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Margin requirements for non-centrally cleared derivatives

05 October 2013

In February 2013, the Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commissions (IOSCO) published a second consultative document on margin requirements for non-centrally cleared derivatives, setting out proposals which aim to (i) reduce systemic risk, and (ii) promote the central clearing of derivatives transactions. The consultation closed for comment on 15 March 2013.

The proposals are important as they will set the global standard for margin requirements for non-centrally cleared derivatives and the document is stated to reflect "near-final policy". It provides, in summary, that:

  • It will be mandatory for financial firms and systemically important non-financial entities who enter into non-centrally cleared derivatives (other than, possibly, physically settled FX forwards and swaps) to have appropriate margining practices in place in the form of the exchange of initial margin (IM) and variation margin (VM) (although intercompany transactions should be treated differently as deemed appropriate by the relevant regulator).
  • The method of calculating IM and VM should be consistent, should reflect all counterparty risk exposures and collateral posted should be "highly liquid" and hold its value "in a time of financial stress".
  • IM should be exchanged on a gross basis and must be easily accessible and/or (to the extent possible) protected (for example, by segregation) if a counterparty defaults and/or becomes insolvent, for which reason rehypothecation will be prohibited, subject possibly to narrow exceptions.
  • The rules should be applied consistently and without duplication across jurisdictions and will be phased in over a period of time.

ISDA and other industry bodies have highlighted the following significant concerns (among a number of others):

  • Decrease in liquidity and increase in systemic risk: In direct contrast to the stated intention of the proposals, if the proposals are implemented in their current form, there is a substantial risk that liquidity in the financial markets will be affected and that the only option available for certain market participants will be to either (i) clear transactions through a central counterparty, or (ii) not participate in the derivatives markets at all. To the extent that market participants are consequently not able to hedge their risk via derivatives transactions, this may actually increase systemic risk.
  • IM: The requirement to post IM on a gross basis is particularly onerous as, in addition to the operational challenges raised, the level of collateral required to be posted is high and will make entering into non-centrally cleared derivatives prohibitively expensive for some market participants.
  • Rehypothecation: The proposed prohibition on rehypothecation is contrary to market practice, and will further impact liquidity and raise costs.
  • Non-systemically important non-financial entities: It is unclear which entities are "non-systemically important" and certain entities, for example SPVs, may struggle to comply with the margin requirements which may negatively affect the structured finance and securitisation markets.
  • Timing: A timeframe for phase-in beginning in 2015 seems too ambitious and may not provide sufficient time for the impact of the proposals to be properly considered.

Allen & Overy LLP has been advising ISDA in preparing its response.