Don’t mess with rules curbing derivatives risk

Derivatives dealing and trading can be high-risk activities with catastrophic financial and economic consequences, as learned during the 2008 financial crisis.

Many derivatives are not only dangerous in itself but serve as a key transmission mechanism for spreading risk. Too often, they act as a conveyor belt distributing misunderstood and underestimated risks, like unseen time bombs throughout the global financial system.

These risks pose a heightened threat to U.S. financial stability, because the five largest domestic derivatives dealers are also the five largest taxpayer-backed U.S. banks, which conduct almost 90% of derivatives dealing by banks nationwide. These largest U.S. banks also dominate the global markets through foreign affiliates, which facilitated much of the roughly $542 trillion in derivatives notional outstanding as of 2017.

Because derivatives dealing is highly leveraged, one of the most important protections to limit risks, promote financial stability and prevent crashes and contagion is requiring collateral, called margin, on all derivatives trades.

That margin is posted both when the trade is entered (initial margin) and over time as the value fluctuates (variable margin). Initial margin is like a performance bond or a down payment on a house. It protects the bank from price changes in the event that the borrower defaults and the property has to be sold.

Yet U.S. bank regulators, including the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency—each meant to protect bank depositors and ultimately, taxpayers — recently proposed to eliminate the required initial margin on uncleared derivatives dealing among affiliates of U.S. banks, or so-called “interaffiliate” derivatives transactions.

This would abolish a critical risk management reform intended to ensure that Wall Street’s derivatives dealer banks can manage counterparty defaults and close out complex portfolios, without cascading problems and precipitating a crisis. Unfortunately, the proposal not only increases risks to the U.S. financial system but also enables the biggest global U.S. banks to avoid or evade core financial protection rules.

The U.S. derivatives dealer banks use interaffiliate derivatives transactions to pass along risks from one legal entity to another within their global corporate family. For example, a London affiliate to a U.S. dealer bank might execute derivatives transactions with European counterparties; and its Hong Kong affiliate might execute derivatives transactions with Asian counterparties. However, when such trades are booked into the foreign affiliates, those affiliates each execute other derivatives transactions that essentially transfer the risks of the initial transactions to the affiliated U.S. bank.

There are some legitimate business reasons to structure derivatives transactions in this manner. For example, a U.S. bank may manage some or all of its corporate group’s risks relating to a particular set of derivatives and/or may have specific risk management expertise.

In addition, non-U.S. counterparties may prefer to enter into a derivatives transaction with a local dealing entity for legal, regulatory and other reasons. This in turn, would allow the foreign affiliate facing the counterparty to facilitate the transaction without needing separate capital or to build out its own risk management and control frameworks.

But those centralized risk management and other benefits come with serious risks. The very purpose of interaffiliate derivatives transactions is to transfer risks between legal entities and, most often, to move risks into U.S. dealer banks that have control or custody of deposits and customer funds.

If the foreign affiliate is not adequately capitalized and properly regulated, the U.S. bank essentially inherits the foreign affiliate’s risks. That is why both Congress and most U.S. financial regulators, prior to the recent proposal, rightly insisted that U.S. banks protect depositors and customers by collecting initial margin from affiliated derivatives counterparties.

Initial margin is a critical protection for U.S. banks, because it is calibrated to the particular derivatives portfolios of foreign affiliates. The initial margin requirement is an output of dealer models that are meant to account for various types of risks in a derivatives portfolio; and project a potential exposure over a specified period of time.

If properly calibrated, the initial margin should be sufficient to cover changes in the value of the derivatives portfolio, and permit the dealer to close-out and manage related risks if the affiliate defaults. Without initial margin, the dealer banks are exposed to whatever ongoing, uncollateralized risks exist in the affiliate’s portfolio at default.

According to an industry trade association, about $40 billion of interaffiliate initial margin was collected by the derivatives dealer banks last year to protect themselves, and others. However, eliminating the required initial margin for interaffiliate transactions does not eliminate the risks necessitating that margin amount. It simply leaves a concentrated group of systemically important (and previously bailed out) dealer banks with $40 billion in potential exposure.

Moreover, foreign affiliates’ derivatives activities may not be subject to a legal and regulatory framework as comprehensive as the U.S. following the aftermath of the 2008 financial crisis. Depending on the nature of the derivatives portfolio, and the counterparties and jurisdictions involved, there may be other risks, like contract or collateral enforceability concerns.

Requiring U.S. dealer banks, with depositor and other customer funds, to collect sufficient high-quality collateral on interaffiliate derivatives transactions protects them from financial difficulties with non-U.S. affiliates. This requirement acts as a buffer against the risks from unregulated or less regulated derivatives activities. And in turn, it serves as a critical protection for depositors, retail investors and others who depend on the safety and soundness of the U.S. entity.

It also ensures that U.S. derivatives reforms cannot be easily avoided or evaded by dealing through affiliates with little more than a key stroke.

This is why Congress unequivocally mandated both initial and variation margin on “all” uncleared derivatives. Eliminating the interaffiliate initial margin is a dangerous decision and one that the banking regulators, including the OCC and FDIC, simply do not have the authority to make.

These are the key realities that the Federal Reserve Board must consider as it prepares to vote on the OCC and FDIC’s proposal.