Swap Traders Could Reduce Margin Under Proposed U.S. Rules

U.S. regulators plan to allow hedge funds and other credit-swap traders to reduce the amount of collateral needed to back transactions through the use of accounts that offset different types of trades.

The Securities and Exchange Commission and Commodity Futures Trading Commission are close to allowing collateral offsets for credit swaps that are tied to indexes and single securities through a process known as portfolio margining. Atlanta-based Intercontinental Exchange Inc., owner of the largest clearinghouse for credit swaps, Citadel LLC and other hedge and mutual funds and banks spent more than a year pushing regulators to support the system for client trades.

“It’s cheaper to operate if you can cross-margin,” Richard Repetto, an analyst at Sandler O’Neill & Partners LP in New York, said in a telephone interview yesterday. He said the rule could help encourage credit-swap trading, which has declined since the onset of the 2008 credit crisis.

The regulation was issued by the SEC for comment on Dec. 14 and a companion measure could be approved by the CFTC as soon as this week, according to a person with direct knowledge of the process.

Dodd-Frank Act requirements that credit swaps be guaranteed at clearinghouses are set to take effect mid-March. The central counterparties stand between buyers and sellers and accept collateral to limit the risk from a trade default spreading throughout the financial system.

Dodd-Frank Rules

Dodd-Frank, the financial-regulation overhaul, was enacted in 2010 after largely unregulated swaps helped fuel the 2008 credit crisis and led to the U.S. rescue of American International Group Inc. The law calls for most swaps to be guaranteed at clearinghouses including those owned by ICE, CME Group Inc. and LCH.Clearnet Group Ltd.

The CFTC is preparing to vote in a private process as early as this week to allow the system at ICE, according to the person, who asked not to be named because the order hasn’t been approved. Clients could save as much as 80 percent of the amount of margin, also known as collateral, necessary to offset index and single-name trades once they’re held in the same account, according to ICE.

“If you can get some guys 80 percent and a bunch of others 20 or 30 it still winds up being worthwhile,” Repetto said.

The SEC released an order on Dec. 14 allowing the commingling and portfolio margining of credit swaps guaranteed at clearinghouses. The agency, which sought comment on the order, would allow dealers including JPMorgan Chase & Co. and Goldman Sachs Group Inc. that are members of a clearinghouse to allow the offsets for their clients.

‘Accurate Measure’

“Portfolio margining may help to alleviate excessive margin calls, improve cash flows and liquidity and reduce volatility,” the SEC said in the order. The agency said it would also, “promote a more accurate measure of the risk of the total position of the customer based on off-setting positions.”

The SEC order sets requirements on dealers that are registered with both agencies, including minimum margin levels for their clients’ trades in portfolio accounts. The collateral amount must be at least the minimum required by the SEC’s own rules.

Citadel, the Chicago-based hedge fund founded by Ken Griffin, and ICE told regulators starting in December 2011 that traditional buyers of credit swaps would be hurt without portfolio margining. Without the approval, only dealers would be able to offset their trades on a portfolio basis.

‘Further Entrenching’

The difference holds the potential for “further entrenching the dominant position of a select number of swap dealers in the CDS marketplace,” Adam Cooper, Citadel’s chief legal officer, said in a Dec. 22, 2011, letter to the CFTC.

Banks including Barclays Plc, Citigroup Inc., Goldman Sachs and Credit Suisse AG also supported portfolio margining for their credit swap clients, according to a Dec. 22, 2011, letter to the CFTC.

The change will encourage trading because clients will have greater ability to clear both types of credit-swaps, said Supurna VedBrat, co-head of market structure and electronic trading at BlackRock Inc., the world’s largest money manager. Credit swaps tied to single securities will be offered for client clearing, VedBrat said in a telephone interview today.

“It becomes a much more margin efficient model from a trading perspective and a necessary step for clients to begin clearing credit products,” she said.

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