Swaps counterparties, including corporate end users, would face increased risks under banking regulators’ swaps margin proposal, according to a study by the International Swaps and Derivatives Association (ISDA).
Global regulators have recommended requiring initial and variation margin on derivatives trades from all financial institutions and systemically important non-financial firms, while exempting other non-financial end users. The rules are still in the works and there is concern they may vary from U.S. regulations, presenting global companies with two sets of initial margin requirements.
The ISDA study does not directly address the impact of proposed margin requirements on end users, whose trades make up 10% or less of the over-the-counter derivatives market. However, it calculates that the largest global banks would each have to pony up between $23 billion and $49 billion of initial margin on average, money that would be unavailable for other purposes.
“Diverting funding from other activities to finance [initial margin] will be harmful to those activities and harmful to the broader economy,” the study says.
As a result, banks may have to curtail derivative activities or pass their higher cost of capital on to customers, which could mean less hedging by corporations.
“Margin requirements would create risk because corporate end-users would be less likely to hedge,” says Christina Crooks, senior manager of government affairs at Financial Executives International, adding that those cost concerns will be exacerbated by the new Basel III capital requirements to be implemented over the next few years.
“Even if [corporates] are exempted but financial entities are subject to margin requirements, then their trading could dry up and make those hedges unavailable to us or more expensive,” says Tom Deas, treasurer at FMC Corp. and chairman of the National Association of Corporate Treasurers (NACT), who's pictured above.
A bill that would ensure that corporates are exempt from margin requirements passed the House of Representatives by a wide margin in March, Crooks notes. The sponsors of the Senate version of the bill, introduced in August, are “hoping to push it over the finish line by year-end, or next year they’ll have to hit the reset button” when the new Congress arrives, she adds.
Should that legislation fail and corporates be required to post margin, they will face additional margin-related risks, according to the ISDA study. It notes, for example, that initial margin requirements can become up to three times larger during stressful periods, so that a $100 million requirement becomes a $300 million.
In addition, the proposal introduces derivative volume thresholds—levels over which market participants must pony up margin for the full notional amount of the derivative. The low end of ISDA’s margin estimate per bank was calculated with the threshold in place, but ISDA says during stressful times, thresholds could increase margin requirements by as much as five times.
Jiro Okochi, founder and CEO of Reval, says that while a company may be far from hitting a $100-million threshold in normal market conditions, a market swing of two standard deviations could push its exposure to $101 million, requiring it to post margin not just for the additional $1 million but the entire $101 million.
“That’s a pretty big bang effect for cash going out the door, at the worst time,” when markets are under extreme stress, says Okochi, who's pictured above.
In a comment letter, ISD says that if regulators impose initial margin requirements, they should “be structured so as to minimize the negative consequences” described in the study. Possible approaches include making initial margin amounts static rather than dynamic and setting the levels low enough “to permit realistic pricing of uncleared swaps,” it says, as well as allowing swap market participants covered by the rule to establish their own initial margin requirements and thresholds.
For previous coverage, see Exemption of FX Swaps, Forwards Leaves Unresolved Issues and Exchanges Try to Lure Swap Users to Futures.