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From the middle of next year, a great many derivatives trades will have to go through a central counterparty (CCP) as regulators push to make such transactions safer. But some will still remain beyond the remit of centralised clearing, and will continue to be negotiated bilaterally in so-called over-the-counter deals. Exactly what to do about these, and how to strip out credit risk, is proving a particular headache for insurance companies.
To a large extent, life insurers have no choice. The Dodd-Frank Act in the US and the European Market Infrastructure Regulation in Europe have toughened requirements on the collateral that firms must post against derivatives transactions. While centralised clearing remains the core focus of these new regulations, more complex transactions – which remain in the bilateral space for the time being - will also face constraints.
The reforms will make credit support annexes (CSAs), which regulate the amount of collateral that firms need to post against derivatives trades, mandatory for OTC transactions. In the past, such agreements have been optional, although in practice, most firms chose to make use of them.
At the moment, buy-side firms can negotiate the type of collateral that they wish to post against derivatives trades, including corporate bonds and cash in various currencies. The new regulations will force companies to post high-quality liquid securities. A higher haircut will be imposed for certain types of collateral, such as that posted in a currency different to the underlying transaction. The new rules will also limit the amount of unsecured credit risk that each party can take, which at the moment is equivalent to a threshold set out under the CSA.
Despite a growing emphasis on centralised clearing, bilateral CSAs are likely to remain relevant for some time to come. Interest rate swaps will be centrally cleared, but for other products, it will not be possible to do so because of the nature of the business, according to Guido Hebert, global head of rates structuring with HSBC in London. "Clearing can only take place if the derivatives is standard and the market is broad and deep enough. For many products, this may not be the case", he says.
The introduction of tougher rules and a growing awareness of the dangers of counterparty risk are prompting large numbers of insurance companies to look at how CSAs might be rewritten in order to offer greater protection. Removal of counterparty risk is also important for investment banks with which the CSA is agreed.
There are many areas, therefore, in which insurers and investment banks can find common ground for agreeing or renegotiating their CSAs. Reducing uncertainty and risk is one of the top priorities for all sides.
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