Tuesday, October 30, 2012

US Hedge Fund Industry Urges Basel-IOSCO Working Group to Consider Risk Management in Margin for Non-Centrally Cleared Derivatives

While generally supporting the efforts of a Basel-IOSCO Working Group to provide an international framework for the bilateral exchange of initial and variation margin for non-centrally cleared derivatives, the US hedge fund industry urged the Working Group to consider the cumulative effect of the proposals on the liquidity of the non-cleared derivatives markets.  In a letter to the Working Group, the Managed Funds Association said that the proposals should not unduly impinge on the ability of market participants to transact on the non-cleared derivatives markets, given their critical role in allowing market participants to meet their risk management needs. Unless carefully managed and monitored, cautioned the MFA, the aggregate impact of the proposals could place unwarranted burdens on market participants, particularly in the period before the market has transitioned to mandatory clearing.

Thus, the Working Group, in its final recommendations, should take into consideration the risk management needs of participants in the non-cleared derivatives markets and to avoid compromising their ability to manage risk effectively. More broadly, the MFA strongly urged regulators across jurisdictions to coordinate with each other in order to ensure a uniform set of margin requirements in non-cleared derivatives markets.

The MFA believes that the derivatives markets operate most efficiently where the margin requirements are harmonized cross-border and applied uniformly with respect to all non-cleared derivatives. A uniform set of margin requirements will facilitate orderly collateral management practices. Without cross-border uniformity, warned the MFA, market participants will have to monitor and comply with multiple margin regimes, which would be a costly and burdensome task that could increase the likelihood for errors and instances of non-compliance. Further, margin requirements that differ according to the jurisdiction would encourage regulatory arbitrage and create advantages for market participants established in certain jurisdictions over other market participants.

The MFA looks forward to the results of the quantitative impact study to assess the effect of the proposed margining requirements on the orderly functioning and liquidity of the non-cleared derivatives markets, and urged the Working Group to consider the results of the study when finalizing the proposals. The final recommendations should take into consideration the importance and continued viability of non-cleared derivatives as customized risk management tools.

Specifically, the MFA supports the bilateral exchange of initial margin, provided that the initial margin requirements appropriately reflect and address the risks to the financial system presented by the non-cleared derivative transaction. However, the association is concerned that buy-side market participants will bear their sell-side counterparties’ costs associated with establishing and maintaining segregated custodian accounts for counterparties. The MFA is also concerned that the increased cost of trading non-cleared derivatives could reduce liquidity and adversely impact market participants’ ability to properly hedge their portfolios. Thus, the group said that the final recommendations should consider the overall cost and liquidity impact of the proposed margining requirements.

Similarly, the MFA supports the proposal to allow portfolio margining. But for portfolio margining to achieve the intended risk offset benefits, said the association, initial margin models should account for risk offsets across suitably correlated cleared and non-cleared derivative and non-derivative products. The MFA believes that such portfolio margining within a single cross-product master netting agreement is instrumental in mitigating the potential shortfall in eligible collateral while ensuring sufficient reserves to preserve systemic safety. Portfolio margining arrangements should account adequately for the risks of a portfolio, continued the hedge fund group, while avoiding the capital inefficiencies of over-collateralization. In addition, portfolio margining arrangements encourage market participants to enter into mutually offsetting transactions and maintain balanced and hedged portfolios.

The MFA does not believe that thresholds are an appropriate tool for managing the liquidity impact of the proposed initial margin requirements. The introduction of thresholds would result in counterparties being treated unequally, said the association, with some counterparties being required to post no initial margin, or a significantly reduced amount after application of a high threshold.