Who pays the bill ? The mechanics of collateral costs for OTC derivatives trades in the US
This article looks at the need for corporations, insurance companies, hedge funds and other users of OTC derivatives to post collateral for their trades under Dodd-Frank. The article discusses the reality of Basel III’s impact on bank balance sheets and that in the end, costs will rise for endclients regardless of whether collateral is posted or not. The article concludes with recommendations for end-clients to assess their exposure now and to identify alternative financing options such as collateral conversion trades.
The arguments have been raging over who should put up collateral for OTC derivatives trades in the US. The CFTC has acknowledged the interest of Congress and proposes to exempt corporations from having to put up initial or variation margin for a bona fide commercial hedge for a non-cleared trade; financial end-clients and speculators will need to post collateral regardless. Meanwhile, the Federal Reserve, FDIC and other banking regulators have said that corporate end-users may be exempt from putting up collateral only if banks think that these firms pose an acceptable credit risk. These proposals are similar with some technical differences, and some categories of traders such as energy companies are difficult to classify. Either way, commercial end-clients believe that they may have escaped having to post collateral and take on increased costs, while financial endclients are busy evaluating clearing agents for central credit counterparties (CCPs) (see Exhibit 1).
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