Proposals on margin requirements for non-cleared OTC derivatives have been welcomed by UK buy-side trade body the Investment Management Association (IMA) but continue to irk the International Swaps and Derivatives Association (ISDA).
The trade associations were both responding to near-final joint proposals on non-cleared swaps margin from the International Organisation of Securities Commissions and the Basel Committee on Banking Supervision (IOSCO-BCBS).
The proposals will be fed into legislation designed to overhaul the OTC derivatives market by mandating the trading of standardised swaps on exchange-like platforms, increased use of central counterparties and reporting of positions to data repositories. The IOSCO-BCBS proposals relate to those swaps that cannot be standardised and are therefore subject to higher capital charges.
The February proposals offered an exemption for initial margin payments on the first €50 million of bilateral swaps deals.
Variation margin would need to be posted, based on the mark-to-market value of a trade on a daily basis. The paper also states that in 2015, any “entity belonging to a group whose aggregate month-end average notional amount of non-centrally-cleared derivatives for the last three months of 2014 exceeds €3.0 trillion” will have to pay initial margin, which is not likely to cover any institutional investment firm. After 2019, the threshold drops to €8 billion on a permanent basis, which will cover many more asset managers.
In its reply to the consultation, the IMA supported the phase in approach, the minimum thresholds – which it described as a “proportionate response” to the risks presented – and the use of two-way margin.
The response from the IMA, authored by director of markets Jane Lowe, added that uncleared, physically-settled FX forwards and swaps should not be subject to initial margin requirements at all and that variation margin should only be used for FX derivatives with a tenor of longer than three years.
“For longer dated contracts…we suggest that variation margin could be appropriate, reflecting potentially greater credit risk,” stated the IMA paper. “However, we caveat this by suggesting that thresholds should be set (perhaps against notional amounts) below which the exchange of collateral for variation margin would not be required.”
ISDA, which has long criticised the need for initial margin requirement for non-cleared swaps as too onerous, again reiterated its concerns through its response to the consultation. “Initial margin does improve the situation of the non-defaulting party and reduces the risk of default contagion across the system,” read ISDA’s response. “However, initial margin comes with some very significant costs. It has the potential to significantly strain the liquidity and financial resources of the posting party.”
If the costs related to initial margin are too high, says ISDA, users may be forced to abandon the use of non-cleared derivatives, leading to imperfect or unsuitable hedges that will lead to increased basis risk.
In its response to the initial proposals, ISDA predicted initial margin requirements as they stand would require an extra US$1.7 trillion – US$10.2 trillion in collateral, depending on whether internal models or standardised schedules are used.