Of all the regulatory changes that have been proposed or implemented, the biggest potential game changer for the OTC derivatives markets are the collateral requirements that will now be imposed on all derivatives transactions.
Collateralization is, to be sure, common practice and an integral risk management tool in the OTC derivatives market today. The growing number of cleared OTC derivatives trades (more than 50% of the IRS market, for example) are subject to both initial (IM) and variation (VM) margins. The terms of collateralization are governed by the Credit Support Annex (CSA) to the ISDA Master Agreement.
To put this in context, collateralization of OTC derivative trades was something that was left to negotiation between two parties who would, based on their assessment of each other, customize and set terms accordingly. Those terms could (or not) include an initial margin (in most cases not), a requirement to post collateral if the mark-to-market exceeded certain levels (threshold amounts), and the type of collateral, frequency of collateral calls, and others.
However, in a broad swipe, new regulations across geographies make collateralization mandatory. More OTC derivatives will be required to be cleared, meaning that counterparties will now need to post IM and VM for them. Similar rules are soon to be unveiled by a group of global regulators, led by the US Federal Reserve Board, for transactions that are not suitable for clearing. By all indications, such collateralization requirements are likely to be more severe than those cleared, if nothing else to induce further use of clearing, and also because such transactions are likely to be less liquid and/or less frequently traded, requiring more collateral.
The effective result of these regulatory developments is a mandatory and massive “risk-off” move. Going forward, all participants in the derivatives markets “will not be allowed” to take the credit risk of their counterparties – be they CCPs or bilateral. The default choice will be no credit assessment, a presumption that the counterparty is not creditworthy, and thus a requirement for full collateralization.
We have written in this column before about the massive increase in new collateral that this regulatory initiative leads to (estimates range anywhere from $0.5 trillion to $2.7 trillion). Whatever the estimate, it is likely to be large (we are talking trillions, with a “t”), and comparable in size to the “quantitative easing” (QE) programs undertaken by major central banks recently. This QE-sized requirement, however, works in the opposite direction of the actual QE, and is likely to have adverse effects on the real economy. That’s because it requires that top quality assets and/or cash be “parked” and remain unutilized, as opposed to being plowed in the real economy (by banks), invested elsewhere (by asset managers) or used for productive purposes (by corporations). In this respect, it is interesting to note that at a time when the markets are likely to face increased demands for quality collateral, the central banks, through their QE programs, have been removing from the market such “quality” collateral (in the form of government, mortgage and other high quality bonds).
In addition, the market faces a lot of practical issues in implementing mandatory collateralization practices on this scale. These issues are likely to further exacerbate the shortage of collateral. In the aftermath of MF Global, confused and worried market participants demand (justifiably so) extra security for the collateral they post. There are demands for full segregation, custodian arrangements with third parties, even demands for no re-hypothecation (should we start marking the banknotes that we deposit as collateral?). CCPs, responding to these concerns, have started offering a variety of “segregated” solutions but the devil is in the details and much attention needs to be paid in understanding what these offerings entail. Further complicating matters is the lack or harmonized practices around the world when it comes to solvency law, as well as the fragmentation in the securities depository systems, particularly in Europe.
So, while a lot of attention is being paid to the question as to whether the market will comply with clearing and other requirements by 2012 year-end, the real elephant in the room is whether the marketplace will come up with the all the collateral that is required, and if it does, what the liquidity implications for the real economy will be. And these events will be coming at a time when other similar “risk-reducing” regulatory initiatives are in the making in the form of increased capital requirements (Basel III) with implications for the capacity of the banks to provide liquidity to the secondary markets, or simply lend money to the real economy.
We may get what some wish for: a completely “de-risked” economy. But at what cost?