Drop margin on swaps leaving Libor, Basel says

Legacy Libor contracts being transitioned to new benchmarks should not have to meet margin requirements, two international regulatory standards bodies said on March 5.

The Basel Committee on Banking Supervision and the International Organization of Securities Commissions (BCBS-Iosco) released a joint notice detailing their recommendations, which go against rules set in the aftermath of the 2008 financial crisis.

The two said any changes made to legacy derivative contracts “solely for the purpose of addressing interest rate benchmark reforms” should not be required to adhere to the margin requirements for non-cleared swaps – though they conceded that local lawmakers across global jurisdictions must make their own determinations.

The news was welcomed by industry participants.

“The statement is a positive step and we think there will be more like it in the months to come,” says Brian Grabenstein, managing director and head of Libor transition at Wells Fargo.

A derivatives head at a buy-side firm concurred: “This is a step in the right direction and I certainly hope the US prudential regulators will follow in the BCBS-Iosco footsteps.” 

In the US, it will be up to the Federal Reserve, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency to make any final rule change. The Fed declined to comment on the BCBS-Iosco notice.

If such a change were made, it would cover any legacy swap transactions from before mandatory central clearing was implemented by the Commodity Futures Trading Commission in 2012, as well as any interest rate derivatives that fall outside the clearing scope altogether, such as swaptions and cross-currency swaps.

Margin rules for non-cleared swaps, which require two counterparties engaged in certain non-cleared derivative transactions to exchange initial margin, began a five-year phased implementation in 2016.

Institutions with more than $3 trillion in non-cleared swaps notional were caught in the net first, mainly the world’s largest banks. This September will usher in phase four of the rule and cover firms with more than $750 billion in non-cleared swaps notional.

Margin for non-cleared trades is higher than for cleared trades and is a costly and operationally burdensome process that participants would rather avoid. On Libor contracts, it is one element that acts as a disincentive to leaving the expiring rate. Banks will no longer be required to give Libor quotes after 2021.

For example, non-deliverable forwards (NDFs) – a type of foreign exchange contract that has typically not cleared – became more expensive to trade once the margin rules came into effect in 2016, which propelled a surge in cleared volume at clearing house LCH.Clearnet as banks tried to reduce the costs of trading those contracts. The margin cost also boosted the amount of inflation swaps that became cleared. 

Getting exemptions from financial crisis rulemaking has been a key tenet of some jurisdictions’ plans to ease the transition burden away from Libor.

For example, the Alternative Reference Rates Committee (ARRC), a group convened by the Federal Reserve Bank of New York, sent a letter last year to US regulators requesting clarification on swap trades’ treatment under Dodd-Frank Title VII if they were amended to include a new fallback provision, or in order to switch to an alternative benchmark.

One such request was that “non-cleared swap margin rules do not apply to legacy derivatives contracts”. A spokesperson for the ARRC was unavailable for comment.

Wells Fargo’s Grabenstein says regulators “have fully endorsed alternative reference rates and have committed to removing unnecessary obstacles to their implementation”.

“The formation of the interest rate benchmark reform subcommittee under the CFTC’s market risk advisory committee as well as the recent IFRS [International Financial Reporting Standards] decision to provide hedge accounting relief are other important examples,” he says.