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Regulatory mandates requiring firms to post initial margin on over-the-counter derivatives (OTCD) are among the biggest changes that Dodd-Frank legislation is set to bring about. According to TABB Group estimates in new research, these new margin rules will cause OTC interest-rate derivatives market participants to shoulder at least $1.4 trillion in new capital charges globally within the next three to five years.
“Although dealers have readily adopted clearing for the most vanilla segment of their OTC derivative portfolios, these exposures require comparatively little initial margin since they represent the cream of the proverbial crop,” says E. Paul Rowady, Jr., a TABB senior analyst and author of “Initial Margins for OTC Derivatives: The Burden of Opportunity Costs.” This new research examines the detailed costs of imposing new initial margin requirements on all OTC interest-rate derivatives, whether cleared or not.
For exotic OTC derivative positions and smaller portfolios held by a majority of other end users, however, Rowady explains that the initial margin requirements will range from painful to the outright extinction of some types of trades. “Only through cross-margining and other offset mechanisms can these opportunity costs be minimized.”
TABB expects these requirements to have a huge impact on which OTC derivative trade structures will remain popular or be abandoned. “Initial margin levels for even the most vanilla trades,” Rowady says, “will continue to be a huge drag on capital, given that they’re starting from zero today. Even small margin requirements attached to huge notional values outstanding have the potential to wreak havoc on product selection.”
Regulators will also need to find a way to foster greater clearing and risk management innovation, says Rowady. “In a hypothetical world in which there’s 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 incremental directional risks would be tagged with margin. But this is not the world we live in. As a result, it’s our clearing models, not necessarily the level of initial margin that represents a significant portion of our capital burdens. Going forward, only innovations in clearing models will serve as the primary path away from these burdens, back toward vibrant, higher volume OTCD markets.”
Aggregating an unprecedented array of margin data across cash, futures and OTC interest-rate products, the 23-page, 21-exhibit report also covers 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 across both OTC and listed derivatives.
The report is available for download by TABB Group Research Alliance Derivatives clients and all pre-qualified media at https://www.tabbgroup.com/Login.aspx.
For an executive summary or to purchase the report, visit http://www.tabbgroup.com or write to info@tabbgroup.com.
