Change of benchmarks and margin regulation

As discussed six months ago in my blogs (here and here), new benchmark indices mean new trades, new trades mean mandatory margin.

If the interest rate benchmark indices like LIBOR, EURIBOR, SONIA, Fed Fund Effective or TOIS are modified or replaced, the contracts referencing them need to be adapted. Those contracts include the CSA referencing those indices as interest rate for cash collateral. Each contract need to be modified individually after agreement of each of the parties in the contract. If a contract is modified, it is considered as a new trade for the regulation related to mandatory margin. For all new trades, a mandatory daily Variation Margin (VM) applies for all counterparties and mandatory segregated Initial Margin (IM) applies for large derivative users, with more and more users falling in that category over time.

The logic of the consequence of reorganizing the market infrastructure for benchmarks seems to have finally reached the "lawyers". A recent article in Risk details the opinions of different lawyers working in the financial market on the subject. Even if it is presented as a new discovery in the article and in round-tables, it is nothing new for you, my blog's readers. Remember my February blog where I said "Don't underestimate this issue" when I discussed the replacement of TOIS by SARON. According to the Risk article, the question was also asked earlier this month at a Bank of England-sponsored round-table related to the reference rate reform. Maybe by someone who had read my earlier blog.

To my opinion, the impact is not only on contracts mentioning the rate index directly but also on contracts referencing it indirectly through the CSA. For example if an equity derivative contract was referencing a CSA with the possibility to post collateral in CHF cash with payment of interest at TOIS, the replacement in the CSA of TOIS by SARON would clearly be a new contract. Under the spirit of the regulation, that equity contract will fall under the mandatory margin regulation. I have not heard any official opinion on this point of indirect impacts.

The rule is clear: any new trade will fall under the mandatory margin rule. Clearly a trade with a new benchmark index can only be a new trade. I have my personal disagreement with the way the rules have been set-up, e.g. expressed in my answer to the EBA request for comments in July 2015, but certainly I support a clear rule that is applied without exception.

Mentioning that the new contracts are "unintended consequences" of the change of benchmark is not an argument. First I hope that regulators and lawmakers have thought about all potential consequences before proposing a rule and that none as obvious as the one discussed here would be called "unintended". Second, if "undesired" consequences were a valid argument, there are plenty of earlier cases were it should apply. For example when doing compression of bilateral portfolios you would be allowed to use vanilla swaps, even if they are mandatory cleared for some users, without having to use synthetic derivatives (see the Risk article on the subject). Also multilateral netting of IM would be allowed if they decrease systemic risk.

Why do I, as a quant, care or give my opinion about legal matters? The legal framework of derivative contracts is now a sub-discipline of quantitative finance; the valuation of derivatives includes the exact wording of the term sheets and applicable regulation. Quants have the most complete view on the pricing, including the impacts of exact contract and regulation wording. The quant community opinion on this matter is at least as important as the one of the legal community, actually more important as they can quantify the impact, not only acknowledge its existence.

I'm curious to see what will happen in case of change of benchmark indices, in particular in the CHF market with the planned discontinuation of the TOIS and the creation of the new SARON. How much issues will it create on the derivatives referencing TOIS directly? How much issues will it create indirectly through CSA referencing TOIS?

Without a doubt a subject TO BE CONTINUED in another blog.

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