BaFin eases clearing house restrictions

BaFin, the German regulator, has removed a requirement for financial institutions to hold capital against transactions with swaps clearing counterparties – a rule that had threatened German banks' use of SwapClear. By Duncan Wood

pg56-clearing-gif

An extraordinary, behind-the-scenes complaint made by Dresdner Bank and Deutsche Bank has resulted in the German regulator cutting to zero the amount of capital that banks are required to hold against transactions with swaps clearing counterparties, such as the SwapClear service run by the London Clearing House (LCH). The decision has been welcomed as "fantastic news" by sources at Dresdner, which had imposed a firm-wide ban on the use of SwapClear this summer to avoid possible punishment from Germany's regulator, BaFin, after the bank approached a regulatory limit on the amount of exposure that German institutions are allowed to have with a single counterparty.

"We were caught between a rock and a very, very hard place indeed," says one source at Dresdner. The bank refused to comment officially for this article, but three sources at Dresdner were willing to talk anonymously about the situation. Deutsche also refused to comment for this article, but it is understood the bank – while having the same reservations as Dresdner – had not been forced to stop using SwapClear. Both banks had apparently been struggling to stay within BaFin's limits for some time and had first raised their concerns more than a year ago.

As things stand, BaFin is in the process of amending its rules, but the change of stance was announced in a letter sent to Dresdner's board on November 4. In that letter, the regulator confirmed that, while it was formalising the new rule, no supervisory action would be taken against banks that breached the single-counterparty exposure limits under the existing rules. Dresdner will now resume use of SwapClear.

The issue revolves around BaFin's belief that the SwapClear service should be treated as a normal counterparty for regulatory capital purposes. Other clearing houses, including Germany's own Eurex Clearing, are already the beneficiaries of a 0% risk weighting (effectively meaning that no capital has to be held). The decision not to extend the same treatment to SwapClear was one of the grounds for Deutsche and Dresdner's protest.

Under the outgoing regime, not only do German banks have to hold capital against transactions that are cleared through the LCH – thereby making the swaps business a bigger drain on resources – but they are also subject to rules stating that no more than 25% of a bank's total capital should be exposed to a single counterparty. "Ordinarily, you'd never have an exposure of that size with one counterparty," says the source. "But we're very big in the swaps market and we do really vast amounts of netting with the LCH via SwapClear."

To get an idea of the amount of business involved, Dresdner's total regulatory capital at the end of 2004 stood at E14 billion. The 25% single-counterparty limit would therefore represent capital of E3.5 billion. Deutsche's total regulatory capital at the end of 2004 stood at E28.6 billion

The growing popularity of SwapClear – which allows banks to run a swaps business more efficiently by working out counterparty exposures and holding collateral on a multilateral, rather than bilateral basis – meant that both Deutsche and Dresdner had long been concerned that they might at some point face a de facto regulatory cap on their use of the service. For Dresdner, that point arrived in June.

The bank's risk function raised a red flag internally, notifying other functions that the limit had been reached. An immediate bar was put on further use of SwapClear and the issue was escalated to board level. "We had to take it seriously," says a source at Dresdner. "If you breach BaFin's regulations, you can get shut down."

Dresdner then had to contact all its swaps counterparties to inform them that further transactions would be cleared bilaterally. "There were repercussions in the market. It brought things to a head and made BaFin acutely aware that this state of affairs couldn't be allowed to continue," says another Dresdner Bank official.

Frustration at both banks had reached a high pitch. "The man-hours that went into this were just shocking," says another banker at Dresdner. "It occupied time in the front office, the back office, at board level, with senior management. I have a folder dedicated to this. It contains 428 emails."

At one point, Dresdner was talking to the LCH about the possibility of engineering "a mass close-out of trades", so that it could reduce its exposure – a process that was viewed with no enthusiasm by the bank's staff. "It would have had an absolutely horrific effect on parts of the bank and on the middle office," says the Dresdner Bank official.

Bankers elsewhere, meanwhile, were apparently ready to argue that BaFin's stance was in breach of European Union competition regulations. It's not clear whether the banks voiced this opinion to BaFin.

By October, the regulator had notified Dresdner that it was looking into the matter, but there was no certainty about the timing of the regulator's review or its outcome. At the end of October, "they signalled that there will be a ruling shortly, but we don't know when and 'shortly' could be years away", says the Dresdner source.

It now looks like the story will have a happy ending: "The issue is solved," says one banker at Dresdner. Another proclaims satisfaction with the way BaFin has handled the problem. "It has been a good process. They have taken the time to learn what SwapClear is about. They don't want to hinder our business. They don't want to put restrictions on what we do."

But questions remain about how the regulator could shift its position in such a dramatic way. In part, the banks' ire was raised by the fact that their competitors in the UK had no restriction on their use of SwapClear – the Financial Services Authority (FSA) had always applied a 0% risk weight to transactions with the LCH and also exempted those transactions from single-counterparty exposure limits. As such, German banks felt that they were at a competitive disadvantage.

Overstep

The relevant rules that both regulators are supposed to follow were drawn up by the Basel Committee in 1988, and transposed into law across the European Union through a directive and national banking laws. One banker complains that the FSA had overstepped its authority in allowing UK banks to avoid holding capital against the LCH: "National regulations are all based on an EU directive, so in general everybody should have the same rule. I don't know what the FSA's rationale was for giving a privileged position to LCH."

The FSA maintains that it has every right to allow banks not to hold capital against clearing counterparties: "We exercise the discretion under Article 43(3) of the Codified Banking Directive to apply a 0% risk weight to over-the-counter contracts cleared by a recognised clearing house acting as a central counterparty," says an FSA official.

BaFin refused to comment for this article, citing confidentiality requirements that are part of the German Banking Act. But a source close to the regulator explained that BaFin believes that "it is not quite clear if the attribution of a 0% risk weight for the purposes of the large exposure limits is a violation of current EU law".

According to this source, the law states that capital requirements for clearing houses should be based on the kind of products they clear, with a distinction being made between exchange-traded and OTC instruments. It's understood that this distinction is the reason why BaFin's currently applies a 0% risk weight to Eurex Clearing (which deals mainly with exchange-traded products), but not to the LCH and SwapClear. Despite the regulator's belief that EU law is unclear on the correct risk weighting to apply, BaFin is now moving to abolish this distinction between the two clearers.

"Especially due to the distinctively lower risk of business with clearing houses and with a view to the upcoming Capital Requirements Directive [CRD], it appears justifiable to BaFin to tolerate banks exceeding their exposure limits concerning swap clearing transactions," says the source close to BaFin. The CRD is the EU-law successor to the 1988 Basel Accord. As such, what the industry may be witnessing here is an early implementation of one of the new Accord's principles.

That's certainly how the source at Dresdner sees it. The drafting of the CRD in September provided official justification for BaFin's decision to drop its capital requirements, the source claims: "For this special issue, we can now refer to rules in the draft version of the new directive."

For its part, the LCH has put up a wall of silence on the subject. LCH officials either refused to comment for this article, or failed to return phone calls.

Only users who have a paid subscription or are part of a corporate subscription are able to print or copy content.

To access these options, along with all other subscription benefits, please contact info@risk.net or view our subscription options here: http://subscriptions.risk.net/subscribe

You are currently unable to copy this content. Please contact info@risk.net to find out more.

Switching CCP – How and why?

As uncertainty surrounding Brexit continues and the impacts of Covid-19-driven market volatility are analysed, it is essential for banks and their end-users to understand their clearing options, and how they can achieve greater capital and cross…

You need to sign in to use this feature. If you don’t have a Risk.net account, please register for a trial.

Sign in
You are currently on corporate access.

To use this feature you will need an individual account. If you have one already please sign in.

Sign in.

Alternatively you can request an individual account here