January 4, 2013 / 9:16 PM / 5 years ago

UPDATE 1-Fed's Yellen backs initial margins for OTC swaps

By Ann Saphir

SAN DIEGO, Jan 4 (Reuters) - A top Federal Reserve official on Friday lent her support to rules that would require swaps traders to post an initial slug of money to back swaps trades, a change that critics say could undercut the global trade in over-the-counter derivatives.

“Even in light of the significant costs of initial margin, it seems clear that some requirements are needed,” Federal Reserve Board Vice Chair Janet Yellen told the annual meeting of the American Economic Association. “A more robust and consistent margin regime for non-centrally cleared derivatives will not only reduce systemic risk, but will also diminish the incentive to tinker with contract language as a way to evade clearing requirements.”

U.S. regulators including the Fed are in the last stages of writing rules aimed at reducing risks in the OTC derivatives markets, where lax regulation helped worsen the financial crisis of 2007-2009.

This year new rules will force most OTC swaps for the first time into clearinghouses like those run by CME Group Inc and IntercontinentalExchange Inc.

Regulators hope that clearing will improve transparency in the $600 trillion global swaps market and reduce the chance that the collapse of any one dealer could threaten the stability of global financial markets, as happened with the failure of American International Group at the height of the crisis.

But many swaps are not standardized and will not be subject to clearing mandates, including an estimated one-third of world interest-rate contracts, the largest part of the OTC swaps market. Regulators want to reduce the risk that failures by traders of these uncleared swaps could bring down world markets.

Among the most controversial of proposed rules are ones that would require swaps traders to post so-called initial margin, a plan that the International Swaps and Derivatives Association says could lock up as much as $1.7 trillion in liquid assets globally.

“This number is eye-opening, to say the least,” Yellen said, adding that the Fed has conducted its own study to quantify the liquidity costs of initial margin requirements. The study’s results, which she did not detail, “will help ensure that in the final framework, the need to reduce systemic risk is appropriately balanced against the resulting liquidity costs.”

Yellen did not address monetary policy or the economic outlook in her prepared remarks, and instead used the forum - which brings together hundreds of economists from around the world - to argue for tougher rules for financial institutions.

Higher capital requirements and other tools can be used to reduce the risks from the failure of large banks, she said.

But Yellen’s comments about swaps were the most pointed.

“It seems highly unlikely that the status quo is consistent with achieving the goals of the G-20 to reduce the potential for systemic risk in the OTC derivatives markets that could threaten the financial system,” she said.

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