Expected regulatory approval of portfolio margining for US credit default swaps (CDSs) will reduce the cost of clearing and could dictate the shape of the derivatives landscape in the future.
A campaign by IntercontinentalExchange (ICE) to demonstrate the benefits of portfolio margining - the ability to offset the collateral paid against correlated swaps exposures -is now bearing fruit, with regulators inclining toward acceptance.
The Securities and Exchange Commission (SEC), which has oversight of single-name swaps, has already approved the use of CDS portfolio margining, while the Commodity Trading Futures Commission, which regulates index swaps, is likely to approve a similar rule in the coming weeks, according to sources close to the situation.
ICE intends to offer CDS portfolio margining through its central counterparty ICE Clear Credit.
"The ability to portfolio margin accounts will encourage earlier adoption of clearing, reduce systemic risk, and provide capital efficiencies for all market participants," said Chris Edmonds, president of ICE Clear Credit.
Central clearing of CDSs, along with interest rate swaps, will take effect for the largest users of derivatives on 11 March in the US, as part of OTC derivatives reforms enacted under Dodd-Frank. As well as central clearing, the legislation requires OTC derivatives to be transacted on exchange-like platforms and reported to swap data repositories.
While emphasising the need to consider risks to customer protections, the SEC noted in its rule filing that portfolio margining of CDSs can offer market-wide benefits by "aligning costs more closely with overall risks presented by an investor's portfolio. Further, portfolio margining may help to alleviate excessive margin calls, improve cash flows and liquidity, and reduce volatility."
Nothing new
Portfolio margining is not a new concept. Clearing houses such as New York Portfolio Clearing (NYPC) clear interest rate futures contracts and cross-margins eligible positions against US Treasury securities and repo agreements. The clearer, which launched on 21 March 2011, plans to add interest rate swaps cleared through LCH.Clearnet's SwapClear US facility to its offering in the coming months.
"Banks have to pay initial margin to multiple clearing houses to collateralise the same exposures, but the net risks are actually a lot smaller," said Sandy Broderick, CEO, NYPC. "Depending on the portfolio make up, portfolio margining can offer an offset of up to 75-90% in margin efficiency."
If portfolio margining gains traction across different asset classes it could determine the winners and losers in swaps clearing as CCPs vie for market share.
To achieve the optimal level of collateral savings, futures commission merchants and buy-side firms that are directly connected to CCPs will have to funnel trades in correlated instruments through a single clearing house. Those clearers that offer the most efficient collateral reductions therefore are likely to come out on top. The number of related swaps a single CCP clears is likely to be a significant factor in determining where volumes migrate to.
Broderick adds that support from policymakers for portfolio margining is recognition of how expensive it is for banks support balance sheet-intensive practices like clearing since the financial crisis.
"Regulators are starting to realise that risk mitigation related to the balance sheet activities of prime brokers and futures commission merchants are becoming more expensive and they have to give something back," he says. "Where risks are sufficiently correlated, it make sense to do this through margin payments at the clearing house level, given their role in mitigating systemic risk."