Bank of England
Che Sidanius
30 October 2012
OTC derivative reforms are 鈥渕ade to shed light, and not heat鈥�, according to the Bank of England鈥檚 Che Sidanius. SLT catches up with him to find out more about the central bank鈥檚 paper on OTC derivatives reform
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What was the aim of the OTC Derivatives Reform and Collateral Demand Impact paper?
The aim of the paper is to estimate the initial margin (or collateral) resulting from the G20 commitments to clear 鈥榮tandardised鈥� OTC derivatives contracts through central counterparties (CCPs) and higher margin requirements on the remaining bilateral contracts. Our study covers only credit default swaps and interest rate swaps (ie, about two thirds of the interest rate derivative market by gross notional). It does not cover all derivatives. A secondary aim was to construct a framework where key variables can be calibrated in order to estimate what effect they may have on overall collateral levels.
While there are a number of studies that considered the effect of the central clearing mandate alone, we thought that it would be informative to model the potential collateral needed resulting for both OTC derivatives reforms. Another objective was to construct a framework where key variables can be calibrated in order to estimate what effect they may have on overall collateral levels. Some of these variables include assumptions on netting benefits that are associated with central clearing, proposed limits on the reuse of collateral or rehypothecation, and how market conditions affect the margin rates applied on the gross notional valued portfolios.
Given the opaqueness of this market and the uncertainty of how these reforms will affect market behaviour, we opted not to report a single number. Instead, we selected to include a range of results. It became very clear that the results are extremely sensitive to the assumptions that one makes, particularly regarding netting.
The methodology behind the paper limits the product scope to IRS and CRS because they are highly standardised and account for a significant share of the OTC derivatives market. Is it possible to see how OTC derivatives will affect collateral demand for the remaining non-standardised products?
The margin requirements for non-centrally cleared OTC derivatives are expected to be higher compared to more standardised contracts. This will translate into more collateral reflecting the generally higher risks with non-standard products.
Collateral could also be affected by any change in the regulation of the re-use of collateral in the bilateral market, commonly referred to as rehypothecation. Re-using collateral, whereby collateral pledged by a counterparty of a transaction is used in another transaction of a different counterparty, is a common practice among market participants.
How will the market have to change in order to embrace central clearing of standardised OTC derivatives once mandates come into effect?
I think that market participants will re-evaluate business strategies and operating models in order to accommodate the central clearing mandate. Legal and operational infrastructure needs to be sufficiently robust during the on-boarding process. Enhancements to risk management systems could help firms to optimise capital and liquidity management.
More emphasis might be placed on having the capability to source and manage collateral on a timely basis as CCPs can issue intraday margin calls on short notice. Clearing members may also opt to be connected to multiple CCPs and leave the choice of a CCP to its client.
How will market participants have to change their strategies to accommodate prospective margin requirements for transactions that are not centrally cleared?
As we point out in the paper, under Basel III, capital that is held against bilateral exposures is expected to increase capital requirements overall. An important driver is the credit valuation adjustment capital charge, which reflects the potential future change in the mark-to-market value of counterparty credit risk.
The initial margin rates on non-centrally cleared contracts have yet to be finalised but could require a minimum 10-day liquidation period, as opposed to the five-day period employed by some CCPs for OTC derivatives. Currently, collateral in the bilateral market is predominantly cash. Increased collateral needs might incentivise market participants to use more non-cash while improving collateral management capabilities overall.
What is demand for high quality collateral like at the moment and what does the paper say about how these reforms will affect it?
Since market participants regard only highly liquid assets鈥攚ith a low probability of default鈥攁s high-quality collateral, assessments that the creditworthiness of some issuers has deteriorated narrows the range of assets that market participants accept as collateral. On the other hand, very large amounts of collateral that are accepted as high quality continue to be issued.
Collateral eligibility criteria differ according to regulatory jurisdictions but generally include cash, government securities and, in some jurisdictions, corporate bonds and equities. However, the International Monetary Fund points out that the number of sovereigns whose debt is considered safe could fall by some $9 trillion from the supply of safe assets by 2016.
Central clearing mandates and margin requirements for non-centrally cleared trades are not the only regulatory reforms that will affect collateral demand. For instance, banks will be required to hold an amount of highly liquid assets that are equal to or greater than stressed net cash outflow over a 30-day period. For the OTC reforms, the main driver of the collateral demand will stem from the requirement to post initial margin. While estimates of margin tend to be based on current trading patterns, it is likely that the patterns of trades or even amount of trades will change in response to margin requirements. In addition, it is still unclear how the market structure for central clearing will evolve, with new CCPs entering the regional markets and competing with incumbent CCPs. One consequence could be the fragmentation of central clearing, which would result in a reduction of multilateral netting.
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