Streetwise Professor

March 29, 2014

Margin Sharing: Dealer Legerdermain, or, That’s Capital, Not Collateral.

Concerns about the burdens of posting margins on OTC derivatives, especially posting by clients who tend to have directional positions, have led banks to propose “margin sharing.”  This is actually something of a scam.  I can understand the belief that margin requirements resulting from Frankendodd and Emir are burdensome, and need to be palliated, but margin sharing is being touted in an intellectually dishonest way.

The basic idea is that under DFA and Emir, both parties have to post margin.  Let’s say A and B trade, and both have to post $50mm in initial margins.  The level of margins is chosen so that the “defaulter (or loser) pays”: that is, under almost all circumstances, the losses on a defaulted position will be less than $50mm, and the defaulter’s collateral is sufficient to cover the loss.  Since either party may default, each needs to post the $50mm margin to cover losses in the event it turns out to be the loser.

But the advocates of margin sharing say this is wasteful, because only one party will default.  So the $50mm posted by the firm that doesn’t end up defaulting is superfluous.  Instead, just have the parties post $25mm each, leaving $50mm in total, which according to the advocates of margin sharing, is what is needed to cover the cost of default.  Problem solved!

But notice the sleight of hand here.  Under the loser pays model, all the $50mm comes out of the defaulter’s margin: the defaulter pays,  the non-defaulter receives all that it is owed, and makes no contribution from its own funds.  Under the margin sharing model, the defaulter may pay only a fraction of the loss, and the non-defaulter may use some of its $25mm contribution to make up the difference.   Both defaulter and non-defaulter pay.

This is fundamentally different from the loser pays model.  In essence, the shared margin is a combination of collateral and capital.  Collateral is meant to cover a defaulter’s market losses.  Capital permits the non-defaulter to absorb a counterparty credit loss.  Margin sharing essentially results in the holding of segregated capital dedicated to a particular counterparty.

I am not a fan of defaulter pays.  Or to put it more exactly, I am not a fan of mandated defaulter pays.  But it is better to confront the problems with the defaulter pays model head on, rather than try to circumvent it with financial doubletalk.

Counterparty credit issues are all about the mix between defaulter pays and non-defaulter pays.  Between collateral and capital.  DFA and Emir mandate a corner solution: defaulter pays.  It is highly debatable (but lamentably under-debated) whether this corner solution is best.  But it is better to have an open discussion of this issue, with a detailed comparison of the costs and benefits of the alternatives.  The margin sharing proposal blurs the distinctions, and therefore obfuscates rather than clarifies.

Call a spade a spade. Argue that there is a better mix of collateral and capital.  Argue that segregated counterparty-specific capital is appropriate.  Or not: the counterparty-specific, segregated nature of the capital in margin sharing seems for all the world to be a backhanded, sneaky way to undermine defaulter pays and move away from the corner solution.  Maybe counterparty-specific, segregated capital isn’t best: but maybe just a requirement based on a  firm’s aggregate counterparty exposures, and which doesn’t silo capital for each counterparty, is better.

Even if the end mix of capital and collateral that would result from collateral sharing  is better than the mandated solution, such ends achieved by sneaky means lead to trouble down the road.  It opens the door for further sneaky, ad hoc, and hence poorly understood, adjustments to the system down the line.  This increases the potential for rent seeking, and for the abuse of regulator discretion, because there is less accountability when policies are changed by stealth.  (Obamacare, anyone?)  Moreover, a series of ad hoc fixes to individual problems tends to lead to an incoherent system that needs reform down the road-and which creates its own systemic risks.  (Again: Obamacare, anyone?)  Furthermore, the information produced in an honest debate is a public good that can improve future policy.

In other words, a rethink on capital vs. collateral is a capital idea.  Let’s have that rethink openly and honestly, rather than pretending that things like margin sharing are consistent with the laws and regulations that mandate margins, when in fact they are fundamentally different.

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  1. Hi Craig

    I agree but – assuming defaulter pays stays – I have a different angle on bilat. IM.

    We (the industry / regulators) need to decided whether banks are privileged charter providers of collateralized OTC or not.

    If not then there is two way IM on all bilateral trades and we have a market which is hard to regulate because non-banks can get into as much risk as a bank without bank regulations to limit their ability to go pop. This approach failed throughout history to prevent crises for US bank deposits until the Fed and the FDIC were created.

    If so we then accept that banks are privileged charter providers of collateralized OTC. Now banks’ cpties have to pay seg IM to banks i.e. D2D two-way, C2D only clients pay. So now:

    1. Banks receive IM on all trades which limits their exposure and therefore their capital requirements as intended. Banks are effectively risk hubs but always well collateralized.

    2. Banks do pay IM on D2D trades. However, Basel III is levelling the balance sheet playing field (previously US GAAP and IFRS are substantially different). This means incentives are aligned across regions globally and banks will work together to reduce D2D cpty risk and there are several tools available – risk compression, multilateral netting, portfolio margining.

    3. Banks don’t pay IM on C2D trades. Given C2D portfolios tend to be directional this is a massive funding cost saving for banks in future (not sure if this shows in the estimate figures?).

    4. Regulators (if they pull their reporting finger out) can see all OTC cpty risk through reporting (directly or via repositories) from CCPs and banks.

    5. Clients are not protected by IM if banks go down but the likelihood of banks going down is reduced because banks always receive IM on trades. If clients want to avoid this risk they can:
    – trade cleared (and are incentivized to do this anyway by bilateral IM funding gross up)
    – they can by CDS protection on the bank (they find this too expensive mostly today)
    – they can run the risk and cross fingers that RRP delivers them a better result than today in default.
    If bank runs on collateralized OTC largely stop as a result of the new OTC regime, clients will have less to worry about – just as bank depositors did after the 1930’s.

    6. The above is also a way to rationalize the US bank regulators proposed approach to bilat IM i.e. bilateral D2D two way, C2D one-way, CCP a special case bank which only receive IM. I’m not sure if this has gone away or not.

    All the best

    Comment by Jon Skinner — March 30, 2014 @ 7:53 am

  2. A spade! Let the OTC market figure out caah and collateral though price discovery. A marketplace where cleared and bi-lateral trades (non-cleared) are traded side-by-side would create an explicit price for the cost of collateral in each market. DF and EMIR have only created a workbench for market racketeers,and chased off the honest folk who want to transfer risk.

    Comment by scott — March 31, 2014 @ 2:57 am

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