Tight deadlines and unwieldy turnaround times have brought an air of desperation to the derivatives market in recent months. But a collective surge for the easiest looking answers could, counterproductively, exacerbate the systemic risks of an already fast-growing repo business and drive firms into a whole other realm of regulatory woe.
Major dealers are already in a race to meet the likely January rollout of EU initial margin requirements for uncleared derivative trades, with Europe and much of Asia playing catch up on the US, Canada and Japan following their implementation of the rules on September 1.
But a March 1 global deadline to begin posting and collecting variation margin on trades will present a bigger regulatory hurdle ahead for the derivatives industry as it will bring in a wider array of market participants. Bankers and lawyers have cited a worrying lack of preparedness among most pension fund managers and insurance companies to meet this implementation timeline, raising the prospects of stress and disaster in the months to come.
But even that high octane scramble may only be the start of the industry’s collateral nightmare.
That is because of the choice of collateral that everyone is choosing to satisfy the margin requirements. Although various forms of collateral are deemed acceptable for use under the rules, US and European regulators’ insistence on margin being presented within one day of a trade mean that the market is fixated on what is most liquid and quickly transferable. As such, it is widely observed that cash – and mainly US dollars – ‘is king’.
To get their hands on dollars, firms on both the buy and sell-sides are increasingly turning to repurchase agreements. Bankers are witnessing a surge of enquiries to open up new repo lines, as firms look to use their portfolios of assets to obtain cash.
While such observations may bode well for the March 1 deadline — in as much as they suggest an attempt at preparedness — they put the derivatives industry on a collision course with regulators in another big systemic risk battle.
Regulators such as the European Securities and Markets Authority (ESMA) have suggested that over-use of securities finance transactions (SFTs) such as repos will lead to a build-up of leverage that could threaten financial stability. As such, they are working on a Regulation on Transparency of Securities Financing Transactions (known as SFTR).
This law, proposed by the European Commission in January 2014, aims to improve the transparency of securities financing transactions in the shadow banking sector. These rules, which are in line with G20 leaders’ commitment to bringing greater transparency to financial markets, also hope to identify the risks of these transactions and their magnitude.
The SFTR will require both financial and non-financial market participants to report details of their SFTs to an approved EU trade repository. These details will include the composition of the collateral, whether the collateral is available for reuse or has been reused, the substitution of collateral at the end of the day and the haircuts applied.
ESMA’s consultation on the rules is open for feedback until November 30. ESMA will use this feedback to finalise its draft technical standards and submit these to the European Commission for endorsement by the end of the first quarter or beginning of the second quarter next year.
As anyone who has witnessed Europe’s progress on margin rules will note, this entails a very tight timeline for the European Commission and parliament to approve the SFTR before they move to finalised implementation from the start of 2018.
And the more people use repo to get their hands on dollars in the meantime, the more they are going to become subject to the vagaries and stresses of that timeline. Regulators and market participants need to wise up to this now, before it is too late.
