Almost a decade on from the financial crisis, a global deadline for reform of the $544tn derivatives market has triggered a last-minute scramble by hundreds of small banks, insurers and pension funds.
Many of these institutions use bespoke derivatives such as swaps to protect their operations from sudden changes in asset prices. In a month’s time they face higher costs and regulatory burdens. Plenty are not ready.
Failure to prepare for the final stage of post-financial crisis rules designed to strengthen the privately negotiated derivatives market, means many companies and investors will be prevented from transacting new swaps to hedge liabilities from the start of March.
Global regulators have succeeded in pushing three-quarters of the interest rate derivatives market, or what are known as standardised trades, into clearing houses that sit between a buyer and seller and manage the fallout should one side default.
The remainder of the market, with a notional value of $110tn, is made up of bespoke deals that are harder to value and price over time. It is this part of the market that faces an imminent shake-up, including the need for those entering derivative contracts to begin supplying variation margin, a form of insurance that moves daily to match fluctuations in asset prices.
The March date “is the industry’s Big Bang”, says Scott O’Malia, chief executive of Isda, the derivatives trade association.
And many of those that will be affected are failing at the first step — ensuring that the legal contracts on which their swaps are based comply with rules brought in by Basel regulators.
Edmund Parker, global head of derivatives at the Mayer Brown law firm in London, has been instructed to make the changes by one of its “£100bn-plus of assets” pension plan clients.
“We contacted each market-making counterparty as soon as we were instructed at the start of January,” he says. “Even with the most proactive approach, at the end of the month we’re awaiting documentation from over half the counterparties — with only four weeks until the deadline. Where they do not have compliant documentation in place by March 1, these counterparties in particular will be shut out of the market for new trades.”
Sweden’s B&P Fund Services, Länsförsäkringar Bank, the Bank of Ireland and Delta Air Lines are a step ahead in getting ready for the change. The scale of the work involved is underlined by NN Investment Partners, a Dutch asset manager with €199bn of assets, which has been preparing for the rules for much of the past decade.
Before 2008 NN exchanged collateral to back its over-the-counter swaps about once a month, and rarely needed to change the amount. It soon realised that more collateral was required to shield them against the risk their counterparty might go bust.
“The number of daily exchanges [of collateral] increased quite significantly,” says Edward Wierenga, head of business implementation at NN. “But with the new regulations collateral is becoming a key factor. It is not just the work around the collateral exchange itself but it is also to be on top of it . . . and all of this needs to take place intraday.”
For those not yet compliant the first step is to rewrite a kind of contract, known as a credit support annex (CSA), that underpins derivatives contract. That means advising, renegotiating and rewriting up to 200,000 CSAs.
“The scale of repapering is enormous. We’ve never seen anything in capital markets with a focus like this,” Nick Chaudrey, head of OTC client clearing at Commerzbank, told an industry conference.
Given the lack of preparation, calls for a delay in implementation are growing louder. Some countries in Asia have granted one. In January the Securities Industry and Financial Markets Association’s asset management group and the Investment Adviser Association called on regulators in the US, Europe and Japan to co-ordinate a six-month pushback. Chris Giancarlo, acting head of the Commodity Futures Trading Commission, the US derivatives regulator, has said he is sympathetic to a delay.
But any respite will be temporary. Both parties will have to agree the level and type of margin, and how it is protected in the event of a default.
Mark Higgins, managing director of global collateral services at BNY Mellon, a US custodian bank, points out that points out that having the right kind of collateral to meet the rules is not enough. “You also have to agree the type [of collateral] with your counterparty. If the majority of banks want you to post cash, and you don’t have much, how do you solve the problem of generating cash?”
That may eventually create an OTC market that looks like the world in which swaps are cleared. But some swaps, because they are illiquid, cannot be accepted by clearing houses. As Bill Stenning, managing director for clearing at Société Générale, notes: “This is not a free option for [smaller institutions] . . . Ultimately, there will be a price difference for that.”
Adding to the burden for derivative users is the fact that tougher capital requirements have reduced the number of clearing brokers. Few of the remaining brokers want the burden of a customer who rarely trades. Increasingly many are setting minimum revenues or clearing fees for users. These could range from $100,000 to $280,000 per year, Isda estimates.
Clearing also means supplying daily margin payments, which will require automating some back office systems for smaller players.
The race to meet the March deadline is not the end of the final post-crisis rules that need to be complied with. In September tougher initial margin requirements, designed to protect counterparties against potential future losses, come into force.
“I’ve got about 10,000 open OTC positions, and moving that book to a new CSA, I don’t think it’s practical,” says one fund manager. “Up until we pay initial margin, I really don’t care about variation margin. I’ve collateralised every single day every one of these trades . . . so this isn’t an issue.”
Others face a painful catch-up. “You can’t do nothing,” says Mr Higgins. “You but have to look for an alternative with less cost.”
