Revised capital rules undermine OTC client clearing, dealers say

Central clearing for over-the-counter derivatives could be jeopardised by draft capital rules that encourage banks to clear, but discourage them from providing intermediary services to other derivatives users. This client clearing business needs support, dealers argue – and some politicians agree. By Ramya Jaidev

Karl Ulrich

A lot of time and money is being invested in the drive to centrally clear over-the-counter derivatives, and regulators have promised to smooth the transition by creating capital incentives to use clearing houses. The latest, and probably final, version of the Basel Committee on Banking Supervision’s capital rules for central counterparty (CCP) exposures does that – offering risk weights of 2% and 4% for cleared trades, if certain conditions are met – but the November 2 consultative paper also piles up capital requirements for banks that offer client clearing services, through which firms that do not meet CCP membership criteria are able to clear.

Under the draft rules, client clearers would need to hold capital against their contribution to CCP default funds, and against the trades they accept for clearing. That’s too much, dealers say. They refuse to share preliminary estimates of the additional capital required by the rules, but the head of OTC clearing at one major European bank says it could force his institution – and others – to abandon the client clearing business.

“If these rules went into effect tomorrow, we would have a capital number so high it would be insane. No matter how hard we try to play the game properly, we keep getting hit in the head. At some point, as the parent of someone who’s playing, you can’t allow your child to get hit in the head anymore. If these charges are too high and we’re managing for the overall benefit of our firms, large dealers are likely to walk away from client clearing,” he says.

Another London-based clearing expert says his own firm won’t leave the business, but he suggests others could. “I think this might lead to a smaller group of participants wanting to offer client clearing,” he says.

That argument ought to resonate with politicians, who see clearing as a key pillar of post-crisis reform – and some are already saying they could soften the Basel text. “If we think the arguments against the charges are correct, we can certainly put amendments into the forthcoming Credit Requirements Regulation (CRR),” says Sharon Bowles, chair of the European Parliament’s Economic and Monetary Affairs Committee.

If these charges are too high and we're managing for the overall benefit of our firms, large dealers are likely to walk away from client clearing

The European Commission published the CRR proposal on July 20, which, together with the fourth Capital Requirements Directive, will translate Basel III into European law. The CRR hasn’t yet been debated by the European Parliament or the Council of the European Union and contains an earlier version of the rules on capital for CCP exposure that does not include a statement on the counterparty capital charge. But – while stressing she hasn’t formed an opinion on the substance of dealers’ arguments – Bowles says it is important to provide an incentive for client clearing and notes that she has tried to support the business in another piece of legislation, the European Market Infrastructure Regulation (Emir). “I would say that is consistent with the thinking I have already demonstrated in amendments that have been included in the parliament’s version of Emir,” she says.

Banks have been worried about Basel’s stance on capital for cleared trades for some time (Risk February 2011, pages 23–25). The proposals were first published on December 20, 2010 and protests started immediately – particularly over the treatment of default fund contributions, which members have to make, but clients can escape. Regulators proposed this risk should be capitalised by looking at the strength of a CCP’s financial resources relative to its cleared risk, but chose to do so using an approach called the current exposure method (CEM), which dealers saw as overly conservative. The CEM remains at the heart of the new proposals, albeit with a tweak that would reduce capital somewhat, but dealers are incensed that little else has changed, despite an 11-month consultation period that also included a non-public second draft in July, and an attempt to quantify the impact of the proposals.

“Basel III talks about providing incentives to banks for more central clearing, but if you look at the rules as a whole, they are just not there. If you clear the same portfolio as a clearing client, you have fewer capital requirements than if you clear it as a clearing member, because as a member you also have to capitalise for the default fund, with that risk-insensitive hypothetical capital construct,” says Ulrich Karl, director for regulatory change at HSBC.

Hypothetical capital measures how big a CCP’s reserves would have to be if it had bilateral trades with all its clearing members under the capital rules for banks. That figure then determines how banks capitalise their exposure to the CCP’s default fund. 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 between 0.16% and 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%.

The dealer community’s argument against the default fund charge is not new – it has maintained from the beginning that the CEM, borrowed from the Basel II framework, is too blunt – but emotions are running higher than before. The European bank’s head of clearing rails against what he sees as a decision to ignore the industry’s arguments. Asked what the Basel Committee’s response has been to the industry’s fears about prohibitive capital charges, he says: “Isn’t the paper released in November the response? From December 2010 to November 2011, that’s the response they’ve given us. I don’t believe they think we’re credible.”

Others are less feisty but no less disappointed. A group of dealers including Citi, HSBC and Morgan Stanley were involved in efforts to build a quantitative impact study (QIS) template to assess the impact of the draft CCP capital rules, which the Basel Committee would have administered. Those efforts have faltered, according to Henry Wayne, managing director of institutional clients’ group risk analytics for Europe at Citi. “It hasn’t progressed because the regulators came back and requested further documentation and instructions in a way that led us to believe the exercise would have little chance of influencing the ongoing dialogue. We wanted to use representative examples to show the methodological flaws; the sense we got is that they wanted to extrapolate the results to show the overall numbers were small and therefore not worth pursuing further,” he says.

The Basel Committee’s risk measurement group (RMG, formerly known as the risk management and modelling group – or RMMG – prior to a September name change) conducted its own QIS in June. The results of that exercise have not been published, but Mark White, who led the RMMG for much of the time the rules were being crafted, says the QIS showed the default fund charge was not exorbitant. White is now senior vice-president of capital management and optimisation at the Bank of Montreal (BMO) in Toronto.

“The default fund capital charges are not unreasonably high. A range of CCPs were involved in that exercise, and a good number of those were of the type where their own financial resources would mean member-contributed default funds were very unlikely to be drawn on. In the overall scheme of the capital charges being levied on banks, these are not high,” White says.

But the results of that exercise are undermined by the fact that only one CCP – LCH.Clearnet’s SwapClear – had any real volume in cleared OTC derivatives, says Citi’s Wayne, and capital implied by the rules mushrooms when applied to larger volumes of cleared trades. “All the other submissions came back saying we’re not seeing the overstatement created by the CEM as the number of positions grow – there wasn’t a lot of volume there. So the regulators went away saying it wasn’t a problem,” he says. Citi conducted its own study, published through the International Swaps and Derivatives Association in May, which showed that on 1,000 randomly generated foreign exchange and rates derivatives portfolios, the exposure generated using the CEM grew more overstated as the number of positions increased.

The Basel Committee has tweaked the CEM calculation in the latest document, allowing an improvement in the netting benefit – the amount of flow per transaction that cannot be netted off has been reduced from 40% to 30%. That’s not as trivial a change as it might seem, says a source close to the RMG. “All else being the same, it should amount to a 16% reduction in the amount of the default fund capital charge. That to me is not insubstantial,” the source says.

Dealers are not reaching for the champagne – even though the Basel paper claims the capital charge would be cut by approximately 23%, not 16%. “It will make a small difference. If you have tens of thousands of transactions, then you still have a huge 30% floor that can’t be netted off,” says HSBC’s Karl.

The industry says it’s not the components of the CEM that are the problem – it’s the methodology as a whole. Most dealers interviewed for this article say they would prefer to model the risk themselves, under the terms of Basel II’s internal model method (IMM). “In a multi-step Monte Carlo simulation, you have many scenarios for all your risk factors and value your portfolio under each of these scenarios, taking netting and collateral fully into account. And that makes it very risk-sensitive,” says Karl.

But the job of calculating hypothetical capital is assigned to the clearing houses under the Basel rules, and therein lies the problem: CCPs lack the modelling nous that would satisfy bank regulators. “There is no IMM that CCPs are using in any consistent way. Could one be developed over time? Absolutely, and I would encourage them to do that. But we need to get something implemented by the start of 2012 that is consistent and verifiable. As it was, there were even complaints from some stakeholders that asking CCPs to do the CEM was asking too much,” says BMO’s White.

For their part, dealers recognise it would take time to develop reliable models, but argue that introducing a conservative stop-gap is a poor solution. Most of the dealers interviewed for this article support the idea of an observation period, like that put in place for Basel III’s liquidity ratios. By waiting to implement the CCP capital framework, both dealers and regulators will have time to understand the full implications of the existing approach and iron out any kinks, they say.

But the committee didn’t reject the IMM purely because it would take too long, says the RMG source. “I’d say most of us in the banking regulatory community think it’s not feasible to build a true IMM across institutions. You’d run into issues of whose model to use. The alternative, which is to have banks each operating their own IMM and accept the output of that as given, would create a perverse incentive – if you tie it to the capital charge, there’s an incentive to make it less risk-sensitive,” the source says.

Dealers are also upset client clearers will face a full bilateral capital charge on trades they pass into a CCP on their customers’ behalf. The charge comprises the larger of exposure at default and stressed exposure at default, multiplied by a risk weight, and a credit value adjustment component. This burden applies irrespective of whether the clearing member only guarantees the trade, as is currently the case in US futures markets, or acts as an intermediary between client and CCP, as with LCH.Clearnet’s SwapClear platform – a clarification the RMG provided after the industry queried the details of the July draft.

The initial margin that is posted by clients offsets the potential future exposure of the trade, and therefore reduces the capital charge. But some dealers say that misses the broader point that there shouldn’t be a bilateral capital charge at all.

“How is it a bilateral trade when it was directed to us for the sole purpose of sending to the clearing house? We do still have counterparty risk to buy-side firms we clear for, but that risk is mitigated by initial margin. If you go back to the old days of calculating capital treatment for risk-weighted assets, if your risk was covered in the form of margin, you didn’t incur a capital charge,” the European bank’s head of clearing argues.

But not everyone thinks the bilateral counterparty charge is mistaken. “This is conceptually the right treatment. If it’s a bilateral, intermediated or cleared trade, we still have the same risk – it doesn’t change and therefore should be treated the same,” says one head of listed derivatives at a European bank. And BMO’s White insists that a bilateral exposure remains and needs to be capitalised.

“I’ve not yet seen an argument as to why the exposure is reduced because the clearing member happens to have an offsetting transaction with the CCP. There is a bilateral exposure to that client – that risk is not mitigated by the fact the clearing member then has a trade with the CCP,” he says.


Guaranteed portability still standing, dealers say

While dealers are dismayed at the capital charges they are set to face, there’s been a warmer reception for the rules around indirect access, which set out capital rules for client firms. In the original document from December 2010, the Basel Committee said client banks’ exposures to clearing members would only qualify for the optimum 2% risk weight if collateral was bankruptcy-remote, and if a client had legal certainty that its trades with one clearing member could be moved to another in the event of the first firm’s collapse – wording that many interpreted as creating a need for clients to sign contracts guaranteeing the portability of cleared business. In turn, that left client clearers worrying how to price guarantees that would create a potentially significant contingent funding obligation – the porting of a client portfolio would only happen at a time of market stress and would probably carry with it a need for additional default fund contributions and the associated extra capital.

But the new draft sets a lower bar for bank clients, which now only need to show it is “highly likely” their positions will be ported to qualify for the 2% risk weight – a change that was welcomed by nearly all the dealers who spoke to Risk for this article.

“We’ve been an outspoken critic of guaranteed portability. In practice, the only time we wouldn’t facilitate portability would be when we simply could not do it, either as a result of operational overload or exhaustion of capital and liquidity to support new trades. In almost all other circumstances, we are very much commercially incentivised to facilitate portability if that’s what’s right for the client,” says Dave Olsen, global head of over-the-counter clearing at JP Morgan in New York.

That may be the case for JP Morgan, but many dealers are said to have signed guarantees already and one bank argues it is a crucial pillar of the clearing framework (Risk August 2011, pages 16–20). A clearing specialist at that bank says the new language won’t be the death of guaranteed portability. “It’s subjective – ‘highly likely’ could easily need to be contractual. If you have two clearing brokers and one defaults, how does it qualify as highly likely if the clearing broker who is supposed to step in has the option to reject you? For me, it would still snap back towards some sort of contractual arrangement – I’m sceptical that the new language has softened it much,” he says.

Others point out that whatever the rules say, clients will still ask for guaranteed portability. “I don’t think it will have a huge impact on the market for guaranteed portability. Certain buy-side individuals will still request something like that because they’ve been shown it by some dealers, so it’s not a concept that will go away,” says one New York-based head of OTC clearing.

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