The term — inter-affiliate trade — is hardly a household phrase.  But it is at the heart of an important risk management issue, and consensus is growing that the issue needs to be addressed by policymakers.

Simply put, inter-affiliate trades are transactions that enable firms to centralize their risk management activities.  A European firm, for example, might prefer to enter into a swap with a local, European-based subsidiary of an American financial institution.  That institution, however, might choose to consolidate its exposure in a centralized, global risk management function.   So its subsidiary would, in turn, enter into an off-setting transaction with the financial institution’s centralized risk management function.  That internal, offsetting transaction is what is known as an inter-affiliate or internal risk management transaction.

Proposed rules in the US (Margin and Capital Requirements for Covered Swap Entities; Proposed Rule, Federal Register / Vol. 79, No. 185 / September 24, 2014) could require subsidiaries of American firms to exchange initial margin on these trades.  This could, in turn, be inconsistent with the regulatory approaches being taken in other key jurisdictions, and put firms operating in the US at a competitive disadvantage internationally.

For these and other reasons, US legislators came together in bipartisan fashion to ask American supervisors to consider exempting internal risk management transactions from the initial margin requirements.  As Congressmen Michael Conaway and Collin Peterson, who are, respectively, the chairman and the ranking member of the US House of Representatives Committee on Agriculture recently wrote to regulators, such transactions:

“enable financial institutions to provide customers with a single, client-facing entity for transactions, simplifying regulatory compliance for bank customers…Internal risk management transactions are necessary for global financial institutions to manage their risk profile and enable banks to provide cost-effective services to their clients.  Requiring affiliates to post initial margin on these transactions will disincentivize the use of this important tool and push higher transactions costs onto end-users.”

Not everyone in Washington agrees with this approach.  Perhaps the biggest concern is that such an exemption might mean that US banks would effectively take on the risks of affiliates that may operate in jurisdictions with lower capital and regulatory requirements.

However, there are a number of existing US regulations (such as the qualitative limits and quantitative requirements on inter-affiliate transactions in the Federal Reserve Act) that are designed to prevent US banks from taking on excessive risks from their affiliates.  In addition, major jurisdictions around the world are imposing rigorous capital, margin, reporting and other requirements to ensure that derivatives risks are transparent, understood and appropriately managed and properly mitigated.  Such rules will apply to the affiliates of US banks based in these jurisdictions.

Finally, imposing obstacles for firms that wish to centrally manage their exposures does not decrease risk.  It actually reduces operational efficiency, increases costs and works to increase risk with no countervailing benefit.  Ultimately, it may hamper the ability of banks to provide products in certain markets that can only be accessed through an affiliate, as the cost of posting inter-affiliate margin would make these products uneconomic.  The result would be a further fragmentation of markets and reduction in liquidity.