Regulators of several countries, including the United States Commodity Futures Trading Commission (CFTC), have

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introduced or proposed rules requiring clearing of over-the-counter (OTC) derivatives through central counterparties. Clearing requirements in turn affect margin requirements, which are one key mechanism used by parties to mitigate counterparty risk. Although clearing rules help shield collateral from the insolvency of the secured party, they also may substantially increase financial and operational costs for the users of cleared derivatives because of the higher margin delivery requirements applicable to such transactions.

Margin Requirements and Their Sources

One of the key mechanisms used by parties to an OTC derivative transaction to reduce counterparty risk is the posting of margin. Typically, one or both of the parties will be required to deliver collateral to secure its payment obligations. If a party defaults by failing to make a payment or becoming subject to an insolvency proceeding, the other party has the right to terminate the OTC derivative and use the posted collateral to pay any termination payment owed by the defaulting party. A party may be required to deliver margin at the outset of the transaction (referred to as “initial margin”) and may also be required to deliver margin periodically as the potential termination payment of the
parties changes over the life of the transaction (referred to as “variation margin”).

Margin requirements for a typical non-cleared OTC derivative are set forth in a bilateral agreement between the parties. OTC derivatives are typically documented under industry-standard master agreements, which are printed forms prepared by the International Swaps and Derivatives Association (ISDA).Margin requirements for such transactions are set forth in a credit support annex (CSA) to the agreement.In contrast, margin requirements for a cleared OTC derivative spring from two sources. First, the DCO that clears the derivative will require both initial and variation margin based on the rules of the DCO and any government regulations applicable to the DCO. Second, since a counterparty to a cleared OTC derivative needs to gain access to a DCO through a Futures Commission Merchant (FCM), which is a member of the DCO, the counterparty will need to enter into a futures account client agreement with the FCM. Under this futures account client agreement, the FCM may require the counterparty to deliver margin in addition to the margin required by the DCO.

Clearing Rules Help Protect Collateral
Parties to a non-cleared OTC derivative can choose in the CSA how collateral delivered by a party must be held. For instance, the CSA may allow the pledgee of the collateral to use all the collateral posted to it in other transactions (that is, the right of “rehypothecation”) and commingle such collateral with collateral posted by other parties. Although a counterparty typically prefers that the collateral it posts be held by a bank custodian and not re-hypothecated, dealers will insist on holding the collateral directly and having the right to re-hypothecate the collateral because this generates significant revenues for them. Such commingling and re-hypothecation of collateral were partially responsible for losses suffered by Lehman’s OTC swap counterparties on the collateral they had posted to Lehman.25 Following the Lehman insolvency, some buy-side clients negotiated prohibitions on re-hypothecation and required third-party custody for posted collateral to prevent commingling.26 The Dodd-Frank Act mandates that a dealer is obligated to segregate initial margin if requested by its counterparty.

The unprecedented regulatory response to the perceived dangers of the OTC derivatives markets is transforming clearing requirements in these multi-trillion dollar markets. The impact of regulatory changes on collateralization requirements and, more generally, on how counterparties to OTC derivatives mitigate counterparty risk cannot be
overstated. Although margin delivered by counterparties to cleared OTC derivatives may be better protected from the insolvency risk of the pledgee under the new regulatory regime, counterparties to cleared swaps will also be subject to more stringent collateral delivery requirements that will be more expensive and more difficult to implement operationally.

Source : Harward Business Law Review online
Paper published by Paul Watterson, Joseph Suh, and Craig Stein


  1. If rehypothecation happens for the collateral placed with CCP, DCO and FCM, I am keen to know how does it prevent the risk from being centralized with these market participants? One mistake on part of CCP could result into a financial catastrophe.


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