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Swaps Users Face Serious Collateral Challenge, Executives Say

Derivatives users will face significant challenges to meet new collateral requirements as the trades are forced into clearinghouses, according to industry executives.

Investors have pledged about $200 billion to back futures trades around the world, Bill de Leon, a managing director at Pacific Investment Management Co., said today on a panel discussion at the Futures Industry Association annual conference in Boca Raton, Florida. That amount could be 10 times as large for the majority of trades in the $708 trillion over-the-counter derivatives market, he said.

“This is going to be one of the biggest challenges going forward,” said Jeffrey Jennings, the global head of listed derivatives at Credit Suisse AG. Exchanges such as CME Group Inc. are expanding the collateral they accept to allow corporate bonds to be pledged and are offering to reduce margin across assets like futures and interest-rate swaps. “That’s not going to be enough,” he said.

Banks, hedge funds and asset managers active in the OTC market are adapting to changes mandated by the Dodd-Frank Act passed by Congress in 2010, including a requirement to process most swaps with a clearinghouse to cut counterparty risk. Clearinghouses require margin to open and maintain a position. In the private swaps market, customers such as pensions or insurance companies often didn’t have to give margin to the bank they did the trade with.

Unacceptable Margin

Other plans by brokerages to offer to transform for their customers unacceptable margin into cash or U.S. Treasuries that are accepted by clearinghouses won’t solve the problem, and may add to risk during volatile times, said David Olsen, global head of OTC clearing for JPMorgan Chase & Co.

“In my opinion, collateral transformation is really just a marketing term for repo,” he said. The collateral obtained from selling securities to garner cash or Treasuries in the repurchase market don’t fit many type of derivative users, such as pensions, that may have 30-year swaps they need to maintain, he said.

The important issue is not the value of the collateral, he said, but the ability to quickly turn it into cash in the event of a market disruption such as the 2008 failure of Lehman Brothers Holdings Inc., he said.

De Leon agreed that collateral transformation is risky. “We would rather post collateral with a haircut that’s segregated,” he said.

LCH.Clearnet Ltd., owner of the world’s largest interest-rate swap clearinghouse, has faced challenges in how collateral value can change over time, said Chief Executive Officer Ian Axe. A year ago the company would take European sovereign debt with no qualms, he said.

“We’re a lot more picky now,” he said.

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