Initial Thoughts on Initial Margin

A recent speech by the Federal Reserve Board’s Vice Chairman appeared to get the New Year off to an inauspicious start for OTC derivatives markets. Initial reports of the speech indicated that it called for tougher regulation and treatment of derivatives, including a requirement for initial margin.

Bah, humbug.

But then we actually read the transcript, and felt a little better. There are some key aspects to the speech that we agree with.

First, there’s recognition about the benefits of a robust variation margin (VM) framework and its role in achieving an important public policy goal:

“The [VM requirement] codifies current best market practice, since the largest derivatives dealers already exchange variation margin daily. However, and importantly, the framework extends this prudent risk-management practice to other derivatives counterparties. Requiring timely payment of variation margin will go a long way toward ensuring that an AIG-like event will not happen again [emphasis ours], since current exposures will not be allowed to build over time to unmanageable levels.”

Second, there’s acknowledgement of the impact that initial margin (IM) requirements will have on liquidity and on the cost and availability of OTC derivatives to end-users: “higher initial margin requirements will make it more costly for market participants to use derivatives to hedge risk.”

Another key point: the speech notes that “requiring less-liquid and highly customized derivatives to be cleared would likely increase systemic risk …” But that’s because the risk management practices of CCPs are not well-suited to manage such risks – and not because the risk of such instruments is unmanageable (for more on this, see our December letter to BCBS-IOSCO on Margin Requirements For Non-Centrally-Cleared Derivatives).

There are, to be sure, some points that we disagree with. And there are some that we really disagree with.

We don’t, for example, believe that IM will reduce systemic risk. If done improperly, it could actually be highly pro-cyclical and increase systemic risk.

And we also don’t see how margin requirements can “diminish the incentive to tinker with contract language as a way to evade clearing requirements.” This notion ‒ that IM is needed to enforce or incentivize clearing ‒ has taken hold in some circles to justify the imposition of IM, but we don’t think it lines up with the facts. Clearing has happened, is happening and will continue to happen because it is a cost-effective means of managing risk through standardized products.

As we stated in the letter to BCBS-IOSCO mentioned earlier: “If a transaction is not clearable, then no amount of IM can cause it to be cleared. If it is clearable, then legal mandates – and not punitive IM – should drive clearing. If a high level of IM is the tool used to try to incentivize clearing, not only would such a strategy fail, but there would be…. potential adverse ramifications.”

2013 looks like a year in which we will be talking a lot about margin requirements. We’re not sure if this will keep us merry and bright over the next 12 months, but it should keep us busy.

Back To The Future

Everyone in OTC derivatives is so busy preparing for the future that we wonder if it’s even worth going back in the past to reexamine some popular assumptions about the financial crisis.

But, in light of a couple of recent developments, we just can’t resist.

First off, witness the exchange that took place recently on CNBC’s Mad Money between host Jim Cramer and his guest, AIG CEO Robert Benmosche. They are talking about the events surrounding AIG’s financial difficulties in September 2008 (starts 8:27 into clip).

Benmosche: …the issue was not capital. The issue was cash. They didn’t have cash.

Cramer: Right, did they have the collateral for the…

Benmosche: They actually had the collateral, but the question was they had no window to go to, because they weren’t a bank until afterwards. Had the same been given to AIG that was given to other companies after AIG got the bailout—as you know, some of the investment houses were given access to the Fed window; other large institutional companies were given access to the Fed window. Had AIG had the same access, I believe that would have solved the liquidity crisis they had.

Cramer: So it wasn’t that bad off, then. It was just a question of the moment in time.

Benmosche: It was cash to meet collateral calls, because, in the end, the financial products that were put on the books, that were bought by the Fed—you saw the profits already—we believe almost all of that will accrete back to what it was supposed to be.

Cramer: That’s incredible.

Benmosche: It was a question of the markets had tanked, the way the accounting was done—which was changed, okay? But the accounting was very aggressive at that point in time, and so it required too much cash to be put up on things that, ultimately, would have worked.

(click for full CNBC transcript)

We prefer to leave the ultimate takeaways from this exchange (and there are several) to our readers. But there’s one worth pointing out. AIG’s actual final cash losses on the credit protection it wrote were not why it needed a bailout. Realized losses would not have caused its collapse.

It was, instead, the cash that had to be posted as collateral for those contracts that caused the company’s distress. This is a point echoed by a new paper from Harvard Professor Hal Scott and the staff of the Committee on Capital Markets Regulation:

To be sure, after AIG’s long-term debt was downgraded by each of the three rating agencies… AIG did not have enough liquidity to meet further collateral demands. Indeed, the downgrades coupled with subsequent market movements caused AIG’s collateral posting obligations to soar to more than $32 billion over the following fifteen days, compared to only about $9 billion of cash entering the week.

A turn not marked on the roadmap

Why is all of this worth rehashing four years after the fact? Because today, the policy debate regarding OTC derivatives is taking a turn that was not on the G20’s original roadmap. That map, as articulated in 2009, called for more clearing of standard, liquid swaps; appropriate capital standards across firms; and increased regulatory transparency. ISDA fully supports ‒ and has actively driven towards ‒ these G20 goals and regulatory efforts to reduce systemic risk.

So what’s the dangerous turn in the road? It’s about efforts to fashion capital and margin requirements for OTC derivatives that can’t be cleared. There are a number of different types of these instruments, used mainly by a variety of end-users in the ordinary course of their businesses, and they total 20% or so of the overall OTC market.

Some would like to see all OTC swaps centrally cleared. Clearinghouses, however, are the new too-big-to-fail institutions. They need to be protected. They must only clear liquid, standardized products. To jam them with less liquid, less standardized products could have potentially disastrous consequences. They must be kept pristine.

Uncleared derivatives are not necesarily any more risky than cleared swaps, it is just that they do not meet the (appropriately) very high bar at the clearinghouses. They do, however, have enormous social value. Examples include inflation swaps, widely used by pension funds globally and cross currency swaps, which are vital to the funding operations of corporations and governments.

It is also worth noting that the types of unclearable OTC derivatives used in the real economy generally have nothing to do with the type of CDS that AIG wrote. (Those were also unclearable and as a result have cast a shadow on the whole category of unclearable swaps.) But the desire to avoid AIG-type situations is potentially leading to a margin framework that could quite possibly end transactions in this important sector, essentially throwing the baby out with the bathwater, and in doing so perhaps perversely increasing risk in the system.

We, like regulators, want to build a framework that ensures AIG can’t happen again. And we believe that experience provides that the best way to do this for uncleared swaps is through a robust variation margin (VM) regime – one in which transactions are valued and collateral exchanged on a daily basis. Frequent exchanges of collateral between counterparties means that large credit exposures that could become destabilizing in periods of market stress can’t build up. Had this practice been followed four years ago, we would not be talking about the AIG situation today. AIG did not, as a matter of course, post daily VM to settle liabilities with its counterparties.

Another example from 2008 draws a stark contrast. Unlike AIG, Lehman Brothers did have robust VM arrangements with its counterparties. Those VM arrangements ensured that the Lehman default did not cause any systemic contagion.

However, while VM is clearly an effective part of the regulatory framework for swaps, policymakers are considering an additional step. They are proposing to impose a different kind of margin – initial margin. This can be thought of as a buffer, a safety cushion of extra collateral over and above any monies owed between parties. The goal, again, is to reduce the chances of systemic risk from a major default.

The Initial Margin paradox

Initial margin, or IM, does help reduce systemic contagion, but it does so at the cost of making market participants more likely to default, since the posting of initial margin consumes valuable liquidity resources at banks, and importantly, creates a future contingent liquidity draw of potentially terminal proportions. This is because IM requirements increase in response to increased market volatility. This procyclical funding draw will happen in the heart of a crisis, at the worst possible time for market participants.

Regulators could undercut the very goal of systemic resiliency that we are all trying to achieve. Our recent presentation makes this clear.

Professor Scott’s paper also makes it clear that AIG’s collapse did not pose systemic threats (questioning in another way the need for IM):

…it is widely believed that…AIG was saved because of the interconnectedness of its derivative positions with other important financial institutions. While it is relatively clear that derivatives helped to bring down AIG, there is no substantial evidence that its failure would have put its counterparties at risk of insolvency. Direct losses from in-the-money CDS positions held by counterparties would have been small relative to their capital.

In addition to these concerns, The IM proposals also can have significant adverse economic and financial consequences. As noted above, they could possibly put an end to the uncleared swaps market. Some commentators might welcome this, but such a position is quite frankly, absurd. Unclearable swaps are critical to the proper functioning of vital sectors of the economy, such as the US housing market and financing of corporations. They are an essential component of the lifeblood of the broader global economy.

We need to get this part of financial regulatory reform right. And to do so, we need to look back so we can move forward.