CMRA's Uncleared Swap Margin Survey Results

CMRA's Galaxy of Risks (partial listing)

CMRA has surveyed a variety of market participants and market observers on the margin regulations for uncleared swaps, which have been gradually rolling out since the fall of last year. Survey participants shared their thoughts on variation margin, initial margin, and ISDA SIMM.

Initial margin and ISDA SIMM

The implementation schedule for initial margin regulations pushes further into the future than for variation margin, with market participants in different stages of compliance through 2020 depending on the size of their positions. Yet, many have already begun to think about the impact of two-way initial margin posting.

Larger buy-side market participants look forward to independent custody of initial margin

Larger buy-side participants, who were often required by their dealer counterparties to post initial margin even before the financial crisis, were enthusiastic about independently custodied initial margin. They noted that in the event of counterparty default, recoveries are often uncertain, but that possession could be nine-tenths of the law.

Two-way initial margin is not without costs that may create market frictions

The majority of survey respondents reported that the direct and secondary funding costs of implementing two-way initial margin posting, with segregated custody of collateral in some instances, was something that highly concerned them. In particular, a few major derivatives dealers noted that they anticipated the potential reduction in counterparty credit risk capital would be minimal compared to the cost of funding initial margin, particularly given the fact that regulators have been trying to move market participants away from advanced internal model approaches for capital.

In particular, market participants were concerned that some products (e.g., total return swaps, liquid credit, certain pay-as-you-go CDS) had initial margin requirements that appear to be punitively high whereas initial margin for large size positions and less liquid products might be insufficient in the event of counterparty default. They commented that a 10-day default window seemed unrealistic for more liquid products but potentially insufficient for more esoteric products, and were unsure of specific counterparty outcomes despite the cost frictions to the system that the initial margin regulations impose.

Vulnerabilities of 10-day 99% historical stress

While for more liquid uncleared swap products, a 10-day liquidation window may be too long, the risks of certain product types can be overlooked by an approach that relies upon available historical data. Market participants should be cognizant of the risk that stress losses set via a historical, VaR-like process may not be indicative of future stresses, and that the calculation of initial margin based on historical data is necessarily vulnerable to the market regime changes that may occur just as initial margin is most needed by non-defaulting counterparties.  For example, the preferred securities market experienced spread widening in September 2008 that greatly surpassed the historical 10-day 99% stress as the result of a paradigm shift in the market for preferred securities in the wake of GSE conservatorship and Lehman’s bankruptcy filing. The Bank of America Merrill Lynch US Preferred, Bank Capital, and Capital Trust Securities (C0PS) Index, had a 10-day 99% stress spread widening that was at most 63 bp over any 5 year period from 1996 (the inception of the index) through August 2008. Yet, in September 2008, when Lehman defaulted spreads had widened by 212 bp over the previous 10 days and would go on to widen by as much as 333 bp within the week – the impact of which would have dwarfed an initial margin requirement based on the previous 10-day 99% stress of 63 bp.

Figure 1: Historical 10-day 99% stress is not a panacea

Variation margin

Variation margin requirements have been standardized, requiring new or amended CSAs (Credit Support Annexes). Collateral is not fungible across old and new CSAs. While there have been a number of complaints about the cost of executing the updated CSAs, the process appears to be well on its way to completion. Most market participants have already implemented compliance with variation margin regulations, with regulatory relief for those not in compliance scheduled to expire by September 2017 in most cases.

Standardization: what does it accomplish and what are the costs?

The most significant change for market participants reported to us is the standardization of collateral and haircuts. The intention that swap valuations not be sensitive to collateral valuation appears largely to have been satisfied. Furthermore, standardized collateral could in theory facilitate novation, especially at a time of distress or potential counterparty default.

The costs to standardization are the increased funding costs, especially if cash has to be posted as collateral. The vast majority of our survey participants have expressed concern over requirements for some counterparties (mainly the larger institutions) to post and collect variation margin in cash. Slightly less than half of survey respondents were worried that limitations on eligible collateral and mandated collateral haircut schedules might impact their own funding considerations.

One of the most pressing issues that has emerged with the new margin regulations is settlement timing. The US has moved to T+1 while other jurisdictions will remain at T+2. This difference across jurisdictions was cited by US-based derivatives dealers as an operational concern, as they reported that some clients were still struggling to implement T+1 settlement because of time zone differences and other logistical obstacles. Moreover, certain market participants subject to T+1 settlement requirements described the mandated shift from T+2/T+3 as a de facto limitation on collateral rehypothecation that would increase their overall funding costs.

Will variation margin regulations aid in the event of future counterparty defaults?

Notably, the new regulations require the posting of variation margin for most financial counterparties, and thus would have likely precluded the viability of some pre-crisis liquidity providers that relied on AAA ratings and one-way CSAs, such as AIG, monoline insurers, and credit derivative product companies (CDPCs). However, the market had already moved toward two-way CSAs even before the new margin regulations, and thus the required posting of variation margin likely codifies market practice rather than promoting new best practices.

Overall, market participants thought that the standards embodied in the new variation margin requirements would be minimally helpful in settling uncleared swaps in the event of counterparty default. They noted that in some cases, high initial margin requirements would likely disincentivize the additional effort required to novate positions away from defaulting counterparties. The response from market participants is consistent with CMRA’s experience in over 15 Lehman-related derivatives settlement claims, where we have observed that most disputes arise because of differences between mid-market variation margin posted and replacement cost (especially in light of elevated bid/offer spreads that manifested most significantly in more esoteric products with few or no market makers).

Conclusions

There is some sense among derivatives dealers that the costs imposed by the variation and initial margin regulations will accelerate the transition towards central clearing. Of course, central clearing is already the primary choice for those products that are eligible for clearing, and there are limitations on the complexity of products that can be cleared. Thus, market participants that are subject to the new regulations may choose to do little or no volume in customized transactions that are not eligible for clearing.

As the market moves increasingly towards central clearing, however, the resilience of central counterparties becomes increasingly relevant while also becoming more challenging because of their growing market share.