The beginning of the phase-in period for collecting and posting margin against non-centrally cleared derivatives trades will prove challenging for financial institutions in Asia, the Thomson Reuters ASEAN Regulatory Summit heard. Officials in Singapore said there were a number of unresolved questions about the local implementation of the regulatory model, which took effect for large firms from today. The structure for margin requirements for non-centrally cleared derivatives was developed by the Basel Committee on Banking Supervision ("BCBS") and the International Organisation of Securities Commissions ("IOSCO").
The Basel Committee and IOSCO have said they will "continue to monitor progress in implementation to ensure consistent implementation across products, jurisdictions and market participants." The global bodies will also liaise with industry as market participants to ensure that initial margin models comply with the regulatory requirements.
The margin requirements for non-centrally cleared derivatives have been designed to reduce systemic risk and to promote a move towards more central clearing of derivatives.
The reforms will follow a staggered implementation timetable, with the largest banks having to comply from 1 September 2016. Any entity belonging to a group with 3 trillion euros in aggregate monthly non-centrally cleared derivatives will be required to exchange variation margin when transacting with another covered entity that meets that condition.
From 1 March 2017, all covered entities will be required to exchange variation margin.
The requirement to exchange two-way initial margin with a threshold of up to 50 million euros will also apply to these larger institutions from today.
"Big Day" for OTC Markets
Only highly liquid assets can be used as collateral for margining, such as cash, government securities or certain types of highly rated equity or fixed-income instruments.
"Today is a big day; in fact it's the biggest day in terms of the regulation of OTC derivatives in the last three decades. This is one of the biggest financial regulatory reforms since the financial crisis," said Jing Gu, senior counsel at the International Swaps and Derivatives Association ("ISDA").
"The framework says that all OTC trades that are not centrally cleared will be subject to a mandatory margining requirement. So yesterday, if you were trading with a bank whether you provided collateral or not was really a commercial or credit decision. But from today in some cases it's going to be mandatory margining," Jing said.
Jing said today's deadline would affect around 20 of the largest dealers in the OTC derivatives space in Japan, the United States and China. Smaller firms and those in other jurisdictions would have to meet the March 2017 deadline.
"If you do a trade with a large Japanese bank right now you have to margin it. If you trade with a U.S. bank after lunchtime – from noon in Asia – you have to margin it," Jing said.
The initial margin requirement is likely to lock up a huge amount of liquidity at affected institutions, Jing said. She said this was likely to be challenging across Asia where there has traditionally been a low requirement for margining trades.
"When Asian banks trade with global dealers a lot of the time they just don't margin the trades. If you look at some ASEAN countries they never margin the trades. That is no longer going to be the case," Jing said.
ISDA is concerned that there might be liquidity challenges, or "gaps", for some of the dealers in the ASEAN region as they struggle to comply with the new requirements.
Some 50 percent of swaps in the ASEAN region are non-clearable. Delegates heard that the advent margining rules could prove challenging for regional financial economic stability as ASEAN market participants are expected to pay a considerable premium to margin their trades.
The lack of margining and clearing infrastructure in the ASEAN region, even for standardised trades, could also add additional costs and complexity for local firms.
"Due to the nature of the way that central clearing regulations have been designed you not only have to have a central counterparty that is big enough and commercial enough to support this but you also need to follow certain global standards. That's quite a high hurdle," one delegate said.
Central Role in Risk Management
Dr. Douglas Streeter Rolph, senior lecturer at the Nanyang Business School, said it was important to remember that derivatives play a central role in risk management among corporates in the ASEAN region.
"We know from active research that corporates do use derivatives as risk management tools, not as gambling tools. So from that perspective it could really hurt the economy if it makes it prohibitively expensive to enter these sorts of trades," Streeter Rolph said.
Lutfey Siddiqi, adjunct professor at the Risk Management Institute in Singapore, said that while margining is unambiguously risk-reducing for bilateral credit risk, it could induce systemic risk.
"If everybody needs to post collateral at the same time, at some point the margin calls may force parties to liquidate their original position," he said.
Siddiqi said liquidating the positions could cause a pro-cyclical downturn in the market which then triggers further margin calls.
"It could create a downward spiral as a result of the system requiring more collateral. So this is a systemic issue that is exacerbated by margin calls and we just need to be aware of those risks," Siddiqi said.