Derivatives rules raise market-liquidity concerns, EDHEC warns

New rules on derivative transactions coming into effect this year raise further concerns about market liquidity, according to EDHEC-Risk Institute.

The research institute published a study analysing the forthcoming framework for calculating initial margin (IM) and variation margin (VM) on transactions involving non-cleared over-the-counter (OTC) derivatives.

The study highlights how the new requirements on collateral to be put aside as IM on non-cleared OTC derivative transactions may put a further squeeze on much-needed liquidity in high-quality assets, such as government bonds and high-grade corporate bonds.

Dominic O’Kane, an affiliate professor of finance at EDHEC Business School and author of the study, said: “There’s a question mark over how much collateral is out there compared with what is going to be required.

“And since there will soon be other requirements coming in from bank capital rules, which will also require additional collateral to be held, the question is, is this going to put a strain on liquidity and availability assets?”

The new framework, which will be in force from September, is based on the recommendations of the Working Group on Margin Requirements (WGMR), formed by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO).

The WGMR has been developing the framework since 2009 as a response to the bankruptcy of Lehman Brothers, the bailout of AIG and the federal takeover of Fannie Mae and Freddie Mac, all of which had large exposure to OTC derivatives.

The new set of rules requires counterparties in non-cleared transactions to hold IM collateral to protect each party from the risk of the other defaulting.

Since the transactions involved are not cleared by central counterparties, such as Swapclear, the IM collateral has to be held in third-party accounts and cannot be used for other purposes.

“Because the principle of the WGMR is that the defaulter pays,” O’Kane added, “the IM collateral has to be held in such a way that it cannot be touched by either counterparty to a derivative transaction until a counterparty defaults, and only then is the non-defaulting part allowed to use the collateral they hold.

“At the same time, the non-defaulting counterparty must receive back the IM collateral that was held by the defaulting counterparty.

“This means the collateral assets cannot be re-hypothecated or reused for funding, repo or other purposes. And therefore these assets are effectively frozen out of the financial system, reducing the amounts of high-quality collateral available.”

O’Kane continued: “Despite reports from the European Central Bank (ECB) that the amount of available collateral is significant, there is a concern the new WGMR framework will have an impact on liquidity.

“In the limit, the demand for high-quality collateral could create a shortage that might push up the prices of certain market instruments.”

The majority of traditional OTC derivative transactions, such as interest rate swaps (IRS) and some swaptions, are already being cleared thanks to the introduction of the European Market Infrastructure Regulation (EMIR), which requires standard derivative products to be cleared by central counterparty clearing houses (CCPs).

From August next year, the exemption for European pension funds from central clearing will also be lifted, which means they will have to start putting IM collateral aside for traditional OTC derivative products, potentially putting further pressure on the system.

While EMIR applies to the larger part of the OTC derivatives market, the non-OTC derivatives market, to which the WGMR framework applies, accounts for a large amount of assets.

A 2013 quantitative impact study (QIS) by the Bank for International Settlements (BIS) on this market shows that the total amount of IM to be allocated would be more than €500bn.

This number assumes a threshold for posting IM of €50m, and netting across asset classes. 

The EDHEC study also focuses on the proposed model for calculating of IM and VM brought forward by the International Swaps and Derivatives Association (ISDA), which is currently being finalised, and may be adopted as the universal model under the WGMR framework.

O’Kane said: “The ISDA model appears to be quite straightforward to implement and should be able to calculate the IM quickly, which is important, as IM needs to be posted regularly.

“The model appears to have enough sophistication to capture the various risks, which is important due to the less standard nature of the non-cleared OTC derivatives market.

“These risks are linked to correlation and volatility that some of the simpler products do not have, so there is a need for a more sophisticated modelling framework.”

He added: “Having a market-wide model is extremely useful, as it enhances transparency and reduces the likelihood of costly and time-consuming disputes between counterparties”.