03 April 2012

ISDA: Response to EBA, ESMA, EIOPA Joint Discussion Paper on risk mitigation techniques for trades not cleared by a central counterparty

The Industry is supportive of the Paper's aims and objectives, and understands the desire expressed by the G20 nations to require over-the-counter derivatives to be cleared where appropriate, and for uncleared trades to be subject to robust operational processes and capital requirements.

ISDA agrees with the concepts of Minimum Transfer Amounts and the requirement, where appropriate, to mark collateral to market daily. ISDA believes that a very significant proportion of uncleared OTC trades will be covered by these requirements. In setting out the matters below where ISDA feels that further discussion is needed; this should be seen in the context of a broad agreement as to aims and objectives and a willingness to work together with regulators to ensure that the proposals are sensitive to industry practice, risk sensitive and workable. Further ISDA fully supports the proposals in paragraph 15 of the paper to disapply the collateral requirements to Non-Financial Counterparties which are not above the (clearing) threshold.

The Industry believes that in crafting legislation to reduce systemic risk, regulators must strive to strike the right balance between efficient risk management, financial stability while seeking to maintain financial innovation and prudent risk-taking supported by sound business practice and encouraging economic expansion. ISDA is very concerned as to the potential for economic dislocation that a mandatory Initial Margin regime could trigger. It therefore urges policy-makers both in the European Union and globally to undertake a robust (i.e. quantitative) cost benefit analysis to ensure that any expected reduction in risk is not outweighed by direct and indirect costs stemming from the unprecedented systemic liquidity demands.

Principal matters where the Industry believes that further dialogue would be beneficial:

There should not be an imposition of a single risk mitigation regime. Rather, firms should be allowed to exercise proper commercial judgement to deploy a number of risk mitigants which are available in the OTC space when exercising risk management. In particular, there should be no requirement to collect Initial Margin (“IM”) on uncleared trades. IM is one of a number of credit risk mitigants for uncleared trades. Firms should be able to choose IM or  other forms or risk mitigation to achieve the required level of financial security. Under the CRD IV proposals, derivatives prices will rise significantly. End users should be able to determine the appropriate balance between funding IM and paying the full price.

Similarly, firms should be free to set appropriate thresholds for collecting Variation Margin (“VM”) by reference to counterparty type, trade and asset type, available capital, liquidity and risk appetite. Many firms have developed collateral models which allow counterparties to benefit from a single margin call resulting from netting and offsetting positions across all trading activities including both cleared and non-cleared derivatives, exchange-traded and securities financing activities. This maximises efficiencies and minimises costs and operational risks. There are fundamental differences in the capital structures of CCP’s and firms which lead to differing blends of IM, VM thresholds and default funds available. CCP’s are operated principally to minimise risk whereas firms are operated to balance risk and reward.

The requirement to value collateral should not be daily but should reflect the type and liquidity of the collateral. Liquid traded instruments will generally be valued on a daily basis but in cases where collateral is illiquid, for example real estate or physical commodities, firms should be able to select an appropriate period over which to carry out valuations. It is expected that cases where collateral is illiquid are a small minority and limited to certain asset classes and industry sectors. The vast majority of collateral is highly liquid and valued daily, and frequently in cash. However, proposals covering cleared trades, uncleared trades, Solvency II and other aspects of Basel III may cause a “collateral shock”, whereby demand for certain classes of collateral will increase significantly. In certain currencies, estimates are that insufficient government debt exists to satisfy the likely demand. The Industry therefore urges regulators to permit, where appropriate, the widest possible definition of collateral consistent with the objectives of The Paper.

Although segregation of IM is not explicitly addressed in the Paper, the Industry believes that it is important for the safety, security and liquidity of OTC markets that any segregation requirements are appropriately calibrated. It believes that segregation arrangements in respect of IM should be offered to all counterparties however the details should be a matter for agreement between the counterparties. A suitable period needs to be allowed for these arrangements to be phased in. It is also unclear how posting of cash IM outside a CCP would be treated under Basel III. Under current rules this would create an exposure to the custodian (or the counterparty if segregated in their books), which could materially increase risk weighted assets. The Industry understands the term “segregation” in the Paper to apply to the segregation of IM.

Many end-users do not have the liquid marketable collateral used to support bilateral margining practices in the market today. Transformation of non-standard collateral types through repo lines will put further pressure on bank balance sheets in an environment where the European Central Bank LTRO is required to facilitate even interbank liquidity. Furthermore, if these repo lines are not committed, they will typically be the first credit lines to be cancelled in a stressed market, leading to systemic effects as firms are forced to sell liquid or long-term investments. In addition, imposing restrictive collateral requirements on robust credit-worthy non-banking entities with a strong asset base may force them to seek liquidity from banking groups in order to fund margin payments, thus contributing to the liquidity squeeze and further concentrating exposures in the same places across the market i.e. within the banking sector.

Full paper

© ISDA - International Swaps and Derivatives Association