Many insurance companies have long used derivative instruments to mitigate risk and match their liabilities – whether for shorter-term ones such as car insurance, or longer-term liabilities such as life insurance – with currency risk, interest rate and longevity risk being among the most-hedged by the industry.1 However, regulatory change in the derivatives markets will shortly present new challenges and risks in the areas of trade clearing, margin payments and collateral management.
The new regulation has been driven by the high-profile failures of market participants with high levels of exposure to certain over-the-counter (OTC) derivative products. In response, governments and regulators have taken steps to reduce risk in the OTC market, with the goal of reducing the threat of a counterparty failure with systemic implications. However, should such a failure occur, regulators aim to transfer the positions smoothly to an applicable market participant.
This has resulted in the introduction of the Dodd-Frank Act in the US and the European Market Infrastructure Regulation (EMIR). These require increased transparency over the derivatives market and demand sufficient high-grade liquid securities and/or cash be set aside to ensure trades are sufficiently collateralised to meet the initial and variation margin payment requirements that ensure a trade is correctly financed.
There are a number of implications arising, but particular impact will fall on the future levels of collateral and liquidity available to derivatives users. Insurers should assess the impact for their investment strategies and ensure they are well-positioned to guarantee regulatory compliance. In doing so, they may also be able to take advantage of some potential opportunities.
Role of clearing houses
The regulation means that ‘central clearing houses’ will soon act as central counterparties for the majority of derivative transactions. This is already under way in the US, as a number of market participants have begun trading certain derivative products via the clearing houses.
Similar changes are in place in Europe and eventually, as clearing becomes mandatory over time for the various categories of investors and instruments, all market participants trading OTC derivatives will be subject to the rules.
Key market impacts
Together, these regulations constitute a significant shake-up of the derivatives market, which will have a number of implications and impacts. At Northern Trust, we feel the following will be foremost:
The regulations will necessitate new infrastructure to manage the new process of central clearing. When making a trade, assets affected by the regulations must be cleared by an authorised clearing member responsible for the clearing, matching and settling of the trade and for the collection and delivery of initial margin payment.
A new derivative central clearing party (CCP) will then be responsible for the safekeeping of initial margin, the valuation of all of the derivatives trades that it holds and the ‘calling’ and management of the variation margin. Both sides of the cleared derivative trades must provide details of all open positions to a trade repository. This will enable monitoring of market exposure and allow regulators to act if they decide the market is at risk due to the exposures being taken by market participants.
• Increased collateral requirements
As mentioned, investors using derivatives will be required to put capital aside to ensure initial margin requirements can be met. As a result of the move to a cleared environment, it has been estimated that global regulations will create an additional demand for collateral of around $4 trillion2. However, regulations are expected to emerge that will also require bilateral trades to be fully collateralised, and the need for collateral may therefore be even greater than has been anticipated.
Initial margin will need to be in the form of high-grade and liquid assets such as [high-grade] government bonds, gold, cash and bonds issued by some government agencies. The possibility of having a shortfall in these eligible assets is therefore a concern for market participants.
Without the required high-grade collateral, market participants will need to purchase or borrow the eligible assets or transform their lower-grade assets into eligible assets, a process commonly known as ‘collateral transformation’, which could be handled by the existing and firmly established securities lending desks. It does, however, rely on a sufficient amount of lending taking place by market participants that hold high-quality liquid assets and are prepared to accept a lower and less liquid asset as collateral in return.
The institutions most likely to gain from this are those that hold large amounts of high-quality liquid assets. This will be true for insurers, who hold high-quality government and corporate assets in their portfolios, especially those weighted towards AAA rated instruments. In particular, those holding assets to maturity could generate additional revenue by lending them to the wider market.
This requirement for initial margin will see insurers deploying more collateral against more counterparties and transactions than ever before. This has led to concerns about the safety of assets as they move through the clearing cycle in the new cleared environment.
Insurers will be looking for transparency over their assets, to see where their collateral is held and be certain it is held safely at every stage of the clearing process. Consequently, custodians and asset servicers will need to offer ‘downstream’ asset segregation all the way to the central clearing house. At Northern Trust, for example, we are devising solutions to provide clients with account structures for cleared derivatives that are specifically designed to heighten asset safety and transparency on collateral flows throughout the central clearing process.
Capital will also be required to satisfy variation margin needs. On a daily basis, the clearing house will calculate the value of the open derivative position and potentially call for variation margin. This variation margin must be provided in cash on the day it is requested in the base currency of the trade itself, so insurers will need to look at their portfolio mix to ensure they have sufficient liquidity in place. If not, they will need access to intraday liquidity in order to meet any expected or unexpected variation margin calls.
Currently, if variation margin is not provided to the clearing house by the ‘cut-off’ time, the position can be closed and the collateral sold to meet the shortfall in funding, with the remaining cash being returned to counterparts. The need, therefore, to either hold liquidity or have access to liquidity will be very important to any holder of a cleared derivative. Portfolios may have to hold more liquid cash than they would normally expect, or they will need to put in place committed funding facilities to ensure that the right amount of cash can be accessed at the right time to meet variation margin calls from the CCP. It is also worth noting that, in stressed market conditions, the cost of liquidity is likely to be much higher than in less volatile scenarios, and a prudent approach would therefore be to have more than one source in place.
• Increased cost
Those trading and owning derivatives will have to pay to support the maintenance of the centrally cleared structure. These costs will include clearing house and clearing member fees, possible collateral transformation costs, liquidity access, default fund contributions and administration and system setup costs. The overall additional per-trade fees are not yet clear, but are expected to be significantly higher than those for bilateral trades.
The arrival of key regulations impacting the OTC derivative market will require insurers using these products to collateralise greater volumes of transactions. With the initial and variation margin requirements under EMIR, the ‘right’ collateral could become scarce. As a result, they will need to make sure they have access to the right collateral at the right time to support successful investment strategies.
Managing eligibility criteria for each clearing member and clearing house will also add an additional layer of complexity to collateral management, while the ‘transformation’ of assets into cash or eligible assets will become increasingly necessary. Having the right operational infrastructure in place – to ensure you have a holistic and transparent view of your collateral usage – will be key to success.
1 Insurance Risk, October 2013
2 Andrew Hauser, head of sterling markets division, The Bank of England, quoted in Financial News, December 10, 2013