Margin as a risk mitigation tool for over-the-counter Derivative Transactions: analysis from an Indian Perspective
Introduction and Background
The systemic risk posed by a relatively less monitored, over-the-counter (OTC) derivative transactions, cannot be ignored especially in light of the 2007 economic and financial crisis. The financial crisis of 2007 particularly the bankruptcy of Lehman Brother, financial distress faced by AIG and other related events exposed the magnified risks imposed by the OTC derivative transactions to the financial economy. The regulators across the globe have understood this and have come up with several regulations and mechanisms to address the risk exposed by OTC derivative transactions. The Group of Twenty (G20), initiated a reform programme in 2009 and have been subsequently meeting up to address these concerns and strategize the policies to minimize the opaque risk that comes along with the current scenario of OTC derivative market.
The fundamental purpose of the G20 with respect to OTC derivative transactions seems to be increasing transparency through encouraging the roles of central clearing counterparties, trade repositories and exchange houses.1 In 2011, G20 decided to introduce mandatory margin requirements on non-centrally cleared derivatives. The Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) then set up the Working Group on Margining Requirements (WGMR) in October 2011 and introduced the standards for margin and related requirements by setting up the policy framework2.3
There are two type of margin associated with derivative transactions. The first is for the current exposure which is reflected in the mark-to-market value at an agreed interval called the variable margin. It covers the day to day fluctuations in currency adjusted on each valuation date. The party in-the-money (or the party in whose favour the market has moved) receives the amount equivalent to the hypothetical loss incurred when replacing the trades due to market movements after a hypothetical termination event. The new framework will enforce the universal use of variation margin (VM). Although VM has been fairly widely used, its use has not been universal.4 The second exposure is based on the credit worthiness of a counterparty. It covers the potential future losses with a counterparty or a portfolio. Across the market, initial margin has been exchanged one way as a practice. The introduction of two-way collateral exchange as initial margin would require change in rules and documentation.
Margin, when effectively implemented, offers enhanced protection against the credit risk associated with the counterparty. And to be effective risk mitigation technique, margin must be easily valuable, liquidable and readily available. Thereby, cash and other highly liquid securities that hold their value under stressed market conditions are better eligible collateral.
Respective countries have implemented the framework with framing their laws5 in principally in alignment with the requirements of the WGMR but still varied in its operational viabilities. RBI, being the regulatory authority in India, came up with the discussion paper on margin rules laying down guidelines and regime for margin exchange in India. RBI in its discussion paper provided that the practice of bilateral margining can reduce contagion and spill over risks by ensuring that collateral is available to offset the losses caused by the default of a derivative counterparty.6 RBI believes that this could also limit the build-up of high amount of uncollateralised exposures in the financial system. It is to be analyzed how far is the discussion paper released by RBI sufficient to address the risk mitigation objectives. Following are the issues that India faces ahead of framing its margin policy.
1. Cost of margin collection in India
Exchange of collateral may involve an absolute transfer of eligible collateral or security creation over eligible collateral. Legal documents in relation to both, transfer and security creation, mandate payment of differing stamp duty (depending on the state on which the documents are executed) in India. This adds to the cost of posting collateral especially when the exchange on margin is frequent (like in the case of variable margin).
Unless there is a provision included in law to exempt stamp duty on margin exchange, the added cost burden on the counterparties may be a deterrent to the counterparties doing business
2. Procedural requirements
Charge creation in India entails certain registration and filing requirements with the respective registrar of charges with the relevant judicatory authority. While declaration of charges over assets of a company is a valid requirement, it is an added procedural burden on the counterparties which may not work in favour of the endorsing and promoting margin exchange. It is a difficult position from the perspective of the law makers to choose between the two situations.
3. Issues in relation to Operations, documentation
To be able to implement the margin regime, there is an immediate requirement of internal operational revamping and technical adaptation by the counterparties. The counterparties shall require a swift and adaptable structure in alignment with the required margin methods. The client facing groups, middle office and treasury support groups and back office teams across organizations shall require to accommodate significant technical changes.
In addition to this, the documentation process to support the two-way collateral, frequent margin exchange with varying margin calculation methods and supporting technological configuration is prerequisite. Likewise, dispute resolution and reconciliation methods as indicated by ISDA in its new credit support annex drafts are something that the counterparties will have to consider.
Although, these issues associated with the systemic revamping are one-time issues that shall set up the long-term road map.7
4. Issues with “contract by contract” applicability of margin
Generally, across the globe OTC transactions are booked under the ISDA Agreement as published by the International Swaps and Derivative Association with suitable modifications. The crux of an ISDA Agreement is the concept of a ‘single agreement’. All the transactions booked under ISDA Agreement between the two parties form one single agreement and upon early termination a net value is calculated for all the transactions that is payable either way. The leading clause for such a calculation is the netting provision. The ease and assistance provided by this concept has led a market participation making it difficult to imagine OTC derivative market without ISDA Agreement and netting. Bankruptcy laws in certain jurisdiction may pose problems to this netting concept of the ISDA Agreement. There are certain jurisdictions where the liquidator has the power of cherry picking favourable transactions to the corporate insolvent and letting go the unfavourable ones. Thereby, the counterparty is left with no option but to settle the transactions as specified by the liquidator. This is in a sense against the spirit in which ISDA Agreement was drafted. The idea was to have a ‘single agreement’ for several transactions and requirement of close-out netting of all outstanding transactions and arriving at a single value payable either way is intrinsic to the type of the master agreement.
Although not unenforceable, there is still certain residual uncertainty with respect to the legality of netting in India. And while ISDA’s legal counsel in India has opined that netting shall be enforceable, RBI has said that there is a “lack of unambiguity” regarding the subject. This is also the reason attributed by RBI in the discussion paper to apply margin on a “contract by contract” basis. This means that the margin shall be exchanged between parties on a gross basis. This imposes higher cost effects on the counterparties and may make the derivative transactions in India dispiriting. In fact, this may lead the parties in an inferior condition vis-vis transactions without exchange of margin. This is also against the practice around the globe. Therefore, in order to have a margin policy in alignment with the global standards and to interest counterparties from across the globe to trade in India, it is imperative that the margin policy be relooked at.
5. Custodial Infrastructure
Presently, large volume of derivative transactions in India are done without margin exchange, there is lack of adequate custodial services in the Indian market.
The custodial service providers play a huge role in effective exchange of margin since this is the easiest mode to ensure bankruptcy remoteness of the exchanged collateral. The authorities must make appropriate policies for registration of third party custodial service providers who should be conversant with each type of the eligible collateral and their nature and the margin policy
6. Central clearing
Promotion of central clearing of standardised OTC derivative transactions is one of the objectives of the G20. Central clearing shall introduce greater transparency in the system. Although, it should be noted that huge number of non-standardised transactions are entered into between counterparties across the globe which may not be centrally cleared and which facilitate greater systemic risk.
A standardised transaction may be cleared by a central counterparty. Which would mean that that CCP shall act as a counterparty for the negotiating parties or the end users. The CCP takes on the credit risk for the negotiating parties and manages their margins from calculation to collection. So for all purposes, the end users interact through the CCP.
The role of the CCP therefore is fundamental. In this regard, the Clearing Corporation of India (the only central clearing party in India) is restricted is its familiarity with clearing. This could be because of lack of cleared transactions in India. And therefore, before mandating central clearing, RBI and other relevant authorities must encourage greater understanding of clearing service in CCIL and other like corporations.
There is no denying the likely casualty of the otherwise effective model for risk safeguarding: liquidity. The counterparties exchanging liquid (or easily liquidable) collateral may negatively impact the liquidity of the counterparties and in effect of the market. Since, high liquidity is fundamental for effective benefits of the margin exchange; it comes with the set back of reduction in liquidity in the market. Financial institutions may need to obtain and deploy additional liquidity resources to meet margin requirements that exceed current practices.
The consequence may be reduced if the parties are allowed to re-use and invest the accepted margin, but that impacts the other issue of bankruptcy remoteness.
7. Bankruptcy remoteness vis a vis market liquidity
The objective of exchanging initial margin is to safeguard the collecting party (or non-defaulting party) from any potential risks upon default by the posting party. For the margin regime to work, it is highly important that the margin collected be segregated from the assets of the collecting party. Lest the collecting party enters bankruptcy and the margin being comingled with its assets are liquidated for discharge its obligations.
Any third party right over the posted margin by way of any re-encumbrance shall result in a worsened situation for the posting party. Although, across the globe, regulators are allowing variable Margin to be reused, re-hypothecated which helps in not reducing the over-all market liquidity; the legal regime must provide specific and limited uses of the exchanged initial margin.
In cross border transactions, this must be in accordance with the laws of the collected party’s jurisdiction. Since, applicable bankruptcy laws shall be that of collected party’s. The best way to ensure that the assets are not mingled and the assets are used for specific listed purposes is to transfer the assets to a trust for the specific benefits of the collecting party under specific circumstances or to have any similar custodial service provider arrangement from any third party. This however adds to the burdensome documentation requirements and procedural setup due to segregation of collateral posted as margin.
To ensure liquidity, collecting party should be allowed to re-use, re-hypothecate or invest the margin and for ensuring bankruptcy remoteness, the collecting party should keep it segregated. Hence, between the issues of liquidity reduction and bankruptcy, the policies must be carefully drafted to find a middle path for the situation in hand.
ISDA has prepared an open source code, the standard initial margin model (SIMM) to facilitate the counterparties with exchange of initial margin. ISDA claims that the SIMM model is based on first order sensitivities and provides result without the disadvantage of reducing liquidity. Although, it is too early for counterparties to adopt the model and confirm results.
There are potential benefits of the margin model but India has a lot of groundwork to do for an effective margining regime for non-cleared derivatives. And the regulatory authority must re0look at the proposed margin policy in light of the issues that may be specific to India rather than implementing the global margin policy indiscriminately. This may be the reason why RBI has delayed the deadline. While certain organizations dealing with international counterparties have adopted the model internally, it remains to be seen how the targeted groups react to the technical and economic impacts of the margin regime in India.