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UPDATE 2-Regulators ease derivatives rule to avoid harming economy
September 2, 2013 / 9:36 AM / in 4 years

UPDATE 2-Regulators ease derivatives rule to avoid harming economy

* Designed to ease demand for collateral

* Global initial swaps margin to be phased in from 2015

* Banks can use wider range of assets as collateral

* Initial margin exemption for some forex contracts

* Lawyers say new rule will lock up big chunks of collateral

By Huw Jones

LONDON, Sept 2 (Reuters) - Global regulators have eased the impact of new rules designed to make the $630 trillion derivatives market safer as they seek to avoid too-tight controls on the sector that some banks argue could harm economic recovery.

The Basel Committee of regulators and central bankers published their final rule for requiring banks and brokerages to post an initial margin on trades in derivatives known as swaps, if those trades do not pass through a “clearing house” which in itself generates a back-up if one party to the trade goes bust.

The reform is part of a wider shake-up of derivatives among the 20 leading economies (G20). It includes mandatory clearing and on-exchange trading of contracts where possible, and for all transactions to be recorded.

Regulators want to apply lessons from the 2007-09 financial crisis in which the opaqueness of derivatives such as credit default swaps - used to insure against falls in bond prices - played a central part in creating market uncertainty.

Use of a clearing house means trades are backed by a default fund as insurance.

The aim of an initial margin - where cash or top quality government bonds are used to back a trade - is to provide a similar safety cushion.

The final rule was published on Monday ahead of a summit of G20 leaders in Russia on Thursday and Friday which will review progress on regulatory reforms.

Mark Carney, chairman of the Financial Stability Board (FSB) which coordinates G20 regulation, said countries still lagged in directing trades to electronic platforms to improve safety.

The European Union and United States have pledged to cooperate over derivatives rules after initial spats and Carney hoped other G20 countries will follow suit.

“With respect to derivatives, deferring to each others’ rules where outcomes are similar is an effective way of preventing regulatory arbitrage but also being realistic about the prospect of having one regulatory standard,” Carney told reporters.

A margin on uncleared swaps will provide the incentive to move trades to platforms and through clearing houses, he said.

CLEARING INCENTIVE

In many cases, the new rule will require both sides of the trade to post an initial margin of between 1-15 percent for the first time. They already post a variation margin that takes into account daily changes in the value of the swaps contract.

Damian Carolan, a lawyer at Allen & Overy, said Basel could not be too mindful of the impact on the economy otherwise it would end up being cheaper not to clear trades.

“They have tried to do what they could but they have not rowed back from a fundamental, material change to the industry which is a two-way margin which is a large amount of collateral to be locked up,” Carolan said.

Some banks have warned that the new rule, coupled with other reforms forcing traders and banks to use more collateral, will create a shortage of top quality collateral.

Industry officials say this would make some users avoid buying derivatives to insure against risks such as adverse changes in currencies, and hit availability of collateral in other markets for financing the economy.

“The Basel Committee ... acknowledge that the margin requirements are new to the market and that their precise impact will depend on a number of factors and market conditions that will only be realised over time as the requirements are put into practice,” the regulators said in a statement.

Airlines and other industries using derivatives to hedge their raw material costs will likely benefit from a threshold that exempts them from initial margins, said Ed Parker of lawfirm Mayer Brown.

The final framework also allows a wider array of eligible collateral for initial margins than was previously envisaged.

Banks would be able to re-use initial margin collateral, a process known as re-hypothecation, but only once, a big setback as collateral is recycled many times currently, Parker said.

The rule will in addition be phased in over a longer period than originally set out, starting in December 2015 for only the very biggest derivatives dealers, and rolled out for the rest of the market over four years.

Other changes from the draft version include an exemption from initial margin requirements for physically settled foreign exchange forward contracts and swaps.

Earlier this year Basel scaled back its new rule requiring banks to build up a buffer of liquidity reserves, again to ease demand for top-quality government bonds.

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