No need to panic about OTC collateral supply, says Bank of England
The possibility that mandatory central clearing of over-the-counter derivatives, coupled with margin requirements for uncleared trades, could create a drain on the supply of eligible collateral has been overestimated and should not be a cause for panic, a senior official at the Bank of England has said.
“There are clearly a number of real regulatory and market factors that are tending towards an increased demand for collateral and those do include the central clearing obligation and the margin obligation on non-cleared OTC derivatives. But it’s important to remember that there is a lot of high-quality collateral available and the amount of it is not numerically decreasing, but actually increasing,” said Edwin Schooling Latter, head of the payments and infrastructure division at the Bank of England, speaking at the OTC Derivatives Clearing Summit in London.
Schooling Latter said that, despite widespread speculation about a possible shortfall of collateral, there are plenty of highly rated governments, including the US and the UK, issuing bonds to tackle budget deficits.
“The Bank of England is not buying it all through quantitative easing, and even where we do buy some of it, we’re obviously creating another high-quality liquid asset in the form of cash reserves,” he said.
Citing recent estimates made by the International Swaps and Derivatives Association that proposed rules for margining of non-centrally-cleared derivatives could result in a requirement for between $15.7 trillion and $29.9 trillion of initial margin, Schooling Latter described the published numbers as “pretty scary estimates”.
But he referred to the Bank of England’s own estimates, published in its latest Financial Stability Report in June, that total initial margin required is more likely to be between $200 billion and $800 billion, three quarters of which would be driven by central clearing. A likely exemption for foreign exchange swaps and forwards is one of the reasons total collateral requirements are likely to be less than the Isda estimates, said Schooling Latter.
“Why is there so much difference in some of these estimates of collateral demand? Not surprisingly, like many things in economics, it depends on the assumptions you make. Firstly, the assumption on what products are covered by these obligations – notably if FX swaps and forwards are excluded, that reduces those Isda numbers by $60–70 billion,” said Schooling Latter, adding that there are clear signals from US authorities that the exemption will be confirmed, providing the groundwork for discussions on the issue in the European Union.
In addition, the calculation of initial margin requirements depends on assumptions about which market participants are covered by the obligations, how many central counterparties will operate, as well as the likely level of rehypothecation of collateral between counterparties and the effectiveness of netting.
“We don’t need to panic about excessive and difficult-to-meet collateral requirements – of course we do need to watch it, and the official community is doing so very carefully. But there are other elements we should also be concerned about, one of which is operational readiness. We are envisaging a lot more initial margin being moved around a lot more counterparties. One question we would have is whether the operational arrangements for that – the back offices and so on – are ready to deal with that increased volume of activity,” said Schooling Latter.
This article was first published on Risk