Central clearing of standardized derivatives and margin requirements for non-cleared derivatives are two of the basic tenets of global financial regulatory reform. They are also inter-related: the purpose of margin requirements is to both reduce systemic risk and promote or incentivize central clearing.
Recent studies and research into clearing incentives and margining raise questions about whether certain aspects of the requirements do in fact support these key policy goals. These questions include:
Does the scope of the current margin framework for non-cleared derivatives appropriately support the goal of systemic risk mitigation? Or does it impose costs on firms that pose little or no systemic risk, and can it potentially have an adverse impact on their risk management activities?
Does margining of non-cleared derivatives (which is higher than margining for cleared derivatives) incentivize central clearing? If and when it is not a major factor, then are the higher margin costs for non-cleared derivatives versus cleared derivatives appropriate, especially in situations where the risks of both may be similar?
This paper draws on research done internally by ISDA and recent studies by policy-makers to analyze and answer these questions.
In terms of systemic risk reduction, a relatively small number of the counterparties (approximately 20%) subject to the initial margin (IM) requirements account for a large majority of the total IM that will be required to be posted (approximately 85%) under the current rule set. Conversely, 80% of the firms currently in scope of the margin rules pose little or no systemic risk, but would collectively be required to document thousands of agreements, and set up thousands of segregated accounts in order to exchange collateral. This could have needless adverse effects on economic and risk hedging activity.
In terms of clearing incentives, while IM for non-cleared swaps may encourage clearing in certain market segments, there is substantial evidence that other economic incentives have a significantly greater impact. This includes regulatory capital requirements for cleared versus non-cleared swaps, as well as the significant benefits that flow from the ability to net a large, diverse swaps portfolio with a single, central counterparty (CCP). Consequently, there are strong incentives to clear, and the higher IM requirement for non-cleared versus cleared swaps may not be necessary to encourage clearing.
Based on this data and analysis, ISDA suggests:
IM should not be required for counterparties that pose little or no systemic risk. Toward this end, the current threshold of €8 billion in notional outstanding could be raised to €100 billion (and restricted to IM eligible trades) – a level that addresses systemic risk issues and avoids adverse and unnecessary consequences for hundreds of firms that pose no such concerns.
The role of margin as a clearing incentive should be re-calibrated, with consideration given for the existing inherent benefits of clearing, such as multilateral netting.