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However, most industry estimates expect that 20 per cent or more of the notional value of OTC derivatives cannot be and will not be clearable. Such swaps play an important economic role for the global economy, ranging from housing to corporate financing. Policymakers are hoping to eliminate counterparty risk of these unclearable trades by proposing margin requirements – both initial (IM) and variation margin (VM) – for them.
ISDA fully supports mandatory exchange of VM among covered entities. Experience (good and bad) has demonstrated that the practice of frequently exchanging the unrealised mark-to-value fluctuations between two parties is beneficial in reducing counterparty risk. It avoids the build-up of large unrealised positions that could become destabilising in periods of market stress. This is a widely adopted practice in the OTC derivatives marketplace. And, had this practice been followed – which was NOT the case with AIG and certain monolines in the US – counterparty risk would not be the issue it has become today for the OTC derivatives industry. So, the requirement for VM exchange alone would be more than enough to address counterparty risk concerns.
However, while ISDA supports the use of VM, the same can not be said for imposing mandatory IM on counterparties. A rudimentary risk/benefit exercise reveals that the approach is flawed. ISDA sees minimal benefits in terms of incremental risk reduction – above and in excess of what is already provided by capital requirements.
What’s worse: ISDA knows that IM requirements in stressed conditions could go up by at least three times, raising potential requirements at a time when liquidity will be most needed. This is a clear recipe for disaster, only exacerbating systemic risk. And as to the proposed use of thresholds to alleviate the IM impact, at times of crisis, they just make the problem worse. It’s a message ISDA plans to share with supervisors and regulators around the world.
ISDA believes that mandatory, risk-sensitive IM will not achieve its purported goals. ISDA instead advocates a three pillar framework for ensuring systemic resiliency: a robust variation margin framework, mandatory clearing for liquid, standardised products, and appropriate capital standards.
Please click on link below for ISDA’s recent analysis of data regarding IM estimates and their impact.