A segregation puzzle July 16, 2012 at 1:07 pm
From BCBS 226, the new (-ish) Basel consultative document on margin requirements for non-centrally-cleared derivatives:
Under current market practices, the exchange of two-way initial margin in bilateral trades is not universal. Accordingly, requiring the segregation or other protection of initial margin collateral may create material incremental liquidity demands and trading costs relative to current practices, as (i) firms would be required to divert significantly more liquid assets to provide initial margin to counterparties on a gross, rather than net, basis, and (ii) firms would no longer retain the ability to use initial margin collected as a source of funding, for rehypothecation or re-use, or for other discretionary purposes.
Given the potential for the net treatment of provided margin to undermine the general benefits of the proposed margin requirements, there was broad consensus among the BCBS and IOSCO that the proposed requirements should address these risks by requiring the gross exchange and the segregation or other effective protection of provided initial margin, so as to preserve its capacity to fully offset the risk of loss in the event of the default of a derivatives counterparty.
This is all very reasonable. Yes, IM can reduce credit risk for the postee, but it can also introduce both liquidity risk (because it has to be funded) and credit risk for the poster (because the margin over the MTM of the portfolio is often an unsecured claim). To mitigate this credit risk, the BCBS says
the collected margin must be subject to arrangements that fully protect the posting party in the event that the collecting party enters bankruptcy to the extent possible under applicable law.
So here’s my point. How much, roughly, of the system’s margin is currently held in arrangements that meet those criteria? My guess is not much. Moreover it is very hard to see how you get both fully segregated margin and rehypothecation. So you pay your money and you take your choice – do you want to mitigate liquidity risk or credit risk today? Pick one.