Gary Gensler has made clear the CFTC will not require firms who centralise their risk management in a central entity to clear their inter-entity business.

He does set out some rules (see link below) the main one is that these inter-group swaps are subject to Variation Margin, in other words must have a CSA in place.

There is also a dissenting statement from Scott O’Malia and Jill Sommers saying that the VM requirement is generally a bad thing, and brings unwanted cost.

Scenario 1: Client <-a-> CCP <-b-> Local Entity <-c-> Central Group Entity

For a clearable product, and let’s assume the Client is in-the-money:

• Swap ‘a’ and ‘b’ will be in clearing and be subject to VM/IM
• The cost of VM is adjusted using PAI via the CCP, so more or less flat
• Requiring VM to be posted from the Central Entity to the Local Entity would transfer the cost of the OTM position into the Central Entity, which might be desirable from a netting and monitoring point of view

Scenario 2: Client <-a-> Local Entity <-c-> Central Group Entity

For a non-clearable product, and assume the Client is in-the-money:

• Swap ‘a’ will be subject to a CSA and meet regulatory requirements for VM & IM
• The CSA should pay Interest on the VM posted by the Local Client, equivalent to PAI
• Swap ‘c’ would still be subject to a CSA, same as above

In both scenarios:

• If VM were not required between Central and Local, then the net VM of the Local Entity would be funded within Local, and this funding cost will show in the P&L of that entity, without any netting across other group entities
• If VM is required, as the CFTC wants, all the net VM across the group will be transferred into the Central Group Entity, and may result in a better net funding position by virtue of keeping all the funding in one place – scale usual brings down cost, or of course a worse position ;-)

I don’t know how this would affect capital calculations, so without a full numerical analysis it’s hard to know whether this inter-affiliate requirement has a net negative effect, or not. It certainly means CSAs being in place within a group. Scott O’Malia (here) makes a point that inter-affiliate trades don’t bring systemic risk, but isn’t that like saying you can remove some of the spokes in a bicycle wheel and not see any weakening of the wheel as a whole. By having VM between affiliates the loss in a default would be lower, even if the default of an affiliate doesn’t bring down the whole group.

Anyone else got views?

Statement of Support: Clearing Exemption for Swaps Between Certain Affiliated Entities.