Astronomical Close Call

Two weeks ago on Sunday, September 7th, at about the same time that many of us were tuning in for the first professional football games of the season, planet Earth had a near miss. An asteroid 60 feet in diameter buzzed past New Zealand at a frighteningly close distance from of just 25,000 miles. In terms of astrophysics, that’s a hair’s breadth! Astronomers breathed a huge sigh of relief, fearful that a direct hit on Sunday could have had the same affect as an asteroid impact in Russia last year.

On February 15, 2013 an asteroid roughly identical in size to last week’s asteroid collided with Earth in the Russian town of Chelyabinsk. When the space rock weighing more than the Eiffel Tower and hurtling at 40,000 mile per hour slammed into the atmosphere, it exploded into a fire ball 20 to 30 times more energetic than the Little Boy atomic bomb used in WWII. As the meteor ripped apart the atmosphere it created a shockwave that shattered glass and collapsed roofs of local cars and buildings. Many onlookers experienced nearly instantaneous sunburns from the massive fire ball whose intensity exceeded the brightness of the sun. All told, 1,500 people were hospitalized and the range of impact form this 20 meter rock covered an area tens of kilometers across.

Just days before the scientific community collectively exhaled at the news that Earth had been spared another meteor impact, the financial markets breathed a sigh of relief when, on September 3rd, US prudential regulators reversed course and proposed to effectively exempt nonfinancial derivatives end users from the margin requirements contained in an earlier proposal. Read more about the Re-Proposed Margin Requirements Here.

One of the last substantial requirements of the Dodd-Frank Act to be implemented by regulators is the margining of OTC derivatives. In interpreting this requirement, US prudential regulators put forth a proposal in April 2011 for the margining of OTC derivatives. This proposal would have required banks to establish collateral support arrangements with their derivatives counterparties, mandating the collection of margin in circumstances that would vary depending on whether the counterparty were financial or nonfinancial.

The required collateral documents would have contained minimum exposure thresholds for posting margin. Such thresholds would have had to match credit limits determined by the bank as appropriate for the associated risk exposure. Would this allow end users to sidestep margin posting thanks to generous thresholds? While it is hard to say whether regulators would have actively challenged bank determinations of appropriateness what is certain is that being subject to margin requirements would have been a huge hurdle for many nonfinancial end users looking to hedge with derivatives. While some end users have enough liquidity to weather collateralizing their derivatives, many do not, and even those that do might prefer to use their liquid funds for more strategic purposes. Whether because their assets are tied up in real estate or are otherwise illiquid, because they are highly leveraged, or for a variety of other reasons, for these end users, the requirement to post margin could have proven prohibitive to hedging for many.

If the original 2011 margin proposal was on course to collide with OTC derivatives end users, then the prudential regulator’s re-proposed margin rules from September 3rd is the financial equivalent of last week’s asteroidial fly-by. The re-proposesd rules reversed course on requiring banks to impose margin on nonfinancial end-user derivatives transactions. This came as a sigh of relief to many worried at the implications to end users of the margin rules in the original proposal.

Although the asteroid did not punch a hole in the sky over New Zealand, some astronomers are claiming that it did not pass by as cleanly as originally thought. In fact, these astronomers are claiming a piece broke free and touched down in Nicaragua. In similar fashion, it may be premature for derivatives end users to start cracking open the celebratory champagne. While nonfinancial end users may be exempted from the margin requirement, the re-proposed rules contain new requirements for financial end users. OTC derivatives users should be sure to carefully study the definition of Financial End User to be sure they know how their entities will be classified.

Asteroid impacts on the scale of Chelyabinsk are rare and sporadic. There’s also not much you can do to safe guard against them. Financial regulation, on the other hand, is rolling out so fast these days that hardly anyone can go untouched. Fortunately, here at Chatham, we have experts wrapping their heads around new regulations as they come, and intelligent strategies for dealing with the changes they bring. If you’ve got questions about what the re-proposed margin rules mean for you, or any other derivatives regulation for that matter, give us a call at 610.925.3120 or email us.