One of the most important market reforms that will be implemented pursuant to the Dodd-Frank Act is the requirement that participants in the over-the-counter ("OTC") derivatives markets clear certain types of trades with a central counterparty ("CCP"). Clearing effectively replaces a single bilateral trade with two new offsetting trades where the CCP acts as the counterparty to each of the original parties. Once a trade is cleared, the parties to the original bilateral trade no longer face each other. In this way, the insertion of a CCP mitigates the risk of nonperformance by one of the parties during the trade (also known as "counterparty risk") by effectively having the CCP ensure performance by the parties.
Instead of each party being at risk to the other for the length of the trade, they both have recourse to the CCP, so that if one of the parties defaults, the other will not lose any amount that it is otherwise owed under that contract.
This so-called "clearing solution" is one that took hold in the wake of the Lehman bankruptcy. Following the Lehman default, market participants were concerned that the default of Lehman would cause other major market participants to default, given that the OTC derivatives markets were highly interconnected. Since many OTC market participants typically hedge their risk with other OTC derivatives, the fear was that a single default could cause a chain reaction of nonperformance or "cascading" defaults. In response to Lehman, regulators seized on the idea of interposing the CCP into the relationship, effectively substituting the bilateral credit risk of the various dealers for a single, centralized hub. A CCP (i) nets offsetting exposures, (ii) calls for and monitors collateral, and (iii) ultimately manages any defaults of its members. Additionally, the CCP will act as a guarantor for every trade, allowing for better reporting and monitoring of the markets. In short, the view that the overall risk to the system arising from any counterparty default is reduced by clearing caught on quickly and has remained at the forefront of the global regulatory reform effort. In the United States, the passage of Dodd-Frank mandated the clearing requirement and set the regulators to the task of figuring out how to prudently manage this new system.
Dodd-Frank and the Clearing Mandate
The threshold test for mandatory clearing under Dodd-Frank is that a CCP has to accept that type of OTC derivative for clearing before it will be required to be cleared. Currently, the market expects that the initial group of trades required to be cleared will include the most liquid single-name and index credit default swaps ("CDS"), along with the most commonly traded forms of interest rate swaps, such as USD, GBP, and EUR fixed/floating swaps in maturities out to 30+ years. However, certain types of derivatives are not expected to be available for clearing in the near term, including products such as swaptions and CDS tranches; certain types of derivatives that are more customized may never be subject to mandatory clearing because they are too specific to be matched up with an offsetting contract. As a result, the current expectation is that once clearing becomes mandatory, many firms will find themselves with portfolios that are split between cleared and uncleared derivatives.
As the market prepares to meet the mandatory clearing requirement under Dodd-Frank, certain questions have begun to emerge about how clearing will work in practice. In particular, firms that trade multiple asset classes within the OTC derivatives markets are starting to examine the impact of taking their cleared trades out of what was previously a single portfolio. Many firms currently use cross-margining, which allows them to realize a significant economic savings. However, the final rules on the treatment of cleared swap customer collateral, as adopted by the Commodity Futures Trading Commission ("CFTC") in January, have caused the market to question whether cross-margining will be available between cleared and uncleared swaps.1
Under the final and proposed rules for both cleared and uncleared derivatives, there will be mandatory initial margin requirements associated with each of these types of trades. Separate proposals on margin requirements for uncleared swaps by the five U.S. prudential regulators, as well as the CFTC and, for security-based swaps, the Securities and Exchange Commission, may restrict how margin can be used by limiting the ability to apply portfolio offsets between certain broad categories of risk.2 That is, a party that had posted excess margin for one category of swap could not use that excess margin to reduce its margin requirements for another swap category. In the prudential regulators' proposals, these categories are commodity, credit, equity, and foreign exchange/interest rate swaps. In addition, the proposals do not appear to contemplate margining across swap and security-based swap transactions, and between other transactions excluded from the definition of "swap" (for example, repurchase transactions, securities lending transactions, or foreign exchange swaps and forwards that are excluded from the definition of a swap). These restrictions on cross-margining could also significantly increase the costs of risk-reducing swaps activity by significantly increasing the margin required for all derivatives, thereby discouraging participants from hedging with swaps, and in turn making the overall markets less liquid. Therefore, the move to mandatory clearing is potentially an expensive one for customers who currently enjoy the benefits of a single portfolio of OTC derivatives.
In this context, cross-margining is a legal arrangement where a dealer looks at its uncleared trades with a customer, then takes into account other opposite or offsetting cleared derivatives and futures trades held by the futures commission merchant affiliate of the dealer. This allows the dealer to calculate a net risk figure that reduces the customer's initial margin requirements for uncleared swaps. Whether or not this type of cross-margining is permissible is a fundamentally important issue for market participants.
Given the potential scarcity of eligible collateral, and the fact that some market participants have never had to post initial margin before, getting clear regulatory guidance is critical to all market participants. Currently, customers are able to agree to some form of customer margining with their clearing members, where the risk of the customer's cleared and uncleared portfolios with that clearing member and its affiliates are viewed on an aggregate basis. As a result, a net initial margin figure can be calculated that is lower than the initial margin that would be separately required on the cleared and uncleared positions.
In theory, cross-margining between cleared and uncleared trades is straightforward. The complexity lies in the fact that the two portfolios are likely to reside in different (albeit affiliated) legal entities subject to different regulatory regimes. As an example, if a customer has a portfolio of uncleared swaptions with a dealer and another separate portfolio of cleared interest rate swaps with the dealer's FCM affiliate—with the swaps positions offsetting the delta on the swaptions—the net initial margin required based on the risk of the combined portfolio would be lower if cross-margining is permitted than would be the case if each portfolio were considered separately. For example, treated separately, the CCP might call for $50 million of margin on cleared swaps, while the uncleared swaptions might require $100 million. However, after giving effect to cross-margining, on a net basis, the total margin required to cover both portfolios, based on the composite risk, might be only $80 million. There would be no reduction to the amount of initial margin required for the portfolio of cleared swaps, but the dealer holding the swaptions positions, knowing that $50 million had been posted to the CCP via its FCM, might need to call for only an additional $30 million to cover the uncleared portfolio. Whether each of the relevant regulators will permit this arrangement and how this reduction will be recognized in terms of the dealer's risk management requirements, including regulatory capital treatment, is still an open question.
Practical Concerns Emerge
In adopting the "legal segregation, operational commingling" ("LSOC") model, the CFTC stated, "While the Commission supports the benefits of portfolio margining, the Commission does not believe it would be prudent to permit collateral margining cleared positions to simultaneously be used to margin uncleared positions."3 Consequently, those firms that have cross-margining arrangements in place today, or that had not been previously required to post initial margin, would be wise to consider the impact of initial margin requirements when clearing is required.
This statement appears to arise due to an incorrect assumption, i.e., that the CFTC believes that in order for cross-margining to work, collateral pledged to support cleared transactions must be double-counted and allowed to be deemed to support uncleared trades. While cleared customer collateral should not be double-counted in any case, under a cross-margining arrangement, cleared customer collateral is not being "used to margin uncleared positions." Rather, cross-margining allows net initial margin calculations to be based on the overall risk of the portfolio, taking into account the required cleared customer collateral and then potentially allowing for a corresponding reduction in uncleared customer collateral. In each case, the aggregate amount of margin will at all times be sufficient for the level of risk when calculated on a portfolio basis.
On a portfolio basis, the margin proposals for both cleared and uncleared swaps will result in much higher margin requirements for all market participants. The Office of the Comptroller of the Currency has estimated the initial margin requirement for uncleared swaps could be as high as $2.05 trillion.4 While these numbers are highly preliminary and necessarily based on assumptions about the split between cleared and uncleared derivatives marketwide, there is no doubt that funding costs associated with initial margin requirements will increase significantly. In this environment, it becomes very important for market participants to be appropriately margined for their risk, taking into account all of the positions in a participant's book, and viewing the risk holistically. In our view, cross-margining incentivizes risk reduction through hedging and the maintenance of balanced portfolios; allows capital to be deployed most efficiently, yielding better returns for the investing public; and facilitates the transition to central clearing. Obtaining legal certainty and regulatory approval for cross-margining of cleared and uncleared OTC derivatives will be a critical part of this equation.
1 77 Fed. Reg. 6336 (Feb 7, 2012), Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions, available here.
2 The "Prudential Regulators" are the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Farm Credit Administration, and the Federal Housing Finance Agency. Both the Prudential Regulators and the CFTC have proposed margin requirements for uncleared swaps.
3 While the term "swap" is defined in Section 721(a)(47) of the Dodd-Frank Act, the CFTC has not yet issued its final rule defining that term. However, we assume for purposes of the clearing mandate that the term "swap" will encompass almost all transactions commonly known as over-the-counter derivatives.
4 OCC study, "Unfunded Mandates Reform Act, Impact Analysis for Swaps Margin and Capital Rule," dated April 15, 2011 ("OCC Study"), available here, pp. 5 - 6.
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