European regulators undecided on initial margin rules for uncleared swaps

European regulators are still unsure to what extent swaps counterparties should be required to provide and collect initial margin on uncleared derivatives trades, and are considering three potential options – one of which resembles the uncleared margin rules proposed by US regulators in April last year.

The proposals were set out in a joint discussion paper published by the European Securities and Markets Authority (Esma), European Banking Authority and the European Insurance and Occupational Pensions Authority on March 6, coinciding with Esma's public hearing on draft technical standards for the European Market Infrastructure Regulation (Emir).

"We are working to create the right combination of obligations and incentives for the use of CCPs. Rules for uncleared contracts should be at least as tough as those for central clearing, making sure there is not a disincentive in the use of a CCP. This is our general approach," said Edouard Vieillefond, head of international affairs at France's Autorité des marchés financiers, speaking at the public hearing in Paris.

Participants in the foreign exchange market had been keenly awaiting the latest discussion paper as an indication of whether collateral requirements for FX swaps and forwards – if not mandated for central clearing – would be appropriately calibrated.

The discussion paper states all derivatives users subject to the rules will probably have to post variation margin on uncleared swaps, but are less clear on whether and to what extent initial margin should be posted. The main stumbling block is liquidity – while the authorities agree initial margin would reduce potential loss and increase stability within the derivatives market, they acknowledge the requirements could result in liquidity constraints and increase the cost of trading.

The paper describes three potential options for initial margin. The first requires all financial counterparties and non-financial counterparties that have breached a clearing threshold, as defined in Emir, to post and collect initial margin.

The second option is for all prudentially regulated financial counterparties to collect initial margin but not post it (unless they trade with another bank), and for non-prudentially regulated financial users to post but not collect collateral.

This is similar to the approach proposed by US regulators last April, which requires swap dealers and major swap participants to collect initial margin, including on interdealer trades. European authorities point out that applying this option would prevent regulatory arbitrage with the US.

The third option would allow prudentially regulated financial counterparties to apply a threshold approach. In other words, the potential future exposure to certain counterparties would be allowed to remain uncollateralised, so long as it remains below a certain level. The threshold would be determined explicitly or by criteria set by regulators. Essentially, this approach would mean the exposure would be covered by capital, rather than by margin and capital.

The European paper also describes how initial margin will likely be calculated. The regulators believe there should be a standardised approach to ensure all counterparties subject to the requirements be able to calculate the requirements, but will also consider the use of appropriate internal models.

The paper states that the mark-to-market method or the standardised method, as set out in Europe's Capital Requirements Regulation, are both feasible options, while the internal model method could also serve as a starting point. It also notes that the calculation should take the requirements established for central counterparties into account, to ensure a similar degree of protection.

“The calibration has to be right so that we can maintain a well-functioning and cost-effective market,” says James Kemp, managing director of the global FX division of the Global Financial Markets Association in London. “The fact that a number of options have been laid out in the paper for discussion suggests European authorities have taken this into consideration, which is encouraging – obviously there is now some work to be done on impact analysis.”