New margin requirements for non-centrally cleared OTC derivatives will let buy-side firms use collateral to pay their prime brokers, but pose a challenge for asset managers unfamiliar with the practice of re-hypothecation.
The Bank of International Settlements this week published the final framework for margin requirements for non-centrally cleared derivatives. Instruments in this category include exotic swaps that would not feasibly pass through central counterparties to reduce risk.
The rules include a one-time re-hypothecation of initial margin collateral is permitted subject to a number of conditions, which the BIS believes will help mitigate the liquidity impact associated with the requirements.
“Re-hypothecation is not the same as re-use, which includes a transfer of title, for repo transactions,” said Godfried De Widts, chairman of the European Repo Committee and director of European affairs for ICAP.
“Re-hypothecation is already somewhat common for hedge funds,” he added, but stressed some asset managers may struggle in adapting to this use of collateral when posting initial margin.
“It’s going to be a challenge for the non-hedge fund sector, for pension funds, insurance companies and those that haven’t become used to putting up initial margin,” he said.
The legal difference between how collateral systems operate in the US and Europe would also affect how asset managers use collateral under these rules, suggested De Widts. In the US, firms ‘pledge’ collateral, but under the European system, ownership of collateral physically changes hands, which creates a stronger system.
The final framework will apply to all financial firms and systemically important non-financial entities that engage in non-centrally cleared derivatives activity. These firms must exchange initial and variation margin commensurate with the counterparty risks arising from each transaction.
The latest framework also exemptions certain transactions. Physically settled FX forwards and swaps will not be subject to initial margin requirements. Variation margin on these derivatives will be exchanged in accordance with standards developed after considering the Basel Committee supervisory guidance for managing settlement risk in FX transactions.
The framework also exempts from initial margin requirements the fixed, physically settled FX transactions that are associated with the exchange of principal of cross-currency swaps. However, the variation margin requirements that are described in the framework apply to all components of cross-currency swaps.
Although this exemption will benefit the sell-side, De Widts said the move was practical, due to the short-term nature of instruments covered.
He said overall, the framework and its planned implementation would focus on maintaining stability in the market.
“These rules are just one part of the framework regarding the increased demand for collateral and the FSB is taking a measured approach by phasing in rules, because it’s impossible to predict the exact effects on the wider market,” he said.
The framework was formed in conjunction with the Basel Committee on Banking Supervision and the International Organization of Securities Commissions, which will monitor and assess the impact of the requirements as they are implemented globally.