Last week, the Coalition for Derivative End Users filed a new comment letter with bank regulators on the rulemaking for the Dodd-Frank reform of the OTC derivatives markets. The Coalition has taken a lead role in lobbying to expand the end-user exemptions on clearing and margins. One interesting thing about the letter is how it betrays progress in the intellectual debate on the cost of margins.
Since early in the debates leading up to the passage of Dodd-Frank and through much of the following year, the Coalition tried to label margins as a pure deadweight cost to end-users. Without a margin mandate, they assert, end-users could trade derivatives with no money down, whereas with a margin mandate end-users would have to cough up cash. That is cash that could otherwise be used to fund investment, create jobs and foster economic growth, claims the Coalition. The cash posted as margin is therefore a deadweight cost associated with the margin mandate.
We and others have pointed out the silliness of this argument as follows.
A non-margined OTC derivatives contract entails credit risk to the dealer, and the dealer charges for this credit risk in the form of a bid-ask spread. Only the truly naïve believe that dealer banks provide these services out of the goodness of their hearts. The banks are shrewd profit maximizers, have explicit internal procedures for assessing the credit risk, for pricing it, and for determining the maximum exposure they will take from any given counterparty. So the Coalition was wrong to treat the non-margined OTC derivative as costless.
The flip side of the argument is that mandated margins can be financed by a credit line from the dealer bank. An explicit credit line financing the mandated margin is nothing more than a replication of the implicit credit line that comes as a part of a non-margined OTC derivative. It doesn’t require different limits or terms than what is already included in the non-margined OTC derivative. The explicit line of credit is no more costly than the implicit line of credit. It’s just that the price paid is clearer.
But of course an implicit credit line embedded in the bid-ask spread has great advantages to dealer banks. It is hidden, bundled with the derivative contract sold and therefore difficult to figure out by client end-users, who never really know how much they are paying for the amount of credit extended. Welcome to the opaque world of OTC markets.
The Coalition’s new comment letter now acknowledges the possibility that end-users could negotiate a line of credit to finance the mandated margin—see section II-B-3. Of course, they don’t accept our assertion that the cost is no greater. The focus of their letter is to point out the problems, difficulties and costs of financing mandated margin using explicit lines of credit.
We don’t agree with their assertions about these costs. But at least now the discussion has moved onto a realistic terrain. Before, they pretended that margin mandates were something radically new, significantly increasing an end-user’s liquidity requirements. Now they have been forced to acknowledge that this is not true. Instead, a margin mandate simply transforms an end-user’s credit requirements from one form into another form. They prefer one form over the other, but that’s an entirely different case to be made from what they had previously been making.
In the past, the Coalition and its allies have been sponsoring research and calculations to show the damage to end-users from mandated margins. All of the calculations were predicated on the argument that the total liquidity requirements of a firm went up—the lead study financed by the Coalition can be found here, and our critique here. Now that the Coalition has sensibly abandoned this argument, participants in the discussion should understand that these old calculations are no longer relevant.
What is the Coalition’s new estimate of the cost of a margin mandate on end-users? The recent comment letter doesn’t produce a number. The letter says that the explicit credit lines needed to finance mandated margin are more expensive than using the implicit credit contained in non-margined OTC derivatives. But the letter doesn’t attempt to quantify this cost.
In our critique of the Coalition’s previous study, based on the old false premise that mandated margins were a pure deadweight cost, we pointed out that
One could argue that the cash requirement is costlier than credit, but then you would have to figure out by how much. That would be an extra, very difficult step in the calculation, and any reasonable estimate for the differential would drive the headline number down enormously, possibly to zero.
We look forward to the Coalition’s new estimates.