Portfolio Margining for Rates: Saving on Clearing

While the CFTC still must make a final determination on which swaps will be eligible for central clearing, the mandatory clearing of a significant portion of over-the-counter interest rate swaps is coming, and it’s going to cost the industry. As of August 2012, the notional value of outstanding OTC interest rate swaps was $514 trillion; if cleared, these products would require $7.1 trillion in gross initial margin. But margin offsets could dramatically reduce these costs.

Offered by clearinghouses for years in other centrally cleared asset classes, portfolio margining enables firms to reduce their margin burden by leveraging offsetting risks in their portfolios to also offset margin requirements. According to the report, when portfolio margining becomes available to all market participants, the industry-wide margin requirements for IR swaps will be cut by at least 32 percent.

Portfolio margining will most significantly benefit those market participants that have the largest offsetting risks, most likely dealers that act as market makers and middlemen between end users, asset managers, insurance companies and hedge funds. But the big banks will benefit as well.

If implemented, the Volcker Rule will prohibit banks from taking proprietary positions, and they are not in the business of taking massive, one-sided risks. As a result, most banks’ trading positions should offset, allowing them to gain considerable margin relief through portfolio margining.

According to the author of the report, Adam Sussman, Director of Research, when all clearable IR swaps are eligible for portfolio margining, the industry will see margin savings of $618 billion. And if more linkages are created among Central Counterparty Clearinghouses (CCPs), the savings could reach as high as $1 trillion.

Meanwhile, other factors also will influence the size of the IR market and thus the future cost of clearing mandates, TABB Group reports. The emergence of pre-trade tools that help managers incorporate margin rules into the portfolio construction process and collateral optimization services should help keep margin requirements in check.In addition, the mere advent of margin requirements is likely to influence product selection. Along with regulatory proposals to impose capital charges on less-liquid and/or more-exotic instruments, margin costs could drive a shift toward products with favorable regulatory status and relatively lower margin requirements.