Today’s Wall Street Journal Article: Late Change Sparks Outcry Over Finance-Overhaul Bill focuses on language struck at the last minute that has end-users fearing that at the end of the day they will have to post margin, despite the intent to allow them the option not to clear trades.
My interpretation is that the instrument itself is exempted from clearing if one of the counterparties is not a financial entity (i.e. most non-financial corporations) and they are hedging commercial risk (to be defined by the Commission) and can demonstrate they can meet the financial obligations (shouldn’t be a problem for most companies using plain vanilla derivatives). Once the swap itself meets the criteria then it doesn’t have to be cleared by the swap dealer or the other counterparty to the clearing firm. If a transaction is not posted to a clearing firm then there are no margining requirements for both sides of the trades and there will not be the need for the bank to turnaround and ask the corporate for margin to cover its costs.
In Section 731 addressing capital and margining requirements for swap dealers and major swap participants, language was struck that clarified again the above end user type exemption, which in my opinion was either an unintended consequence or that legal staff have understood that it would be redundant to restate the exemption. So yes it probably would have been better to leave it in for clarity, but if you think about the mechanics of margining it raises a big question. Who would a swap dealer or major swap participant post margin to for un-cleared trades? The CFTC or SEC?
In order for the CFTC to manage margining, they would have to calculate the appropriate initial and variation margin levels for each un-cleared trade (which would easily be in the hundreds of thousands), set up the legal and financial infrastructure to hold and return margin on a daily basis, including accrued interest, provide all of the reporting and resolve disputes and address enforcement of those who are delinquent, including the right to go in an unwind a swap position they don’t have the legal right to as its not in their name. These are all of the things a clearing firm is set up to do in order to minimize the credit risk of the derivative. Perhaps the CFTC could outsource this to another entity, but I can’t imagine this is what they want to do.
Section 731 will essentially drive swap dealers and major swap participants to focus on coming up with standardized trades that can trade on an exchange or at least have enough liquidity to clear. This has always been the underlying hopes of the reform, so not sure what the hype is about.