SEC’s last-minute CDS margin fix sparks buy-side anger

Buy-side firms have reacted angrily to temporary portfolio margining provisions rushed out by the Securities and Exchange Commission (SEC) late on Friday as the clock counted down towards the start of mandatory clearing in the US.

The last-minute fix allows firms to benefit from offsets between cleared index credit default swaps (CDSs), which are subject to the mandate, and single-name contracts, which are not. But instead of allowing the portfolio to be margined at the same level as that calculated by a central counterparty (CCP) – the terms available to dealers – the SEC is insisting that buy-side firms post at least 150% of the margin charged by the CCP, rising to 200% for most hedge funds.

“It’s a huge hit and one we are sensitive to. It won’t prevent us trading but it may prevent other market participants – and that will hurt liquidity. This is a big issue for the buy side,” says Michael O’Brien, head of global trading at investment management firm Eaton Vance.

The SEC’s move follows a sustained campaign from both buy- and sell-side firms and came late on March 8, in a letter sent by the agency to market participants. It gives temporary approval for futures commission merchants (FCMs) to collect 150% of margin calculated by CDS clearer Ice Clear Credit, but only if the client has “virtually no credit risk”. For all other clients, 200% must be collected on positions held in the portfolio margin account – which is expected to catch most buy-side firms.

“As defined, the 200% requirement will encompass almost every single hedge fund,” says a US head of over-the-counter clearing at one European bank in New York. “The 150% applies to entities defined as having virtually no credit risk – equivalent to an AAA or AA rating. Not many entities have that distinction. There is definitely room for an improved structure that addresses the agency’s concerns while having palatable economic terms for market participants.”

Some buy-side firms are frustrated they are unable to clear on the same terms as CCP members, which have been able to portfolio-margin CDSs for over a year at 100% of the clearing house margin call.

“The 200% level is arbitrary and unexplained. It puts the buy side at a material disadvantage to the sell side. We can’t understand why the SEC wants an approach that is punitive to the buy side,” says one manager at a buy-side firm.

The problems arise because the Dodd-Frank Act splits supervision of the CDS market between the SEC and the Commodity Futures Trading Commission (CFTC), with the latter given responsibility for swaps – including CDS indexes – while the former has oversight of so-called security-based swaps, including single-name CDSs. As a result, FCMs have to put client positions in swaps and security-based swaps into separate accounts, meaning customers are unable to benefit from any offsets between the two sets of positions.

That could dramatically magnify collateral requirements. A hypothetical example published by Ice describes a portfolio of bought protection on 125 names of $1 million each at a five-year tenor, and an offsetting index trade where protection is sold with a notional of $125 million. Under portfolio margining, the total initial margin would be $1.25 million; without it, the figure would be $5.53 million.

The SEC published an exemption order in December that essentially gives FCMs the ability to commingle and portfolio margin customer positions in cleared CDS contracts in a single segregated account, extending the benefits of cross-margining to buy-side firms. However, a number of conditions were added, including a stipulation that each FCM obtain approval for its margin methodology from the SEC.

No approvals have been granted to date, so the March 8 letter effectively acts as a stop-gap, allowing portfolio margining to start subject to the blanket multipliers.

The SEC letter also allows FCMs to collect margin at a level of 100% from clients – but only if they take a capital charge on the difference between that and the applicable higher multiplier. Dealers are reluctant to absorb this charge and warn they would pass on the additional cost to the client anyway.

“Subsidising the risk and taking a capital charge is not something we feel is appropriate given the new regulatory regime. Doing so would be quite punitive and would result in additional costs being passed along to our clients,” says the European bank’s head of US clearing.

The SEC did not respond to a request for comment by press time.

 

This article was first published on Risk

 

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