Consensus and Disagreement
FINCAD sponsored a panel discussion titled “Margin Requirements for Non-centrally Cleared Derivatives,” which was hosted by Lepus on April 30, 2014 in New York. Panelists and audience members seemed to agree on what brought us to this point, with the Lehman Brothers and the post-crisis environment leading to the 2009 G20 set of reforms morphing into margin requirements on bi-lateral OTC derivatives. This shaped today’s regulatory environment and focus on market transparency in OTC derivatives settlement, pricing and trade processing. On the other hand, with the December 2015 deadline approaching, there was no apparent agreement on operational approaches and what form the future OTC derivatives market will take. We can expect to see more heated discussion in this area as the deadline approaches.
Overwhelming Technology & Operational Requirements
There was general panel agreement on the significant amount of operational and technology change required. Some examples included the renegotiation or CSAs as well as onboarding of clients requiring extensive augmentation of business processes. On the other side, some of the largest issues focused on initial margin computation, imminent cost increases and segregation of collateral. With respect to margin and collateral workflow, there has been a market trend for shared utilities for processes, such as tri-reconciliation processes. Despite the possible adoption of ISDAs SIMM (Standard Initial Margin Model) BCBS 261, it is likely that there will still be a larger market need for different client models.
Expanded Role for Shared Utilities
There was discussion of a possibility for a shared utility amongst the dealers for the quantitative modeling that could be used in computing initial margin requirements. Utilizing an independent third party would help to lessen the implementation burden experienced by many of the dealers as well as many of the buy-side firms that would be subject to the calculation of these IM and VM requirements. This would also help to provide transparency into the modeling and pricing process. One challenge is the need to explain to clients how a price was derived, ascertaining model assumptions and how to decompose pricing. (Please see our earlier paper prepared in in collaboration with Sapient, The Cost of Clearing: A Buy-side Investigation)
One later question from the audience focused on the amount of regulation and if the operational workload and increased costs may push out many, save a few of the largest and most dedicated niche firms and dealers. It seems that some market participants suited for longer term viability in the OTC derivatives will be end-users, bona-fide hedgers and corporations. This was another area of panel debate on what the future market composition of the end-user, buy-side and dealer market may look like as regulations unfold.
Regardless, all market participants will inevitably bear significantly greater costs. Cost sensitivity may be lower for some buy-side firms looking to hedge exposures as their primary priority. Nevertheless, cost increases due to a trillion-dollar collateral posting demand will be felt by all in the marketplace. While the need to compute variation margin may not be a significant change at the dealer level, we may see the greatest impact at the end-user level, where the operational and computation implementation will likely be new efforts.