Banks Face Billions in Collateral Needs Under EU Swap Rules

  • European Commission still has to approve the new rules
  • Collateral requirements estimated at 200 to 400 billion euros

Europe’s biggest banks will need billions of dollars to meet collateral requirements for derivatives starting this year under the latest version of a key rule that seeks to reduce risk.

The standards, which will be phased in from September, may require EU buyers and sellers of swaps to set aside between 200 billion euros ($220.5 billion) and 420 billion euros in total once they are fully effective in 2020, three European regulators said on Tuesday in final draft standards. The requirement aims to stiffen standards for swaps contracted directly between traders rather than being settled at clearinghouses.

“The challenge now will be for the industry to implement the rules in time for the September 2016 start date -– just six months away,” Scott O’Malia, chief executive of the International Swaps and Derivatives Association, said in a statement after the rules were published. It’s a “tight time frame” to comply with the requirements, he said.

After the 2008 credit crisis, regulators around the world pledged to increase the amount of securities, cash and other collateral backstopping trades in the $553 trillion global swaps market. The extra collateral is meant to protect against the threat that the default of one trader spreads risk to others and potentially throughout the financial system.

The financial industry must revise thousands of legal documents, test technology and put in place procedures for exchanging collateral, according to O’Malia. The standards must still be approved by the European Commission, the bloc’s executive arm.

“The overall reduction of systemic risk and the promotion of central clearing are identified as the main benefits of this framework,” the European Banking Authority, European Securities and Markets Authority and European Insurance and Occupational Pensions Authority said in the document.

While regulators have been putting in place separate rules that require many commonly traded interest-rate, credit and other swaps to be settled at clearinghouses owned by LCH.Clearnet Group Ltd., Intercontinental Exchange Inc. and CME Group Inc., a portion of the swap market is still expected to take place directly between buyers and sellers in over-the-counter transactions.

New Requirements

The standards impose a new EU requirement for banks such as JPMorgan Chase & Co. and Barclays Plc to exchange initial margin, or collateral, at the beginning of transactions to cover the potential future losses stemming from a counterparty’s default. Currently, traders primarily exchange collateral daily or during the life of the contract to protect against swings in the market value of a transaction, rather than as a trade is initiated.

The Basel Committee on Banking Supervision, which laid out a global framework for the requirements, estimated that at least 700 billion euros ($771 billion) might be needed to meet the initial margin standards. U.S. banking regulators led by the Federal Reserve estimated last year that the rules could require firms in the U.S. to have $315 billion in initial margin.

The actual cost of financing collateral would be smaller, though the Federal Reserve still estimated it could cost lenders billions of dollars each year. The collateral requirements could decrease significantly as new rules push traders to settle more trades at clearinghouses.

Using clearinghouses would typically wind up being cheaper, encouraging the move. A 2014 Deloitte study showed that the incremental collateral, capital and compliance costs of using non-cleared trades would be more than 10 times that of clearing.

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