Friday, August 12, 2016

Margin Requirements for Non-Centrally Cleared OTC Derivatives

[The following guest post is contributed by Rishi A., who is a 5th year law student at HNLU, Raipur]

Introduction

At the end of 2008, the world, especially the United States, witnessed one of the worst financial crises. The tipping point in this crisis was not the bad credit quality of the household mortgages that were losing their value because of a number of reasons including the growing interest rates of the mortgages. The issue here was that there were layers of other instruments, derivatives like mortgage backed securities (MBSs) and collateralized debt obligations (CDOs), which were created keeping these mortgages as the underlying securities. Hence, once the underlying assets deteriorated in their value, these derivatives too started losing their value and the rest is history.[1]

During this time, private banks and other financial institutions had major holdings in these MBSs and CDOs. Thus, when the instruments started losing value and when it became difficult to find buyers, the banks found themselves under extraordinary liability. As a result of this, we saw Lehman Brothers file for bankruptcy and other major banks relying on the government for a bail-out. The banks and financial institutions generally conducted their trades Over-The-Counter (OTC), whereby they could keep the transactions private. Furthermore, these transactions did not require disclosures to be made to the central securities regulator as they were not conducted on exchanges. The fact that these transactions were conducted in the absence of a central counterparty was considered to be one of the reasons for their default and thus the crisis.[2]

A derivative without any counterparty poses two primary risks – first of default and second of systemic risks, as was evidenced from the 2008 financial crisis.[3] Thus, to counter these risks posed, it was decided to implement a margin requirement. Such a requirement would require a party, buying a derivative, to pay a margin amount or provide a security that could be used to absorb any losses that could arise because of a party’s default; in turn it would also help the party from keeping its financial resources being used to make good the losses.[4]

Margin Requirements

OTC transactions are transactions between two private entities which are not cleared by a central counterparty. However, in the last year or so, the Basel Committee on Banking Supervision and the International Organization of Securities Commissions came up with a framework on margin requirements for non-centrally cleared derivatives.  In May 2016, the Reserve Bank of India too came up with a Discussion Paper on the same subject and has requested market participants for their views.

Margin requirements will require one party to deposit an initial margin with the other party, so that the risk of default is adequately protected by the collateral provided as the initial margin. The amount of the initial margin would be assessed after evaluating the potential exposure of the contract being transacted. Thereafter, a variation margin would become applicable, which would work as a ‘Mark-to-Market’ requirement that would be computed on a daily basis, thus covering the current exposure of that contract. While a mark-to-market is required to be settled on a daily basis, the discussion paper proposes to allow the settlement of the variation margin on a regular basis.

Similar to the international framework, physically settled derivatives like commodity derivatives, which provide the commodities as collateral, have been excluded from calling for initial margins.[5]  More importantly, the discussion paper has also provided a list of eligible collaterals that can be exchanged as initial or variation margins and they include: cash; securities issued by the Central or State Government; and corporate bonds above BBB rating. The international framework on the other hand allows equities in major stock indices and also gold to be used as collateral for the margins. Further, the margin requirement would be made applicable to OTC derivative transactions conducted by scheduled banks and other entities under the purview of the RBI. The discussion paper proposes to restrict the application of the margin requirements to transactions of derivatives which are not centrally cleared with the view to contain any potential systemic risks and to promote central clearing. However, with an aim to implement the requirement phase-wise, the RBI has proposed to make the requirement applicable to all financial entities and certain large non-financial entities, wherein large non-financial entities have been used to mean non-financial entities which have an aggregate notional amount of outstanding non-centrally cleared derivatives at or more than INR 1000 billion. While the international framework makes the margin requirement applicable to every entity participating in non-centrally cleared derivative transactions, the RBI has also proposed to extend the application over all interested entities but only in a phased manner.

One major difference that needs to be highlighted is that while the international framework allows for the re-hypothecation of the Initial Margin collected (only once, that too to hedge that particular position’s risk) the RBI’s discussion paper does not allow for the same. It however, does allow the re-hypothecation of the Variable Margin.  The RBI reasons it out by stating that the Initial Margin, which by itself is supposed to be treated as a security against the chances of default by the opposite party creating third party charges over the same, would defeat the purpose of creating the margin.

The discussion paper also proposes to exempt intra-group transactions between group entities from calling for initial or variation margin. Furthermore, the RBI has offered to coordinate with foreign jurisdictions in implementing these margin requirements. It has stated that for cross-border transactions, if the host country has its margin requirement regulations, those would be imposed on the transactions, and if the host country does not have any such regulations, then the RBI’s requirement would be applicable on the transaction.

Conclusion

A Quantitative Impact Study conducted before the release of the international framework estimated that close to 600 billion Euros would be mobilised for the purposes of providing initial margin.[6] Assuming that the initial margin requirement applicable on RBI regulated transactions mobilises a similar amount, it was prudent for RBI to restrict that capital from being re-pledged or re-hypothecated. On the other hand, allowing the pledge or hypothecation of the variation margin, which would effectively represent the mark-to-market payments made for centrally cleared derivatives, makes more sense as it is nominal in comparison with the initial margin. More importantly, a default in producing the variation margin is less likely to create systemic risks as compared to the default in the producing the initial margin.

Furthermore, studies also suggest that large market participants would eventually move out of the non-centrally cleared OTC derivatives segment as the transaction costs have substantially increased.[7] This could effectively lead to the elimination of speculators who would now look to invest in less capital intensive segments and encourage financial institutions like banks to shift to trading standardized contracts which are floated on the exchanges, thus bringing the transactions under regulatory purview.

The RBI had asked the interested parties to send their comments on the discussion paper by June; we can therefore hope to see the final regulations on the margin requirement soon.

- Rishi A.




[1] For extra reading please refer to http://www.federalreservehistory.org/Events/DetailView/55 or see the 2015 Hollywood movie, ‘The Big Short’.

[2] Dr. Shrawan Kumar Singh, ‘U.S. Sub-Prime Crisis & Its Total Global Consequences’, Available at: http://www.igidr.ac.in/conf/money/mfc-11/Singh_Shrawan.pdf.

[3] ‘Margin Requirements for non-centrally cleared derivatives’, Basel Committee on Banking Supervision and International Organisation of Securities Commission, March, 2015, Available at: http://www.bis.org/bcbs/publ/d317.htm

[4] Ibid.

[5] Ibid.

[6] ‘Quantitative Impact Study on Margin Requirements for Non-Centrally Cleared OTC Derivatives’, Appendix C, Second Consultative Document: Margin Requirements for Non-Centrally Clear Derivatives, February, 2013, Available at: http://www.bis.org/publ/bcbs242.pdf

[7] ‘OTC Derivatives: The New Cost of Trading’,  EMEA Centre for Regulatory Strategy, Available at: http://www2.deloitte.com/content/dam/Deloitte/uk/Documents/financial-services/deloitte-uk-fs-otc-derivatives-april-14.pdf

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