Derivatives dealers have been kidding themselves that they have a choice about whether to standardise collateral agreements, and the freedom to make their minds up at some future date.
That's only true if they are also willing to see the market wither away.
Credit support annexes (CSAs) give huge flexibility to the users of non-cleared derivatives – allowing them to specify the types of collateral they will post and how much unsecured counterparty risk they will tolerate, for example – but this freedom has a growing price tag, which varies from bank to bank. The added cost and complexity makes cleared trades more attractive, in part because valuation and margining is carried out by a central counterparty (CCP).
Market participants are finally voting with their feet. According to the International Swaps and Derivatives Association, the non-cleared market shrank in notional size by almost one third last year. That's a shocking collapse in demand for a big, mature financial product.
Crucially, the Isda analysis suggests the collapse – from around $122 trillion to $86 trillion – was not just a result of CCPs hoovering up more of the clearable universe. Firms have also been turning their backs on products that cannot be cleared, such as cross-currency swaps, swaptions and options, with notionals dropping from $83 trillion in 2014 to $65 trillion a year later.
Senior traders worry the market will lose a further 90% of its volume over the coming five years, or simply "grind to a halt" with unclearable products dying off completely.
That has lit a fire under the industry. In the final instalment of a four-part look at the future of the non-cleared market, Risk.net revealed two parallel initiatives that would unscramble CSAs and – dealers hope – shore up the market. In one, a group of the biggest banks is seeking to agree a set of restricted terms for interdealer margining as part of their preparations for the incoming non-cleared margining regime; the same terms could, in theory, later be offered to clients.
This path should have been followed earlier, one dealer source argued, calling it a "strategic error" to continue allowing full flexibility: "It was a once-in-a-generation opportunity to learn from the past 25 years of using the documents."
The second initiative is equally secretive but more intriguing. It would bring CCP-style standards – strict limits on eligible collateral, independent valuation and margining – to the non-cleared market, though with a CCP acting as an agent rather than the counterparty. LCH is said to be behind this one – the firm declined to comment – but talks are in their early stages.
Both ideas address the chief cause of the market's woes – the lack of fungibility created by today's CSAs – so could conceivably shore up volumes. But if a non-cleared trade ends up resembling a cleared trade in the way it is collateralised then it also removes one of the non-cleared products' selling points. Would it ultimately act as a bridge, speeding the passage of more products into clearing houses?
Possibly. It was certainly no surprise when Isda announced on June 9 that it is expanding its board to include two directors from the cleared derivatives market.