be identified and operationalised. The BCBS and IOSCO encourage further consideration of other potential macroprudential benefits of margin requirements for non-centrally-cleared derivatives and of the need for international coordination that may arise in this respect.