July 7 (Bloomberg) -- Banks may have to meet minimum collateral rules for over-the-counter derivatives trades that aren’t centrally cleared as part of a push by global regulators to make the market safer.
The Basel Committee on Banking Supervision yesterday published a draft of the standards, which it said would prevent companies from exploiting rule differences between nations. The paper sets out a partial list of assets that can count as collateral, including gold and some equities.
“International consistency with regard to margin requirements and their implementation is crucial,” the Basel group said in an e-mailed statement. The measures, which are being published for public comment, would apply to trades involving financial-services companies and large businesses in other industries that trade these securities.
European Union and U.S. regulators are struggling to align rules for the $648 trillion market for OTC derivatives, which became a target for tougher oversight after the 2008 collapse of Lehman Brothers Holdings Inc. The Basel committee has already issued rules that would more than triple the capital banks must hold to protect against losses.
The draft document’s approach to margin standards “would lower the risk of financial entities, promote clearing and help avoid regulatory arbitrage,” Gary Gensler, chairman of the U.S. Commodity Futures Trading Commission, said in a separate statement yesterday.
Banks warn that inconsistencies in rule-making and overlapping requirements may increase costs and give foreign competitors an advantage. Lenders also say that making collateral rules too tough risks crippling markets by forcing traders to set aside the bulk of their high-quality assets.
Under today’s proposal, regulators would allow companies to use a range of instruments as collateral, including cash, government debt, “high-quality corporate and covered bonds,” gold and equities listed on “major” stock exchanges.
Extending the list of eligible collateral beyond “the most-liquid, highest-quality assets” reduces the risk of the rules damaging markets, according to the draft. The Basel committee will carry out a study on the plan’s impact.
The proposal gives a standard list of losses imposed on investors that should be applied to these securities, while still leaving traders scope to use internal models instead.
The International Swaps and Derivatives Association estimates that $3.6 trillion of collateral was in circulation in the uncleared OTC derivatives market at the end of 2011, an increase of 24 percent from the previous year.
The rise was attributed to developments including downgrades of banks by credit-ratings companies, the euro-area debt crisis and a decline in interest rates.
The Basel committee, which drafted the paper in collaboration with the International Organization of Securities Commissions, will seek comment until Sept. 28. Basel rules have no legal force and must be implemented by nations before they can take effect.
According to the proposal, both parties to a trade should post so-called initial and variation margins.
Initial margin is collateral posted at the beginning of a trade. Variation margin may be exchanged daily to offset risk from incremental price movements.
The Basel group is weighing possible exemptions to the rule for smaller transactions, though its members are split over how such a threshold should be “designed and calibrated,” according to the draft.
The Group of 20 nations called in 2009 for trades in standard types of OTC derivatives to take place through clearinghouses as part of an effort to make the market simpler and more robust. The G-20 then agreed in 2011 to set margin requirements for transactions that take place away from central clearing to boost the resilience of the financial system.
Today’s plans would also force firms to ring-fence and not re-use collateral so that it wouldn’t be lost to the company that posts it if a trader goes bankrupt.
There is a “broad consensus” among regulators that “the re-use of initial margin should be prohibited,” the committee said. Still, the U.S. Securities and Exchange Commission believes it should be allowed “in very limited circumstances.”
“The dealers are just going to squeal if that right gets taken away from them,” Christian A. Johnson, a University of Utah law professor, said yesterday in a telephone interview. “It’ll put tremendous pressure on dealers. It just exponentially raises the amount of collateral they’ll have to have.”
The proposal on margins covers non-cleared credit, interest rate, commodity and foreign-exchange derivatives. In the U.S., the Treasury Department proposed an exemption for foreign-exchange swaps and forwards from most of the Dodd-Frank Act’s clearing and trading rules. The Treasury said there was less counterparty and settlement risk in foreign-exchange contracts than other types of derivatives.
“It is unclear whether these characteristics fully offset the need for margin requirements,” the Basel committee said in its report. The committee is seeking comment on whether to allow an exemption for foreign-exchange contracts, such as those with durations of less than a month or a year.
The Basel committee, which is headquartered at the Bank for International Settlements, brings together banking regulators from 27 nations including the U.S., U.K. and China.
Madrid-based IOSCO brings together national market regulators from more than 100 countries to coordinate rules and share information.