Non-US sovereigns should collateralise swaps, say US bank regulators

All non-US sovereigns would be asked to start posting collateral on bilateral derivatives trades with US counterparties, under a new joint proposal from five US regulators - a radical attempt to change the status quo for sovereign derivatives users, many of which currently refuse to post collateral, despite the funding and capital costs this creates for dealers.

"It is about time governments walk the walk - not just talk the talk. If we are all truly interested in reducing risk, then it makes sense sovereigns are required to post margin just like any other end-user," says one senior derivatives trader.

But the selective application of the requirement to non-US entities is already sparking criticism. Some dealers speculate it will simply make it harder for US dealers to win business from foreign debt offices and central banks. Others predict it would prompt the same response from other nations: "What happens next - does France call for all non-French sovereigns to start posting collateral to its banks?" asks a senior trader at one European bank.

The draft rules are the latest element of the Dodd-Frank Wall Street Reform and Consumer Protection Act to be tackled by regulators, and is laid out in a notice of proposed rulemaking co-authored by five US agencies, including the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation. Dated April 7, the proposals cover dealers and other active derivatives market participants that are subject to the bank regulators' oversight. The Commodity Futures Trading Commission (CFTC), has proposed a similar set of rules, which will apply to firms outside the bank agencies' purview. A spokesperson confirms the CFTC proposal also calls for sovereign collateral posting.

"The proposal includes foreign governments in the definition of financial entity. Therefore, they would be subject to margin requirements for trades with swap dealers or major swap participants. This provision is identical to the provision in the prudential regulators' proposal," he says.

It’s about time governments walk the walk - not just talk the talk. If we are all truly interested in reducing risk, then it makes sense that sovereigns are required to post margin just like any other end user

The agencies note that sovereigns "do not fit easily" into the rules, but argue that they should be treated like other financial end-users of derivatives because of the interlinkages between sovereigns and their domestic banking industries. Nevertheless, dealers have been taken aback by the decision.

"Even within the context of the regulators' expansive view of the extra-territorial application of Dodd-Frank, I am surprised they can interpret its provisions in a way that would give them jurisdiction over foreign sovereigns," says another derivatives dealer.

Others note they don't have to - the rules would apply to US-regulated dealers rather than to the sovereigns directly. In other words, US dealers would be required to obtain collateral from their foreign sovereign clients - those clients would not be obliged to post it.

This fight has been brewing for some time, according to John Wilson, former global head of OTC clearing at RBS. He notes that the Dodd-Frank Act contains a provision exempting US sovereign entities from the legislation generally. Non-US sovereigns have directly approached US authorities to argue that's unfair, he says.

"There have been a number of representations made directly to the CFTC and the US government by non-US sovereigns concerning the treatment of foreign sovereign entities - in that they were not being recognised in the same way US sovereign entities were. So it was already on the agenda, however, as evidenced today, they took no notice at all. European sovereigns now face a choice of either avoiding US swap dealers and reducing their counterparty choice or incurring clearing costs - neither will be appealing," says John Wilson, former global head of OTC clearing at RBS.

As things stand, many sovereigns insist collateral is posted to them when they are in the money on a trade, but refuse to reciprocate when the value flips round - a so-called 'one-way' collateral agreement that leaves dealers with a funding obligation estimated at around $150 billion. The absence of credit mitigation creates other knock-on effects - dealers have to buy protection in the credit default swap market, or face higher capital requirements under the incoming Basel III rules.

"I think it would be sensible for all sovereign debt management organisations to post collateral on a bilateral basis. For one thing, it would significantly reduce the problem of credit value adjustment and the associated capital requirements under Basel III," says another dealer.

The industry has been trying to persuade its sovereign clients to change their practices, with little success, and some have recently begun reaching out to organisations such as the Bank for International Settlements and the International Monetary Fund in the hope they will opine on the subject. The US regulators' attempt to make collateral posting mandatory goes far beyond those hopes.

The agencies' joint proposal defines non-US sovereign entities as financial end-users, which are divided into two categories: high- and low-risk profiles. Sovereign users of swaps would almost certainly fall into the high-risk category because many have swap positions that exceed $2.5 billion in daily average aggregate uncollateralised exposure, or $4 billion in daily average aggregate uncollateralised exposure plus daily average potential exposure. According to the proposal, dealers would be required to cllect both initial and variation margin from all high-risk financial end-users - including sovereigns.

This article first appeared on Risk.net.