LONDON Two numbers at the heart of an overhaul aimed at cutting risk in the $700 trillion (434 trillion pounds) derivatives industry will determine how much more users such as airlines, banks and pension funds must pay.
The industry is waiting for what David Clark, chairman of the Wholesale Markets Brokers' Association (WMBA), told Reuters were the "magic numbers".
The first will determine how much capital banks must tie up to cover exposures on trades at clearing houses. The second refers to the margin banks must post on uncleared transactions.
The numbers will be decided by regulators racing to complete a new global framework, which will have been three years in the making, ready ahead of a January deadline.
Once agreed, it will determine the economics of millions of transactions, bump up costs for users, and leave some smaller financial players out in the cold while bolstering banks with deeper pockets.
Just 15 dealers - including BNP Paribas (BNPP.PA), Deutsche Bank (DBKGn.DE), Goldman Sachs (GS.N), HSBC (HSBA.L), Morgan Stanley (MS.N), Societe Generale (SOGN.PA), and UBS UBSN.VX - account for over 80 percent of derivatives trading.
Policymakers were alarmed at how the vast, opaque and lightly regulated derivatives sector destabilised U.S. insurer AIG (AIG.N) in 2008, triggering a $182 billion taxpayer bailout - one that may see U.S. taxpayers book a $15 billion profit.
After AIG and the demise in 2008 of U.S. bank Lehman Brothers, which was also heavily involved in derivatives, G20 leaders agreed in 2009 that by the end of this year most derivatives must pass through a clearing house.
Clearers are backed by a fund in case one of the parties goes bust. They also create a transparent electronic trail for regulators to follow.
The contracts are traded between banks, or sold by banks to companies such as airlines for hedging, meaning insuring against changes in prices of raw materials such as jet fuel.
"Banks are sitting on so many unknowns. At the moment they do not know which business models are viable," the WMBA's Clark said.
The aim is to slot a set of rules that have so far been thrashed out separately into a single framework to create a global financial incentive to clear trades rather than leaving them uncleared.
The industry has already said that a badly configured framework will wreak havoc, and regulators have been dampening expectations it will be perfectly calibrated by day one in January.
"There are so many permutations. I do not think setting these rules can take account of all of these things and that would also get into a level of detail that is not likely to be productive," one G20 source said.
"What is important is that in the basic architecture, there needs to be a coherence. No doubt this framework is not going to be perfect, as that would be a tall order. The authorities are clear where they want to end up, and over time these things would be tweaked," the source said.
Global bodies such as the Financial Stability Board - the G20's regulation coordinator - as well as the Basel Committee on Banking Supervision and the IOSCO markets supervisor have been working intensively on the framework as the industry watches nervously.
"It will take a while to get right. The question is how much permanent damage is done to the market between day one and getting it right," said Peter Sime, head of risk and research at the International Swaps and Derivatives Association (ISDA), an industry body.
Regulators will update leaders of the world's top 20 economies (G20) in June on the framework, with public consultations on some elements shortly afterwards.
To create an underlying incentive to clear transactions, the first of Clark's two magic numbers must end up with a lower cost for users than the second. In practice, many regulatory strands feed into those two numbers, creating a system of continually moving parts.
"The difficulty is that all this straddles so many different aspects of regulation. It is about getting the calibration right in a world where national regimes still differ," a second regulatory official familiar with the work said.
"Counterparties of clearing houses will have a common risk weight that applies across whatever the nature of the exposure is," the G20 source said.
The amount of capital needed to cover a trade at a clearing house will hinge on the size of the 'risk weight' which, in turn, will depend on whether the clearer meets tough new rules to ensure its robustness.
Currently, these counterparty exposures can be zero risk-weighted, meaning little or no capital is set aside.
"A risk weight of 2-4 percent on exposures to margin held by clearing houses is a possible outcome," said Rory Cunningham, director of public affairs at London-based LCH.Clearnet, one of the world's top clearing houses.
Other capital charges will also have to be factored into the clearing side of the equation, most importantly those on the exposure to a clearer's default fund, which, Cunningham said, will significantly increase users' costs.
ISDA's Sime fears that once all the capital charges on the cleared trades have been totted up, it would need punitive margins on uncleared trades to keep the clearing incentive intact.
Everyone agrees these capital calculations will be decisive in whether a bank or user clears products, how much capital is set aside, and how much of the capital costs will be passed on to clients, Clark said.
For uncleared trades, regulators want a global minimum margin in place from January when the phasing in of capital charges must start under the G20's broader Basel III accord on bank capital buffers.
"Ideally, it would be for an initial and variation margin. A sensible margining system will have both," the G20 source said.
Some regulators want to go further and have two-way margining, meaning each side of a bilateral trade posts margin.
These measures will mark a step change because, typically, initial margins are not posted on bilateral trades, though there is collateral calculated daily on trades between banks.
Commercial users of derivatives for 'real economy' hedging of risks -- such as airlines -- do not post margins at present and are waiting to see to what extent they will be exempt from posting margin in future.
It is a major issue for corporates and other end users, such as pension funds, as they often do not have the large cash flow needed to service a margin.
Still, their exemptions may be diluted by banks having to tie up additional capital on exposures to corporates whose costs would be passed on to companies in the form of higher fees.
"Regulators need to remember that these transactions have not been a source of systemic risk to the financial system and it is difficult to construct any scenario in which they could become such a source," said Richard Raeburn, chairman of the European Association of Corporate Treasurers.
CRACKS AND COLLATERAL
Nevertheless a well calibrated global framework would be a significant step forward in ironing out regional differences that could spark unfair competition, Clark said.
But there are concerns over how to enforce the framework, especially as the derivatives rules being finalised in the United States and European Union have loopholes.
"Policymakers will undoubtedly need to be careful to avoid any kinds of cracks through which things might fall," LCH.Clearnet's Cunningham said.
Making the framework work in practice will also need swathes of extra collateral and the industry is already saying there simply may not be enough of the stuff in certain currencies.
The U.S. Office of the Comptroller of the Currency estimated an initial margin requirement for uncleared trades in the United States could top $2 trillion.
This could play into the hands of players who, with deep pockets and strong credit ratings, are better able to get their hands on top quality collateral.
The upshot is likely to be a sector restructuring.
"It is possible there may be a total reshaping of the industry, with a significant reduction in the size of the market due to costs from margins and collateral," Sime said.
"A number of smaller businesses could potentially be left out in the cold as it won't be profitable to transact derivatives with them. Some big players say they are not going to be in derivatives going ahead because they do not believe their customers will pay those costs."
Such unintended consequences could mean less hedging and that risks in the financial system may actually rise, the opposite to what the G20 intended with its new framework.
(Editing by Dan Lalor)