On September 3rd, the prudential regulators (including the Federal Reserve, FDIC, and OCC) re-proposed the second major element of derivatives reform – mandatory margin on uncleared swaps. The re-proposed rule is designed to end years of debate that began with the release of the proposed rule in April 2011 and reflects the international guidelines for uncleared margin finalized by the Basel Committee of Banking Supervision and the International Organization of Securities Commissions (BCBS/IOSCO) in September 2013. See PwC’s Regulatory Brief, Margin on uncleared swaps: Global agreement in theory but not yet in practice (September 2013).
The US re-proposal is largely consistent with the BCBS/IOSCO guidelines; however, certain provisions of the re-proposal differ and will pose hurdles for market participants. These provisions involve significant change to the bilateral OTC swaps market and further limit a key source of liquidity (by prohibiting collateral reuse and requiring collateral segregation with a third party custodian) that will increase costs. This cost increase is perhaps somewhat desirable to regulators, as the re-proposal is intended to incentivize market participants to trade derivatives through central counterparties in order to reduce the systemic risk of bilateral trading.
Key US divergences from BCBS/IOSCO
- Reuse of initial margin: While the final guidelines issued by BCBS/ISOCO limit the reuse of collateral pledged to satisfy initial margin requirements to one time only, the re-proposal goes even further by fully prohibiting such reuse. This prohibition will strain bank wholesale funding markets by restricting the use of pledged collateral for repo transactions.
- Segregation of collateral: BCBS/IOSCO requires segregation of initial margin like the re-proposal does, but the re-proposal also requires the segregated initial margin to be held at a third party custodian. Market participants will incur additional costs to segregate and safe-keep this collateral and will need to determine whether to absorb these fees or pass them on to their customers/counterparties.
US consistencies with BCBS/IOSCO
- Initial margin thresholds: A swap entity must collect or post initial margin where the amount of required margin exceeds a threshold of $65 million on a consolidated entity basis, which recent estimates by US regulators project will cause $600 billion of additional collateral to be needed. While this is a significant total amount, the re-proposal’s maintaining of this threshold continues a more pragmatic approach that was adopted as part of the BCBS/IOSCO guidance.
- Collection of initial margin: The re-proposal adopts a “risk-based” approach to the collection of initial margin based upon whether the counterparty is another swap entity, a financial end user, or an “other counterparty” (defined as commercial end users, sovereigns, and multilateral development banks). This approach enables market participants to rely on internal risk models, although the models must be approved by regulators. If market participants are unable to use internal models, they will be required to use a punitive formula-based risk model to calculate initial margin. The US takes a different approach in this area from BCBS/IOSCO in one key respect by setting the threshold for two-way margin for financial end users (but not for swap entities) at $3 billion, which is more onerous than the BCBS/IOSCO threshold of about $11 billion.
- End user exemption: Commercial end users are exempted from mandatory margin requirements. Rather the swap entity may decide whether to collect margin from the counterparty, as is common practice today. While the BCBS/IOSCO guidelines also exempt commercial end users, the US’s 2011 proposal did not, raising concerns among commercial hedgers. Requiring margin for this segment of the market would have had a significant impact on mid- and small-size corporations that do not have the resources or liquidity to post initial or daily variation margin.
- Collateral eligibility: The re-proposal significantly expands the types of collateral acceptable as initial margin, further reducing the strain on prime liquid securities that has been an ongoing concern. By expanding the scope of asset classes, the many institutions that have portfolios comprised largely of non-agency/non-standard collateral can deploy this inventory to satisfy their margin obligations. Additionally, there will be more highly liquid collateral available (such as US Treasuries) to satisfy other regulatory requirements (e.g., the recently finalized Liquidity Coverage Ratio).
- Cross-border limitations: Foreign entities dealing with other foreign entities are not subject to the re-proposal’s requirements. Further, a foreign entity that is dealing in certain swap transactions with US counterparties can comply with its home country regulations, if and when those regulations are deemed “comparable” by the US.
- Conformance period: The re-proposal enacts a phased-in conformance period from 2015 to 2019 (based on the entity’s OTC portfolio size). Phasing in compliance will provide less sophisticated market participants more time to enhance their operational/technological infrastructures and margin methodologies, significantly reducing the up-front cost and resourcing constraints that these participants would undoubtedly have faced to quickly implement these changes.
- Collateral haircuts: US and foreign regulators are working to develop a minimum risk-based haircut schedule for collateral, with the aspiration of global application. Firms need to consider and plan for this potential significant change as it will greatly impact current wholesale funding market activities and existing collateral management operations.
- Future US and global regulation: The US will be caught up with the EU and Japan, who earlier this year issued their proposals that largely conform with BCBS/IOSCO, once the CFTC and SEC issue their uncleared margin re-proposals. With those other nations’ comment periods now closed, key global final rulemakings should emerge during 2015. Global congruence will be imperative, as unharmonized rules would introduce stifling layers of increased operational complexity and arbitrage opportunities.
The full and original memorandum was published by PricewaterhouseCoopers LLP on September 5, 2014, and is available here.