The Bank for International Settlements warned that new margin requirements for uncleared derivatives could raise costs and encourage a shift of more interest rate trading onto exchanges and into central clearing.
The new variation margin rules for uncleared over-the-counter derivatives will come into effect on 1 March 2017 and will immediately apply to a wide variety of counterparties including a variety of dealers, buyside firms, pension funds and corporates. The initial margin rules came into force in September this year for the largest swap dealers in the United States, Japan and Canada, and the next phase begin in January 2017. Margin rules will be implemented in Europe and Asia next year.
The BIS said in its latest quarterly review yesterday: “Such margining requirements could raise the costs of OTC trading and thereby encourage a shift in trading activity to exchanges.”
The study found that the average daily turnover of US dollar-denominated interest rate derivatives nearly doubled while the turnover of euro-denominated instruments has halved between 2013 and the 2016 BIS Triennial Central Bank Survey.
“Negative interest rates in the eurozone may have been another factor dampening the demand for euro-denominated interest rate derivatives,” said the BIS. “Negative rates imply an additional cost of holding euro-denominated derivatives, as any cash deposited for margin requirements incurs a negative return.”
The review continued that OTC markets have adapted to regulatory changes by a wider adoption of portfolio compression which allows counterparties to “tear-up” offsetting trades in their portfolios to reduce the notional outstanding and number of line items in their portfolio while maintaining the same risk exposure. “The increasing use of clearing houses has facilitated trade compression, as they allow for an efficient identification of offsetting exposures,” added the BIS.
As a result more than 70% of notional values are now centrally cleared in all major currency segments in interest rate derivatives and electronic trading platforms, including swap execution facilities in the US, have made inroads. At the end of June 2016, 75% of dealers’ outstanding OTC interest rate derivatives contracts were against central counterparties, compared with 37% for credit derivatives and less than 2% for foreign exchange and equity derivatives.
The BIS said: “Regulators continue to expand clearing requirements, and many are also starting to require higher capital and margin for non-centrally cleared derivatives. This strengthens the incentive to move trades to CCPs. In the United States and other key markets, margining requirements began to be phased in starting in September 2016, so their impact on clearing will only become clear in future data.”
Ciaran O’Flynn, EMEA head of bank resource management at Morgan Stanley spoke on a panel at the Trade Execution Legal Forum in London last week hosted by the International Swaps and Derivatives Association.
O’Flynn said: “There is a mountain of documentation for uncleared margins and it hard to see past the next three to four months. It is extremely challenging as each large liquidity provider has thousands of documents that need to be sent out and returned.”
This month Isda published a guidance note for the market on the standardization of the variation margin documentation which provides terms for collateralizing derivatives transactions.
Isda said in a statement: “For many, the March 1, 2017 regulatory date may be a good opportunity to make a change, but the optimal level of market standardization may not be adopted in a single step. Market participants should continue to review their collateral terms and consider how they could benefit from greater standardization, even after the regulations are live.”
J. Christopher Giancarlo, commissioner at the US regulator Commodity Futures Trading Commission, said in a speech at the Isda forum that the margin rules have been made more challenging due to the short implementation timeframe imposed by regulators.
“Unfortunately, regulators imposed an unrealistic deadline on the marketplace and seem intent on sticking to that deadline regardless of the effect on the health of the market and market participants,” said Giancarlo. “As the variation margin deadline approaches, I call on my fellow regulators to determine the market’s readiness and help ease the transition as much as possible to ensure the orderly functioning of the marketplace.”
Edwin Schooling Latter, head of markets policy at the Financial Conduct Authority, the UK regulator, said at the Isda forum: “Huge efforts are being made to implement the margin standards.”
Last month TriOptima and LCH both said they would offer services for the incoming variation margin rules
TriOptima, Icap’s unit which provides post-trade infrastructure for OTC derivatives, has launched triResolve Margin, which provides an automated and exception-based margin processing solution and a variety of institutions including the buyside and corporates such as Delta Air Lines have signed up to the new web-based collateral management service.
LCH, the clearing business owned by the London Stock Exchange Group, is launching LCH SwapAgent in the first half of next year for processing trades in the OTC bilateral rates and foreign exchange markets. When using SwapAgent, LCH will not become the clearing counterparty but will act as an independent calculation agent, facilitating the calculation and exchange of bilateral margin. Clients will be able to use the service for standardized document terms, trade processing, margining and payment processing.
Eleven dealers have confirmed their support for LCH SwapAgent including Bank of America Merrill Lynch, Barclays, BNP Paribas, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, J.P. Morgan, Morgan Stanley and RBS.
More on the margin rules: