Derivatives collateralization: One-way vs Two-way Margining

Counterparty credit risk is a fundamental concern in business transactions. Over time, various mitigation strategies have evolved to address it. However, in the run-up to the Global Financial Crisis, this risk reemerged to threaten financial stability. The epitome of the risk arising from the counterparty risk was in the Over-the-Counter (OTC) derivatives market which represents one of the highest concentrations of such a risk. In the wake of the global financial crisis, the regulators’ objective was clear: tackling the gargantuan amount of counterparty credit risk in the OTC derivative markets. Policymakers came up with two main measures: having OTC derivatives cleared through a central counterparty, and laying down margin requirements with respect to uncleared OTC derivatives. Those measures were implemented and have become legal requirements since then—by means of European Market Infrastructure Regulation (EMIR) in the EU, and through Title VII of the Dodd-Frank Act in the US.

Our working paper focuses on the regulatory requirement relating to initial margin to be posted in the context of uncleared OTC derivatives. Specifically, on regulators’ choice of the two-way margining over one-way margining, which was by-and-large the pre-reforms market practice. The two-way margining means that as a general rule, counterparties entering into a non-cleared OTC derivative contract are required to exchange initial margin (IM) and variation margin (VM) throughout the duration of the contract. Margins are exchanged by means of collateral being provided to the counterparty, either in the form of cash or securities.

Posting collateral does mitigate counterparty credit risk. However, when margins are in the form of securities, it does have an impact on liquidity of financial markets—a negative one.
Apart from cash, high-quality liquid assets (HQLAs) are the only category of financial instruments which can properly perform the function of financial collateral—and that holds true with respect to any kind of financial transaction highly relying on collateralisation. Yet, those assets are admittedly scarce. Under uncleared OTC derivative agreements, collateral has been typically posted by means of either title transfer financial collateral arrangements (TTCA) or security interest financial collateral arrangements (SFCA), the latter with the right of use or rehypothecation provided to the collateral-taker. This entails that the HQLAs used with respect to an OTC derivative contract could be re-used under a different transaction, thereby significantly limiting the adverse impact on liquidity. However, when collateral is posted as IM, the re-use is forbidden. This does not alleviate the problem associated with the scarcity of HQLAs. Compounding matters further, first, IMs are not to be offset (meaning that both counterparties simultaneously provide IMs); second, with regard to IM, securities are to be preferred to cash as collateral. Hence, having collateral posted, mostly as IM, is set to significantly shrink the number of HQLAs available, which means impairing the liquidity of financial markets—not just OTC derivatives markets.

Keeping counterparty credit risk under control is arguably as important as the liquidity of financial markets. OTC derivative markets have a peculiar architecture which impacts the distribution of counterparty credit risk. Two clear sides can be pinpointed. On the sell-side, a dozen investment banks act as de facto market-makers—the so-called broker-dealers. They are the hubs of such markets, being engaged in the vast majority of transactions executed. The buy-side, instead, is made of all entities which intend to, by means of OTC derivatives, (re-)mould the array of risks to which they are exposed; within this group, basically any type of entity can be found.

In a stylised transaction, a buy-side entity would approach a sell-side investment bank with the aim of entering into an OTC derivative contract. In its role as de facto market-maker, the sell-side firm would enter into the derivative contract. Then, it would turn to the market with the aim of entering into an OTC derivative contract featuring opposite economic terms so as to offload the unwanted market risk. Quite often, on the other end of such OTC transaction, there would be a fellow sell-side firm.

It is as a result of such dynamics that sell-side firms become the epicentre of counterparty credit risk. Importantly, the sell-side group is homogenous—different from the buy-side group. It is composed merely of highly regulated investment banks, and all of them are to comply with very stringent capital requirements, a leverage ratio, as well as a liquidity coverage requirement. In a nutshell, they are supposed to be safe and sound counterparties from a counterparty-credit-risk perspective.

As the counterparty credit risk is heavily concentrated on the sell-side firms, it is essential for them to mitigate such a risk through adequate collateral. These entities qualify as hubs within OTC derivative markets; it is in relation to them that any lack of mitigation of counterparty credit risk may pose significant systemic risk concerns. The same may not be true with regard to buy-side entities. Therefore, having sell-side firms provided with collateral is crucial, but it is far less important with regard to buy-side firms. Moreover, the fact that sell-side firms are all highly regulated and safer counterparties renders the function performed by collateral less relevant.

To conclude, posting collateral is evidently set to adversely affect the liquidity of financial markets. The two-way margining essentially doubles such a negative impact. Thus, looking through the prism of liquidity, the one-way margining is the better option. As far as counterparty credit risk is concerned, due to the fashion OTC derivative markets are structured, the one-way margining, with sell-side firms necessarily receiving collateral, appears to be sufficient to adequately tackle it, with no adverse impact in terms of systemic risk. All in all, the one-way margining yields a better trade-off between liquidity and counterparty credit risk and between the efficiency of financial markets and systemic risk. Building on the above, we argue that the regulatory framework should be revised: the two-way margining ought to be repealed and the one-way margining should be adopted, with sell-side firms being on the receiving end.

The authors’ paper can be found here.

Cristiano Borgogna is a Legal advisor at Amundi Luxembourg SA. Any view expressed within this paper is solely of the author and cannot by any means be ascribed to Amundi Luxembourg SA or to the Amundi group.

Hossein Nabilou is an Assistant Professor of Law & Finance at the University of Amsterdam, Amsterdam Law School.