Banks to Increase Collateral on Swaps Trades Under Basel

Banks must back trades in the $633 trillion market for swaps and other over-the-counter derivatives with additional collateral as global regulators seek to choke off opportunities for excessive risk taking.

The plans jointly issued by two groups of international standard-setters target swaps traded outside of clearinghouses and would ensure lenders have safeguards in place when a trading partner defaults. The regulators said they scaled back some of the proposals to address bank concerns that the rules would restrict lending.

Nations are seeking to toughen and align rules for over-the-counter derivatives, which became a target for oversight after the 2008 collapse of Lehman Brothers Holdings Inc. and the rescue of American International Group Inc., two of the largest traders of credit-default swaps.

The rules strike a balance between safety and “the need to allow the financial system to underpin credit growth and economic recovery,” Richard Reid, a finance research fellow at the University of Dundee in Scotland, said by e-mail.

Systemically important firms “will have to exchange initial and variation margin commensurate with the counterparty risks,” the Basel Committee on Banking Supervision and International Organization of Securities Commissions said in an e-mailed statement. The rules will be phased in over a four-year period beginning in December 2015, they said.

Liquidity Crunch

Lenders including HSBC Holdings Plc, UBS AG and Deutsche Bank AG warned earlier this year that a provisional version of the plans would cause a global liquidity crunch.

Changes were made in a bid to address banks’ concerns, the Basel group said. Foreign exchange swaps and forwards contracts that are physically settled will be exempt from the bulk of the measures, as will be deals worth less than 50 million euros ($66 million).

“This rule is a first-time event in all of the rules crafted since the crisis,” Karen Shaw Petrou, managing partner of Washington-based research firm Federal Financial Analytics Inc., said in an e-mail.

“Regulators seem finally to have realized they can’t do everything all at once without serious, perverse consequences,” said Petrou. “Had the margin rules been finalized as proposed, shortages of as much as $11 trillion in eligible collateral would have resulted.”

Traders will also be permitted some limited scope to use collateral they are given to back other trades, the Basel group said.

The posting of collateral is when a party to a trade hands over assets to their counterparty as a guarantee that they will not be left empty handed should the trader default on their obligations.

Daily Exchange

Initial margin is collateral posted at the beginning of a trade. Variation margin may be exchanged daily to offset risk from incremental price movements.

Under the rules published today both parties to a trade would be required to post initial and variation margin, once the 50 million euro threshold is breached.

The threshold, which concerns the “initial margin,” would be measured against all the non-centrally cleared OTC derivative trades between the two companies.

The rules would apply initially to the “most active and most systemically important derivatives market participants,” with their scope gradually expanding over the phase-in period.

High Quality

“A broad array” of securities will be allowed to count as collateral under the rules, “further reducing the liquidity impact,” the standard setters said. Eligible securities include cash, high-quality government and corporate debt, covered bonds, equities and gold, according to a non-exhaustive list prepared by the regulators.

In tandem with rules for swaps, regulators are also seeking to toughen requirements for other parts of the financial markets that could be a source of systemic risks. The Financial Stability Board last week published liquidity rules and other measures for firms involved in repurchase agreements and other kinds of securities financing transactions.

Mark Carney, chairman of the FSB, said today that parts of the repurchase agreement, or repo market were “undoubtedly an accelerant” of the financial crisis. While these parts of the market have since disappeared, similar activities have the potential to re-emerge, he said. Carney made the comments at a press conference in London.

Repos are contracts where one investor agrees to sell a security and then buy it back at a future date and a fixed price. Lehman and MF Global Holdings Ltd. used a type of repo before their failures to appear healthier than they were, bankruptcy officials and lawmakers have said.

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