Consumers may not realize it, but they are benefitting from the derivative markets every day. How? Derivatives, such as swaps and futures, are financial contracts that derive their value from an underlying asset, and businesses use them to lock in stable prices for consumers on everything from milk, to cars, to heating bills, to interest rates on home mortgages.
Strong regulations that provide transparency to the derivatives markets are crucial. However, one regulatory glitch is locking up $40 billion in cash that could be used by businesses to help provide economic growth and job creation.
The glitch is a requirement for initial margin to be posted on inter-affiliate swaps. Unlike other types of swaps that are traded between two different firms, inter-affiliate swaps are traded between the same company’s affiliated entities. They help companies centrally manage their risk and limit their exposure to third parties.
The Dodd-Frank Act’s Title VII created a framework for regulating the swap markets. Among many other requirements, the law subjected swap dealers and market participants to margin requirements to cover potential trading losses and protect against the risk of a counterparty default.
Since inter-affiliate swaps are internal transactions and do not pose the same risks as other types of swaps, the Commodity Futures Trading Commission (CFTC), Securities and Exchange Commission (SEC) European regulators, and most other major G20 regulators exempt inter-affiliate swaps from initial margin requirements. Most recently, the SEC voted on June 21, 2019 to finalize its regulations on capital, margin, and segregation requirements for security-based swaps and exempted inter-affiliate transactions from initial margin requirements. In 2016, the CFTC commented in its final margin rules for uncleared swaps that requiring initial margin for inter-affiliate transactions would “limit the ability of U.S. companies to efficiently allocate risk among affiliates and manage risk centrally.”
Indeed, that prediction has become reality.
In contrast to the majority of regulators around the world, the U.S. prudential regulators do require initial margin for inter-affiliate transactions. According to an International Swaps and Derivatives Association (ISDA) survey, almost $40 billion is being held in initial margin just to cover inter-affiliate transactions. That $40 billion is sitting on a shelf collecting dust, when banks could be putting it back into the economy and helping to fuel job creation – including using it to fund small business loans, home mortgages, and other consumer investments. Moreover, the cost of this increased margin can be passed down to end-users who use derivatives to hedge their commercial risk, which in turn would result in higher prices for consumer goods and services. Finally, the inconsistency between the U.S. prudential regulators and the rest of the world puts U.S. businesses at a competitive disadvantage.
Many stakeholders are voicing their concern and urging prudential regulators to fix this problem.
The Coalition for Derivatives End-Users, which is made up of manufacturers, energy companies, farmers, insurers, and other types of businesses, has commented on the negative impacts to end-users and requested an exemption. Lawmakers have also recently called on prudential regulators for an exemption. Over the past several months, more than 40 Republican and Democratic members of Congress have asked regulators to eliminate initial margin requirements for inter-affiliate swaps, citing concerns regarding the ability of U.S. firms to compete globally due to restrictive inter-affiliate initial margin requirements, the increased costs for end-users, and ultimately the increased costs for consumers and investors.
In order to preserve the U.S.’ ability to compete globally and consumers’ access to cost-effective goods and services, prudential regulators should align with the CFTC, SEC, and the rest of the world, and eliminate initial margin requirements for inter-affiliate swap transactions.
