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Collateral vs. settlement. What’s in a name?

SIFMA has published a letter to the Prudential Regulators confirming a market-wide move to explicitly classify variation margin (VM) as settlement rather than collateral. The exercise has substantial implications for the amount of regulatory capital that must be held against cleared OTC derivatives. The effect is to radically reduce the potential future exposure (PFE) element of the VM calculation, reducing the “maturity” of the swap to one day, with a consequent reduction in the assigned notional multiplier; IRS with less than 1 year to maturity would be classified at the PFE floor of 0.5%, all other IRS would be categorised as a one year swap. The consequent reduction in PFE is estimated to reduce capital requirements by up to 66%. The collateral vs. settlement dichotomy mirrors the different approaches taken by futures exchanges and that of the uncleared bilateral swaps markets; uncleared swaps VM acts to collateralise unrealised P&L, VM in the cleared futures markets acts to settle realised P&L. While VM payments in the futures markets have always been regarded as settlement, depending on jurisdiction and preference, swaps VM may be documented as security interest or title transfer. However, even if effected by title transfer, swaps VM receivers pay a price alignment interest (PAI), typically the overnight rate in the relevant currency, to compensate the VM sender for loss of interest. This would seem to imply that the margin remains the property of its sender and should be regarded as a collateral payment. The PAI is justified on the grounds that the cleared market, although “settled”, should retain parity with the uncleared collateralised market; although one might have thought that large disparities in regulatory capital burden would undermine parity in the other direction. CCPs have adjusted their rulebooks to distinguish two product types, collateralised to market (CTM) and settled to market (STM). However, the decision is in the gift of the national and supra-national regulators, a footnote to the Basel III leverage ratio accords preferential rates to settlement[1] and ESMA has already indicated that cash VM should not be regarded as collateral[2]. It is difficult to see a systemic-risk argument that would disallow favourable capital treatment along the STM model, and the vast amounts involved will finance some high-power lobbying. While the CCPs and their members may simply “rebrand” their swaps, the process is less clear for those further down the clearing chain and for participants in the uncleared market. The CSA is explicitly collateral-based and does not lend itself well to the STM model. While an interesting alternative may exist via the ISDA Contracts for Difference Annexe, allowing daily cash settlement via current frameworks, transition to an STM system would still require a very significant degree of negotiation and repapering. However, given the billions that may be saved by what is effectively a change of name, the economics of such an exercise are compelling.

[1] Answer 6. “cash variation margin received associated with derivative transactions and fulfilling the criteria in paragraph 25 of the Basel III leverage ratio framework may be viewed as a form of pre-settlement and hence not considered as a credit risk mitigant for the purpose of the Basel III leverage ratio”

[2] 57.“As cash for VM is considered the pure settlement of a claim, this should not be subject to any haircut. “



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