Easing derivatives trading rule would help the system, not hurt it
Recent attempts by policymakers to eliminate an initial margin requirement for certain trading swaps between affiliates of the same financial institution would reduce costs for consumers and businesses.
Such an action would also remove a competitive disadvantage for U.S. banks while promoting safety and soundness in the financial system. This is counter to a recent BankThink in the July 16 issue of American Banker that made a number of incorrect assertions around both the need for continuing the margins requirement, and the rationale for ending it.
However, it is important to first address the hyperbolic characterization of swaps, or derivatives. Swaps are an important and heavily regulated tool that banks and other institutions use to help manage their exposure, and that of American businesses and consumers, to risk and market fluctuations.
The requirement that banks post an initial margin based on swaps between their own affiliates is one that should be revisited and ultimately removed. And there is good reason why.
First, it yields no benefit. There are two regulatory margin requirements: initial margin and variation margin.
Initial margin is exchanged at the time a swap transaction is established — and adjusted during the life of the transaction as needed — to minimize losses if a counterparty defaults on its obligations.
This is sound policy for third-party contracts. But in the case of two affiliates or legal entities under the same corporate holding company, the exchange of interaffiliate initial margin serves no purpose in ensuring contract performance.
Variation margin, however, does properly mitigate risk between affiliates. That’s because variation margin requires the exchange of collateral between affiliates based on the current value of the swaps, and accounts for changes in market value. The amount being collected through variation margin is also quite sizable.
In 2018, the top 20 firms collected more than $850 billion in variation margin, or more than 20 times the amount of initial margin for interaffiliate swaps. In addition, banks also post initial margin on all trades with covered true third parties, amounting to approximately $158 billion.
The technical fix policymakers are considering would only apply to the initial margin between affiliates. It would not change the variation margin requirement between affiliates, nor the initial and variation margin requirements for external counterparties.
Second, if the initial margin requirement for interaffiliate swaps is maintained, the cost will ultimately be borne by customers and hurt American competitiveness.
Indeed, swaps are an important tool utilized by pension funds for teachers, firefighters, manufacturers and many other kinds of businesses — big and small — to help manage risk. The collection of initial margin on transactions between affiliates increases costs for swaps for these end-users and subsequent customers.
Given that U.S. bank regulators are the only major G-20 authorities to impose these requirements, the nation’s banks are left on an uneven playing field when competing both against foreign banks and other U.S. nonbanks. European and Japanese regulators, as well as the Commodity Futures Trading Commission and Securities and Exchange Commission, do not require initial margin collection between affiliates.
Further, the assertion of lax regulation outside the U.S. is a red herring. It does not support the fact that all major jurisdictions have implemented substantial and similar rules regarding swaps and margin requirements, as per the G-20 Pittsburgh accords then led by the Obama administration.
The current initial margin requirement also puts the safety and soundness of banks at risk. Initial margin requirements on interaffiliate swaps perversely act as a disincentive to better, centralized risk management of an institution.
The associated costs discourage interaffiliate swaps in favor of hedging with third parties. Removing the requirement would help broaden a bank’s view of its overall risk exposure, and enhance the safety and soundness of the financial system.
Finally, the recent BankThink piece oddly mentioned a proposal to revise the enhanced supplementary leverage ratio — a wholly unrelated issue — and repeated an inaccurate assertion that the change would lead to a large decrease in the amount of required capital at banks.
Margin is not the same as capital. And importantly, the Federal Reserve’s own analysis showed that the proposal would not result in a material change in capital at the eight U.S.-based global systemically important banks.
The eight global systemically important banks have increased their capital to roughly $925 billion, or more than 40% during the past 10 years.
Regulators worldwide and institutions have taken other important steps to greatly enhance the safety and resiliency of the global financial system. CFTC leadership of both political parties have supported the revision.
After a decade of rapid regulatory change, we agree with the domestic and foreign regulators who have said it is imperative to review the rules to ensure its effectiveness and efficiency.
Elimination of the interaffiliate initial margin requirement has bipartisan support because it would enhance the ability of banks to serve the economy without sacrificing regulatory improvements made in the past decade. Such a move is smart policy that would benefit consumers and businesses alike.