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Opportunities and Challenges for Hedge Funds in the Coming Era of Optimization
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41
In March 2014, the final EMIR technical standards with
respect to clearing were published and in April they
entered into force. Under EMIR, all OTC derivatives
contracts that the European Securities Market
Association (ESMA) has determined are subject to
mandatory clearing must be cleared by an authorized
central counterparty (CCP) with high-quality assets
posted as collateral for margin purposes (cash or
G20 government bonds). While the clearing obligation
is broadly defined, it does exclude certain hedging
activities for nonfinancial counterparties.
For noncleared derivatives, EMIR defined certain
risk mitigation requirements including timely
confirmation, dispute resolution, reconciliation and
portfolio compression. There are also new margin
requirements including predetermined minimums
for initial and variation margin from both swap
participants and a requirement for daily valuations. In
the past, only clients, not dealers, had to post margin
on swap transactions. This is illustrated in Chart 28.
The consistent theme in the industry is concern that
collateral demands under the new regimes are likely
to become too extreme and tie up excessive amounts
of HQLA.
With most CCPs limiting collateral to either cash or
G20 government bonds (HQLA) the global demand
on the collateral with the lowest risk-weighted asset
assignment has been rapidly increasing across CCPs
in the U.S. and Europe. Many interviewees expressed
concern about the future state requirements for
collateral postings.
OTC Derivatives-Related Demand for HQLA
Collateral Begins to Expand
Mandatory clearing of OTC derivatives under the
Dodd-Frank Act began in March 2013 for Category I
participants, June 2013 for Category II participants
and September 2013 for Category III participants.
This represented the full suite of required entities,
and the shift to the new market structure was fully
underway by Q4 2013 in the U.S. market.
“ Collateral optimization… a big driver for the buy side is the EMIR
push to CCPs. Synthetic derivatives can be traded bilaterally
today and your counterpart may have wider acceptable collateral
requirements. Now margin requirements are changing. You
need higher-grade securities for initial margin and cash for
variation margin—you don’t use securities for variation margin
because it moves around too much,” — Agent Lender
Chart 28: Increased Margin Requirements Under OTC Derivative Regulations
OTC Derivitives Post-regulation
OTC Derivitives Pre-regulation
Exposure to
Underlying
Asset
Daily Margin
Requirement
Initial and
Variation Margins
Cleared Swap
Transactions
Source: Citi Business Advisory Services
Swap Buyer
Cleared Swaps
Non-cleared Swaps
Swap Buyer
Initial and
Variation Margins
Dealer
Tri-part
Custody
Account
FCM
CCP
Dealer
Initial and
Variation
Margins
Initial and
Netted Variation
Margins
Exposure to
Underlying
Asset
Initial and
Variation
Margins