Federal regulators announced on Wednesday an overhaul of a murky Wall Street market that gained infamy during the financial crisis of 2008.
The Federal Reserve and the Office of the Comptroller of the Currency, as well as three other agencies, proposed a rule that would apply to over-the-counter derivatives, the financial instruments that banks and other financial entities use to speculate or hedge their risks.
American banks have nearly $280 trillion of derivatives on their books, and they earn some of their biggest profits from trading in them. But the 2008 crisis revealed how flaws in the market had allowed for dangerous buildups of risk at large Wall Street firms and worsened the run on the banking system.
Since then, regulators have been trying to make the derivatives market less risky. The rule proposed on Wednesday focuses on margin payments, which traders in derivatives make to each other to protect against the risk that they don’t get paid what they are owed. Such margin payments add discipline to a high-octane trading activity and make it more likely that derivatives traders can bear losses if one large entity collapses. But the industry, seeking to minimize its costs, has not applied margin requirements evenly across the system. The proposed rule aims to change that.
“This is a really important rule,” said Marcus Stanley, policy director at Americans for Financial Reform, a group that has called for stricter financial regulation. “Margin is the first line of defense in the derivatives market.”
Regulators originally proposed a rule on margin payments in 2011. Because the latest version has significant differences, they chose to “re-propose” the rule, a relatively rare occurrence for new regulations that stem from the Dodd-Frank Act, which Congress passed in 2010 to overhaul the financial system. The regulators made the changes to bring American margin rules in line with new international ones approved in 2013, and in response to public comments.
“While it has taken us some time to get to this point, today’s action does represent significant progress,” Thomas J. Curry, the comptroller of the currency, said in a statement.
The margin rule was proposed on the same day as regulators completed a separate rule on liquidity, which requires banks to have cash or assets that they can sell quickly to meet cash demands in stressed times.
The rule “makes such squeezes less likely by limiting large banks from taking on excessive liquidity risk in advance of a period of financial stress,” said Daniel K. Tarullo, the Fed governor who oversees regulation.
The link between the liquidity rule and the margin rule is that both could force banks to acquire more high-quality assets for regulatory reasons. Such assets tend to have low yields, and having to hold more of them could erode profits at banks, an industry concern.
Still, Wall Street and other users of derivatives breathed a big sigh of relief at seeing that the proposed margin rules did not demand that nonfinancial corporations post margin payments. Such companies, known as “end users” in the market, typically use derivatives to hedge the value of the goods they produce, like commodities.
“America’s business leaders are pleased that the Federal Reserve Board and other financial regulators have recognized that nonfinancial companies that rely on derivatives to reduce risk should not be subject to margin,” John Engler, president of the Business Roundtable, said in a statement.
But some consumer advocates asserted that the end-user exemption could undermine another important part of the derivatives overhaul. Other postcrisis regulations aim to execute derivatives through clearinghouses, nonbank entities that require transparent amounts of margin. The hope is that clearinghouses will be sturdier than banks in a crisis and prevent the crisis from spreading across the globe.
But since corporate end-users of derivatives do not have to post margin, they may have less incentive to use derivatives that go through clearinghouses. “As a result, the swaps markets are going to look like the dark, unregulated precrash over-the-counter markets that benefited no one but the big dealer banks,” said Dennis Kelleher, president of Better Markets, a group that favors tougher regulation.
It is hard to assess the financial burden of the new margin rule.
In a news briefing on Wednesday, an agency official said that he could not gauge whether it would lead to an overall increase in margin across the system. Some features of the rule, he said, would lead to higher margin, while others might lead to a decrease.
Large Wall Street derivatives dealers, for instance, may end up posting more margin than they do today. At the outset of an over-the-counter derivatives trade, before it has created a gain or loss, both parties may have to post so-called initial margin. Wall Street dealers, which are the biggest traders in the over-the-counter derivatives market, typically do not post initial margin to each other, a big saving for such firms. But under the new rule, they would have to post initial margin to each other. In addition, they would have to post initial margin to other types of financial firms — like insurers — that use derivatives in their underlying business.
But the new version of the rule introduces a measure that may lead to overall less initial margin in the system. Specifically, it states that a dealer does not need to collect initial margin from a trading partner until it is owed more than $65 million in such margin.
In recent months, consumer advocates have reacted with concern to news reports that United States banks are evading some new derivatives regulations by moving trades to non-American subsidiaries that do not have an explicit guarantee from their United States parent. These trades are then subject to foreign derivatives regulation. But it may be harder to evade the new margin rules because they state that banks shifting trading to such entities will have to show that the foreign rules measure up to the American ones.
Some parts of the margin rule take effect at the end of 2015. Others will be phased in between then and December 2019, more than 10 years after the crisis.