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I would like to highlight two examples where review and recalibration of the rules is required – the incentives for clearing and the threshold for the final phase of margin requirements for non-cleared derivatives. I’ll also identify two areas where global harmonization and cooperation are vitally important: benchmark reform and Brexit.
Starting with the incentives that are driving derivatives users to clear. Recall that 88% of interest rate derivatives trading volume is now is cleared. A study by the Financial Stability Board shows that capital rules and netting efficiency are primarily driving this behavior. However, there are a number of other regulatory incentives to clear, including the non-cleared margin rules. If these regulatory incentives are calibrated inappropriately and make it overly punitive to trade bilaterally, it could make non-cleared derivatives much more expensive.
This will increase costs for those end users that need customized, bespoke hedges to manage their risks, and drive products not suited to clearing into clearing houses, exposing them to inappropriate risk. We will work with policy-makers to optimize clearing – for risk management and cost efficiency – but also ensure there is a continued healthy market for bilateral trades as well.
Now, let’s focus on the current regulatory situation of those non-cleared derivatives trades. In particular, I’d like to focus on systemic risk and whether these rules are appropriately calibrated.
The non-cleared margin requirements are being phased in over five years to 2020, beginning with the largest firms. So far, about 35 banks and one buy-side firm have come into scope – remember that number.
By September 2020, more than 1,100 smaller entities will fall into scope. These firms will have to negotiate new documentation with all their counterparties, set up new custodial arrangements and put in place new margin calculation systems. Despite this, most will not actually be required to post initial margin, because their exposures with each counterparty fall below a minimum threshold.
Now, policy makers largely got this correct. The policy generally exempts those that don’t pose systemic risk from exchanging margin. However, this exposes small end users to significant compliance costs for no gain.
We believe the threshold for compliance should be raised from the current $8 billion in aggregate non-cleared average notional amount of non-cleared derivatives to $100 billion. This will exclude a large number of smaller entities, but will have a very minor impact on the amount of collateral held in the system.
The importance of these initiatives extends well beyond the people who work in the derivatives market. Companies all over the world rely on derivatives to manage their risk, whether that means locking in the cost of issuing debt to finance investment, reducing exchange rate uncertainty, managing oil price fluctuations or protecting pensions for retirees. A robust and liquid cleared and non-cleared derivatives market is essential to support corporate financing, economic growth and the creation of jobs.
Given this, it’s not surprising that some big looming issues are encouraging those policy-makers worried about economic growth to pause and reflect.
Benchmark reform is one such issue. There is currently about $370 trillion in total notional exposure to contracts referenced to interbank offered rates, or IBORs. That’s not limited to derivatives markets – it also touches mortgages, loans, retail deposits and securitizations.