A change in the wording of the financial reform bill now being finalized in the US Congress could cost US companies as much as $1 trillion in capital and liquidity requirements, according to research by the International Swaps and Derivatives Association, Inc. (ISDA). About $400 billion would be needed as collateral that corporations could be required to post with their dealer counterparties to cover the current exposure of their OTC derivatives transactions. ISDA estimates that $370 billion represents the additional credit capacity that companies could need to maintain to cover potential future exposure of those transactions. If markets return to levels prevailing at the end of 2008, additional collateral needs would bring the total to $1 trillion.
The Dodd-Frank Wall Street Reform and Consumer Protection Act could lead to a requirement of initial and variation margin (also referred to as collateral posting) for all over-the-counter (OTC) derivatives that are not cleared, including those involving an end-user. The legislation presented to the conference committee would have explicitly exempted corporate end-users from margin requirements on such transactions. This exemption is no longer in the bill. If the bill is passed without this exemption, regulators could significantly increase the costs of hedging exposures.
To assess the impact of this provision, ISDA’s Research team analyzed year-end 2009 data available from the Office of the Comptroller of the Currency regarding derivatives exposure and margining. The Association’s analysis is based in part on this data and also includes assumptions and estimates regarding corporate end-user exposure, required margin levels and other factors.
“The margining requirements for corporate end-users as currently drafted in the bill runs the risk of imposing a significant cost on US companies and could impede their ability to manage their business and financial risks,” said Conrad Voldstad, ISDA chief executive officer. “These provisions would increase rather than decrease risk. They work against the bill’s main purpose, which ISDA clearly supports, of enhancing financial stability and strengthening our financial system.”
At year-end 2009, the notional value of derivatives held by US commercial banks totaled $213 trillion according to the OCC. Assuming 10% of this amount reflects corporate end-user activity, and that the initial margin requirement would be 1% (a typical level) of the notional amount, then US companies would face a $213 billion collateral requirement.
In addition to initial margin, US companies could also face variation margin requirements under the bill. According to the OCC, the Net Current Credit Exposure (NCCE) of US banks at year-end 2009 was $398 billion. Of this amount, 41% or $163 billion was related to corporate users of OTC derivatives. Approximately 31% of this amount was collateralized and 69% or $112 billion was not collateralized.
In addition to the approximately $325 billion in initial ($213 billion) and variation ($112 billion) margin that US companies could face related to their OTC derivatives transactions with US banks, they would also be required to post margin for their transactions with non-US banks. Using a conservative estimate of non-US banks’ share of the US corporate derivatives market, ISDA’s analysis indicates that the cash and liquidity requirements of US companies might increase by about another $81 billion to $406 billion.
ISDA’s analysis also considered collateral requirements that US companies would face with regard to the Potential Future Exposure (PFE) of their bank counterparties. PFE is a metric that the OCC requires banks to estimate and represents the potential change in derivatives exposure that banks might face on their transactions with clients. In order to be prepared for possible variation margin calls resulting from rising OTC derivatives exposure, prudent companies would most likely arrange for back-up credit facilities or set aside existing cash that might otherwise be used to expand their businesses and create jobs. For all users of derivatives, Potential Future Exposure was $723 billion. Assuming that 41% of this Potential Future Exposure relates to corporate (as it does for NCCE), corporations could face an additional liquidity requirement of $370 billion, including $296 billion on their PFE with US banks and $74 billion with non-US banks.
ISDA’s research also noted that since the end of 2008, the net current credit exposure (NCCE) of US banks has fallen by about $400 billion. If a period of severe market turmoil was to occur, the NCCE could increase. This could mean several hundred billion dollars of additional collateral requirements for end-users and bring the final total to $1 trillion.
The following table summarizes ISDA’s analysis of the potential capital and liquidity requirements that US companies would face as a result of any collateral requirements imposed as a result of the financial regulatory reform legislation:
Initial margin to US banks $ 213 billion
Variation margin to US banks 112
Initial margin to non-US banks 53
Variation margin to non-US banks 28
Total margin required: $ 406 billion
PFE credit facility:
US banks $ 296
Non-US banks 74
Total PFE credit facility: $ 370 billion
Total capital / credit required: $ 776 billion
