We are still some way from pinning down the precise costs and risks of using different derivatives instruments under the emerging new regulatory framework, but last week the pitfalls for investment managers became slightly easier to identify.
First, the International Organisation of Securities Commissions (IOSCO) and the Basel Committee on Banking Supervision published the 80-odd responses they'd received to their second round of proposals for margin requirements for non-cleared derivatives. Second, specialist consultancy Finadium issued a guide to understanding the differences between cleared OTC swaps and exchange-traded futures from a risk management and initial margin calculation perspective. The Finadium report lays out the nuances that separate SPAN from historical Value-at-Risk (VaR) as well as the implications of omnibus accounts versus legally separate, operationally co-mingled structures.
But the differences in SPAN / historical VaR models typically used to calculate initial margin for futures vs cleared and non-cleared swaps is not as important as the fact that, when calculating initial margin requirements, futures exchanges assume a one-day liquidation period compared with five for cleared swaps and ten for non-cleared swaps, under those IOSCO / Basel Committee proposals. From a credit exposure perspective, the worst case scenario for a swap future is an extreme one-day change in the value of the contract, which is inevitably a far less scary prospect than five or ten days of volatility, regardless of risk calculation methodology. Initial margin charged by swaps clearing CCPs inevitably reflects these differences in exposure.
Nevertheless, a significant difference to initial margin outlay can be made by netting / offsetting positions to reduce total exposures. The ability to do this is limited by jurisdiction, by clearing house and by broker. Differences between bankruptcy laws will continue to make it challenging to net across jurisdictions. But clearing houses are beginning to work together to provide cross-netting opportunities within jurisdictions, for example the US-based 'Project Trinity' arrangement between LCH.Clearnet (for swaps), the DTCC (for cash and repo trades) and NYSE Euronext (for futures) hopes to include a broad array of trades in what they call 'one pot' margining. The ability of the CME to clear swaps and futures also offers an opportunity for offset more products within the same organisation. But it is also worth asking your brokers whether they are optimising netting with the clearing organisations they face in a way that allows you to reduce margin costs.
On the non-cleared side, the picture is not quite so rosy, understandably as the whole ethos of regulatory change is to dissuade market participants away from bilateral trades. For anyone with a couple of hours to spare, the feedback to IOSCO / Basel Committee is an interesting insight into how market participants from Shell to Amundi to Deutsche Bank see the proposed new margin regime. Organisations closely associated with the existing OTC world are perhaps the most trenchant in their views, arguing that the high margins will cause considerable damage to liquidity.
"We are concerned that this high level of margin would mean that market makers will withdraw from the derivative markets, with consequences for the general economy in that end-users of the market will find it harder to hedge their currency or inflation rate risks," wrote the Wholesale Market Brokers' Association.
If they are right, the temporary exemption proposed by IOSCO / Basel will not provide much protection.