The product no-one wants to sell: portability held up by lack of rules

Under-the-counter derivatives

portability

Users of client clearing services want to know their cleared trades have a home if the original provider collapses. Quietly, some dealers are offering guarantees, but they fear the regulatory treatment these contingent funding liabilities might receive. By Ramya Jaidev

It's the product every client wants to buy and no dealer wants to offer: a guarantee to accept a cleared portfolio in the event of another clearing provider collapsing. Without this portability guarantee, derivatives users that access a central counterparty (CCP) indirectly, through its inner circle of clearing members, could have their positions liquidated if one of the member firms implodes – and smaller banks that use indirect clearing won’t be able to apply the rock-bottom 2% risk-weight to their cleared portfolio.

That’s a powerful incentive. But for clearing members, a portability agreement means committing to accept a new portfolio of trades – probably requiring additional contributions to a CCP’s default fund, which would then need to be capitalised. Pending a final ruling on the treatment of CCP exposures from the Basel Committeee on Banking Supervision, there’s currently no clarity on whether this potential requirement for additional capital should itself be capitalised, nor on how the contingent funding risk associated with a default fund and capital top-up would be captured by Basel III’s rules on liquidity.

That uncertainty prompted the European Commission (EC) to step in – proposing on July 20 that dealers should assign “a value of zero” to contingent exposures arising from portability agreements as part of the fourth Capital Requirements Directive (CRD IV), its proposals for the implementation of Basel III. Dealers have reacted with a mixture of scepticism and delight – as though handed a gift by a bitter enemy – but EC sources say portability is so important to central clearing that they had to act (see box 1). It’s not known whether the Basel Committee, which has taken a hard line on contingent risks, will agree with the EC’s stance.

Dealers say the only certainty is that the extra burden generated by porting positions would come at the worst possible time. “This could impose extreme demands on a clearing member during a period of stress. We don’t normally put ourselves in a situation where our risk position can change so dramatically in the most distressed of environments – we’re talking about a major dealer going under, not a small bank – so that could be difficult to control,” says one clearing specialist at a European bank in New York.

Without standard agreements to review, the Basel Committee says it hasn’t been able to provide guidelines on how they should be treated, creating a Catch-22 – clearing members argue they are unable to offer portability guarantees until they know the full implications.

We don't normally put ourselves in a situation where our risk position can change so dramatically in the most distressed of environments - we're talking a major dealer going under, not a small bank - so that could be difficult to control

“Clients are generally willing to pay for the costs involved in central clearing. However, it’s very difficult for clearing members to be transparent about these costs,” says Christopher Perkins, North American head of derivatives clearing at Citi.

Others are more forthright. A clearing specialist at one bank says his firm will not consider offering portability unless a top client makes it a precondition of clearing. Another says individual banks will be unwilling to sign contracts with more than two or three of their top clients, however those contracts are treated, potentially leaving hundreds of clients unprotected.

That is the industry’s public stance, anyway. But portability agreements are being signed – either because they give clearing members an edge in the scramble for client mandates, or because clients are insisting.

“If you’re trying to offer a credible product and capture initial market share, you may be tempted to provide some assurance to the clients you’re going to handle, but until Basel and the Committee on Payment and Settlement Systems and International Organization of Securities Commissions (CPSS-Iosco) resolve some of the conceptual thinking around bankruptcy remoteness and portability, there is still an element of wait-and-see,” says Henry Wayne, managing director of institutional clients group risk analytics for Europe at Citi.

The head of client clearing at another institution says clearing members have no choice but to offer it, in some situations: “Clients are demanding guaranteed portability as a precursor to a firm being considered as a provider of client clearing services. If you can’t offer it, you’re not in the beauty parade.”

It’s not hard to see where those demands come from. The Council of the European Union’s July 18 draft of the European Market Infrastructure Regulation states a clearing member would only be obliged to accept a portfolio cleared by a defaulting peer if the client in question had signed a contract in advance – without that agreement, portability will depend on post-default negotiations between a defaulting firm’s clients and the remaining clearing members. If no new agreement can be struck before an unspecified deadline, the CCP is free to liquidate the client’s positions. That contrasts with arrangements in the US, where CCPs organise portability and, if disputes get in the way, the Commodity Futures Trading Commission (CFTC) has the power to intervene (see box 2).

For smaller banks that plan to access CCPs indirectly, the need for portability guarantees stems from rules proposed by the Basel Committee last December. There, regulators say client banks will only obtain a 2% risk-weight on their cleared portfolios if “relevant laws, regulation, rules and contractual arrangements ensure that the client’s contracts with the defaulted or insolvent clearing member will be taken over by another clearing member” in the event of the primary clearing member’s default.

Agreements signed

Only one of the dealers contacted for this article admits to offering guaranteed portability, but one client says it has now agreed portability contracts with three banks. Other clients say they have discussed terms with a number of would-be providers and one – a large, UK-based asset manager – says some clearing members have raised the subject without even being asked, suggesting it’s not always a case of dealers having their arms twisted.

The dealer that has signed portability guarantees declines to say how many, but makes it clear the terms are not open-ended. “These are known and controlled contingent funding liabilities in small scales for certain clearing houses and for certain clients,” says a senior clearing specialist at the bank. The price of the service is built into the client clearing contract, he says – adding that the bank will not consider guaranteeing portability for a client that does not already clear through it.

The client with portability agreements in place sketches out some of the conditions on which the guarantee might depend. Protections include rolling 30- or 90-day structures, the ability for either party to terminate the contract within a set notice period, delta exposure or initial margin limits to ensure the ported positions are manageable, and the promise that the client will honour all outstanding margin obligations before porting, he says.

These limits are vital to clearing members, say participants. “Operating with, say, 30 days notice means you can terminate the contract and renegotiate if things change. Ultimately, while clearing brokers can tell their clients they are happy to sign the agreement now, they may have to renegotiate the price if the capital regime changes and such guarantees attract capital charges,” says John Wilson, former global head of over-the-counter clearing at Royal Bank of Scotland.

The capital regime, however, is not the only factor. Guaranteed portability may require two types of commitment from a clearing member – to provide a top-up to the CCP’s default fund once the new positions have been consolidated with the firm’s existing ones, and to add extra capital against that. As a result, Basel’s liquidity rules – which cover a variety of contingent funding risks – may also come into play. There are lots of moving parts here. For one thing, the size and risk parameters of the porting client’s positions will vary tremendously – and CCPs levy default fund charges based on the net risk brought into the clearing house by each clearing member, so the degree of offset between existing cleared positions and ported positions matters. For another, some CCPs are less reliant on default funds, charging larger amounts of initial margin instead – a model many dealers prefer because it means more of the loss is absorbed by a defaulting firm’s margin, rather than by the pooled funds provided by clearing members, where losses are shared by all members.

Once the size of any additional default fund contribution is known, clearing members will need to hold extra capital against it – an element of Basel III that remains a work in progress. Proposals were published by the Basel Committee in December, laying out a controversial system in which clearing members use a regulatory formula to work out how big the loss-absorbing resources at each CCP ought to be – the ‘hypothetical capital’ – then compare the size of the actual default fund with that number.

To the extent the pre-funded default funds provided by the CCP and its clearing members are equal to the CCP’s hypothetical capital, the portion of member-provided default fund contributions would be capitalised at 100%, based on a 1,250% risk weight and the assumption of 8% capital. Any excess above the theoretical capital level would be capitalised at just 1.6%, while any shortfall that involves a commitment by the clearing member to contribute additional funds to cover CCP losses would attract a higher charge – banks would have to recognise 120% of the amount expected to be drawn, which is then capitalised at 100%.

But those rules apply to existing default fund exposures. It is not clear whether the contingent commitment made in a portability agreement would require capital to be held in advance – putting it pithily, that could be described as a capital reserve against a capital reserve against a default fund, with the charge being contingent on the collapse of another clearing member. Some dealers argue that would be overkill.

“If it ends up being the ruling that the guaranteed portability offer would require more capital to be held against the default fund, then the desire to offer it goes down even more,” a US-based head of OTC clearing says. That’s why some dealers welcomed the CRD IV draft text.

Many expect the worst, however. “We are taking a conservative view as to the capital we would have to hold against the default fund top-up,” says one London-based head of OTC clearing. “But we face significant challenges in being able to pass those costs on, without knowing the composition of portfolios.” The client who has already signed a guaranteed portability agreement says the terms of the contracts do not allow the provider to look through to its portfolio at any point prior to a default – the risk limits embedded in the agreement are supposed to provide the security the porting firm needs.

It is up to the Basel Committee to clear this up, dealers say – and two clearing specialists say the guaranteed portability issue has been raised with the committee’s risk management and modelling group (RMMG), which is responsible for the CCP capital rules. Mark White, assistant superintendent at Canada’s Office of the Superintendent of Financial Institutions (Osfi), and chair of the RMMG while Basel’s CCP proposals were being drawn up, says regulators haven’t yet been shown example contracts. White has since accepted a job at a Canadian bank and is on gardening leave from Osfi – he has also given up the RMMG role.

While the Basel text on capital requirements for indirect clearing appears to require something like a guaranteed portability agreement – with its call for “contractual arrangements” to ensure a portfolio will be picked up by another clearing member – White says the RMMG did not anticipate it becoming an off-the-shelf service that dealers would provide. Instead, the regulators had in mind something more akin to the US clearing model, in which a CCP allocates client portfolios to surviving clearing members following a member firm default, with the CFTC prepared to step in to resolve any snarl-ups.

“My expectation was that it would be achieved by CCPs and members through their rules, or through regulatory overlay. I’m not saying it can’t be done through these one-off contracts, but they would have to be very carefully scrutinised to find out whether they actually result in an assurance of portability,” he says.

This is one reason the Basel Committee has been caught off guard in terms of the potential capital treatment for guaranteed portability, he adds. “If it’s done either through regulatory overlay, CCP rules or CCP members banding together to act, I don’t think there is a compelling need to separately capitalise that contingent risk, because it’s all being done within the CCP and - provided you've adequately capitalised the primary exposure - there should be enough capital,” he says.

In its current guise, however, White notes further capital charges may be needed in Pillar I – meaning regulators would set an explicit requirement – but he says clearing members have to take the lead. In the meantime, he says, if there’s a risk that isn’t captured by Pillar I requirements, banks ought to be holding extra capital as part of their Pillar II obligation – designed to cover all exposures not explicitly covered in the first pillar.

“You can’t set capital rules for contracts that you don't fully understand – it’s a chicken and egg situation - but if banks contract to assure portability outside of CCP arrangements and regulatory requirements, regulators will need to assess them separately. In that case, banks should be approaching their national supervisors and CCPs approaching their overseers, so they can determine what the appropriate Pillar I treatment should be. But, frankly, banks should be holding capital against these contracts under Pillar II regardless,” he says.

The chicken and egg story is replayed on liquidity. The dealer that has signed portability agreements says it will treat the potential default fund contribution as a contingent funding liability, falling within the scope of Basel III’s liquidity coverage ratio (LCR), but declines to add any detail. The LCR requires dealers to hold a buffer of tightly defined liquid assets large enough to offset expected outflows during a 30-day period of severe stress – so dealers would need to make some kind of assumption about the size of the funding outflow associated with portability agreements.

Others agree guaranteed portability commitments might be relevant when calculating potential outflows in the LCR’s stress scenario – therefore contributing to the required size of the liquidity buffer. “You can see that in principle, it’s a funding liability, but we are not 100% sure,” says the New York-based head of systemic risk management.

Like White, a senior regulatory source close to Basel’s liquidity working group – which drew up the LCR – claims not to be familiar with guaranteed portability agreements in any detail. Upon hearing the explanation that the contingent funding liability would arise because the guaranteed portability provider would be legally obliged to take on a client position, and therefore required to post the amount associated with the incremental risk to the CCP’s default fund, the source says it could be captured under the LCR. He points out that the liquidity rules are both a work in progress and a regulatory minimum, and argues national supervisors may have to step in and require firms to hold additional liquidity against funding risks not explicitly captured in the Basel rules.

Regulators are not the only ones in a muddle, though. There’s little agreement among clearing members about what portability means – an intent to accept a set of cleared positions in the event of another’s default, or a cast-iron guarantee. This ought to worry clients.

One clearing member thought to have signed a portability contract denies it has provided a guarantee. When contacted by Risk, the client in question insists it has a contract obliging that particular clearing provider to port positions up to a total risk limit, which is not fully utilised in the normal course of business, upon the default of one or more of its other clearing members – which sounds a lot like a guarantee, albeit a limited one.

Others say they can provide portability up to a point, but insist it has to stop short of a guarantee – the principal challenge being the inability to monitor the contents of a portfolio prior to it being ported across. “We have no idea of the visibility of the portfolio until the default. We have a good estimation of our funding and risk limits, so we could set constraints and limits about what we may take on in a crisis. But it is essentially a financing facility – an agreement to deliver your balance sheet at some unknown point in the future, and we can reject the portfolio if we want. It is not guaranteed,” says the London-based head of OTC clearing.

Regulators say it is ultimately up to clearing members to bring guaranteed portability and the problems it creates to their attention – and there is some dialogue between the two sides. According to Citi’s Wayne, a group of dealers, including Citi, HSBC and Morgan Stanley, recently received the go-ahead from Basel to produce a quantitative impact study (QIS) template on the capital effects of the push to widen OTC clearing, along with a commitment from the RMMG to revisit the calibration of its rules on CCP exposure in 2012. But, he notes, guaranteed portability is not on the QIS agenda.

 

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Europe pushes for portability

It has been rare, in the post-crisis environment, to find a banker who will argue regulatory reform doesn’t go far enough – but dealers have been shocked by the European Commission (EC) stance on portability, laid out for the first time on July 20 in the fourth Capital Requirements Directive (CRD IV), the text that will implement new capital and liquidity rules in Europe. Buried in the text, article 296 of the proposal says clearing members can assign a value of zero to the contingent obligation created by a contractual agreement to provide portability.

The clause, which pre-empts the Basel Committee on Banking Supervision’s thinking on the subject, could make it easier for dealers to offer guaranteed portability, as it could mean dealers don’t have to hold capital or liquidity against the possible costs incurred in the event of a port, such as top-up default fund contributions. ”We received the news positively,” says Joe Cassidy, global head of rates and commodities, over-the-counter clearing and intermediation at Deutsche Bank.

Others are less convinced and one dealer that is offering guaranteed portability says it will ignore the ruling, if implemented. “We’d always recognise any contingent funding liabilities that we had as a result of anything like this and include them in our funding plans. So even if we weren’t told to do it, we would – it’s prudent,” a senior clearing specialist at the bank says.

The CRD IV proposal is still in its early stages – the European Parliament and the Council of the European Union still have to weigh in. More to the point, a source close to the EC indicates the clause may have been intended to serve as a placeholder while the Basel Committee deliberates: “If we hadn’t included the provision, the proposal would not work. It is an integral part of incentivising the move towards central clearing. If we hadn’t included this provision the whole concept wouldn’t have worked,” he says. “But we have signalled very clearly to our Basel friends and to the Polish presidency of the Council of the European Union that if we see the need to adjust the proposals after Basel comes up with its final document, we will do that during the Polish presidency. The intention is probably to follow what the Basel Committee has in mind, there are no intentions to undermine the Basel Committee.”

A source close to the Basel Committee says the final rules on capitalising bank exposure to CCPs will be published in the third quarter, although it is not known if the rules will address guaranteed portability.

 

The US solution: no client left behind

Clients, clearing providers and central counterparties (CCPs) in the US could be forgiven for feeling a little smug. Unlike Europe, where the onus is on clients to obtain contractual certainty that their cleared positions have a home if their clearing member defaults, the US system requires futures commission merchants (FCMs) and CCPs to work it out between them – with the Commodity Futures Trading Commission (CFTC) ready to step in and forcibly share out a defaulting FCM’s positions among the remaining members if necessary.

Given that de facto regulatory guarantee, US clients are under less pressure to thrash out a separate portability contract with their FCMs. Instead, Supurna Vedbrat, co-head of the market structure and electronic trading team within the portfolio management group at BlackRock, an asset manager, says the aim should be to agree on a construct that allows for “immediate portability”. In other words, an undertaking to accept a portfolio without the need for the CFTC to intervene, but which stops short of a guarantee. Vedbrat claims not to need the added certainty: “We are going to have relationships with multiple FCMs – and if the FCMs do not let us port for reasons that don’t sound reasonable, it is going to hurt their business model,” she says.

It helps that BlackRock – which announced on July 27 that it had cleared its first interest rate swaps on LCH.Clearnet’s SwapClear via Goldman Sachs – expects to have relationships with as many as seven FCMs, and that the asset manager will be clearing with each of them, Vedbrat says. Whether smaller clients will be able to expect immediate portability, rather than waiting for CCPs and the CFTC to ride to the rescue, remains an open question.

FCMs are also not covered by Basel’s capital and liquidity rules, as they are legally distinct from banks – again, that makes it easier for US firms to offer portability – but it raises concerns that client clearers elsewhere may be at a competitive disadvantage.

To some, the conflict between European and US models – the former sees clearing members as principals in their relationship with a CCP, while the latter sees FCMs purely as agents – explains the lack of clarity on the capital and liquidity treatment for portability guarantees. “At this juncture, any differentiation of principal from agency model will skew the market. The systemic implications of this, and in particular of liquidity, are the focus of any global regulatory college like Basel or CPSS-Iosco. Both models have pros and cons – we’ve got to be very careful how this framework is written because it will skew the market one way,” says Henry Wayne, managing director of institutional clients group risk analytics for Europe at Citi, adding that Citi does not have a preference one way or the other.

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