Initial Margin for OTC Derivatives: The Burden of Opportunity Costs

Author(s):
E. Paul Rowady, Jr.
Date:
August 15, 2011
Research Type:
Vision Note
Rights:
           
Executive Summary

New initial margin requirements are going to have a huge impact on which OTC derivative products become more popular and which are abandoned. For example, like a sin tax, the proposed level of initial margin requirements for uncleared trades will render certain trade structures extinct. Initial margin levels for even the most vanilla trades will still be a huge drag on capital given that they are starting from zero today. Even small margin requirements attached to huge notional values outstanding have the potential to wreak havoc on product selection.

The impact of these “opportunity” costs on OTC derivative product selection and volumes will be unprecedented. At worst, some of the more exotic structures will be deconstructed into a series of vanilla structures, and volumes across the entire OTCD product spectrum will become depressed. And since cash and derivatives markets are symbiotic, depressed flows could be found in futures and cash bonds, as well.

Margin offsets are the key to minimizing these costs. Therefore, clearinghouses must continue to conceive new methods and business models that provide more margin relief through cross-margining, portfolio-margining, and other netting mechanisms. Their innovations should encompass the full product spectrum; this is not just an OTC derivatives problem. Providing more offsets between cash and listed derivatives—and/or greater cross-product offsets—would go a long way toward reducing existing margin costs. Sure, OTCDs need to be in the mix, but there are a lot of players in that scrum. Progress on cash vs. futures, for instance, is a less toxic political football.

Regulators also need to find a way to foster greater clearing and risk management innovation in this space. We may be hoping against hope that this is possible in the current environment, and we are not necessarily saying “get out of the way.” But consider the playing field: In a hypothetical world in which there is only one global CCP, maximum offsets would be possible with minimal impediments. All instrument structures would flow into a central clearing mechanism in which the maximum level of risk would be neutralized and the incremental directional risks would be tagged with margin.

Going forward, only innovations in clearing models and risk analysis will be able to improve upon the current levels of offsets. Market participants, regulators and clearinghouses will need to work effectively together to design new clearing mechanism that will provide higher offset levels. Oddly enough, most portfolios are hedged to the point where they should be awarded greater margin relief. Unfortunately, most clearing models can’t see all sides of the trade. It is in this sense that the cost of initial margin is really the cost of our current clearing mechanisms. Improving these mechanisms is the best path towards preserving some semblance of the status quo.

TABB Group Vision Note

Initial Margin for OTC Derivatives: The Burden of Opportunity Costs

This 23-page, 21-exhibit vision note explores the impact of imposing new initial margin requirements on both cleared and uncleared OTC derivatives, culminating in a detailed estimate of these requirements on the OTC interest rate derivatives product spectrum. Aggregating an unprecedented array of margin data across cash, futures and OTC products, this report also discusses the critical importance of margin offsets and the need for innovations in clearing models to increase cross-margining relief far beyond today’s levels in order to counteract the potential for large scale changes in product demand.

Areas of Interest
  • Fixed Income
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