New EU bank rules threaten Eurex, LCH investment policies

CCPs with EU bank licences currently run leverage ratios of less than half the minimum

Derivatives central clearing counterparties (CCPs) that hold banking licences in the European Union are in line to be subject to new capital and liquidity ratios designed for banks, under proposed amendments to the EU’s prudential framework that ignore advice from supervisory agencies.

In particular, the imposition of the leverage ratio could force CCPs to substantially increase their equity capital, change the way they invest the cash margin they receive, or push members to post more non-cash collateral, because leading clearing houses currently run ratios of less than half the required minimum.

An EU official source confirms the draft revised Capital Requirements Regulation (CRR II), published last November, “did not propose to exempt CCPs” from either the binding leverage ratio or the net stable funding ratio (NSFR), which the legislation will introduce once finalised.

“This means, as long as a CCP has a banking licence, it must comply with these requirements,” the source says.

In Germany and France, CCPs are required to hold banking licences, meaning two of the largest firms will be subject to the new rules – Eurex Clearing in Germany, and LCH SA in France (the subsidiary of the UK’s LCH). These CCPs are already subject to the current version of the CRR, but will have to comply with both the leverage ratio and NSFR in the future, unless an exemption is added to the final version of the prudential framework.

“The CCPs are trying to get the message across to lawmakers and regulators that they are not in the same type of business as banks, insurance and asset managers. Either it needs to be recognised that they are a different breed and category in the regulation or they should explicitly get an exemption,” says Amir Kia, a director in Deloitte’s risk and capital management team, who stresses he is offering a personal opinion.

The CCPs are trying to get the message across to lawmakers and regulators that they are not in the same type of business as banks, insurance and asset managers

Amir Kia, Deloitte

The leverage ratio is a capital backstop, forcing banks to hold at least 3% equity capital against total exposure. If a CCP were subject to the leverage ratio, it could constrain the amount of cash the clearing house can invest, or force the CCP to increase its capital base.

“CCPs have to invest clearing members’ cash, and if these investments fall under the leverage ratio, then it might affect their capital requirements,” says a clearing expert.

Both Eurex Clearing and LCH SA are currently running a leverage ratio of less than half the minimum required 3%.

According to Eurex Clearing’s Pillar 3 disclosure report, their leverage ratio as of December 31, 2016 was 1.42%. Using LCH SA’s Generally Accepted Accounting Principles (Gaap) report and Pillar 3 disclosures, Risk.net estimates LCH SA is running a leverage ratio of 0.9%.

LCH SA was asked to confirm the accuracy of Risk.net’s estimate but declined to do so, stating it does not disclose this figure.

CCPs typically invest cash from their financial resources, such as margin received and default fund contributions, in deposit accounts or highly quality sovereign bonds. This is due to restrictions placed on them by the European Market Infrastructure Regulation (Emir).

In its investment policy criteria, Eurex Clearing states it must invest in assets with a minimum credit rating of AA–. But the leverage ratio doesn’t take into account the very low risk profile of assets, hence the low ratio the CCPs currently run.

As these CCPs have banking licences, they can also take advantage of parking their cash at their central bank. More than half of Eurex Clearing’s assets were held at the Bundesbank, according to its annual report.

In 2016, the Bank of England announced it would exempt reserves held at the central bank from the leverage ratio, but that move has not been followed by other European regulators. This means reserves at the central bank would still count toward the leverage ratio exposure measure for CCPs licensed in continental Europe.

The constraint could incentivise CCPs to take less cash for margin payments and seek other types of collateral such as bonds, which do not need to be reinvested.

“It could create quite interesting incentive structures for CCPs. For liquidity management, it is helpful for a CCP to get some of the margin in cash, but the leverage ratio could incentivise CCPs to accept as little cash as possible,” says the clearing expert.

LCH SA and Eurex Clearing will also have to deal with the administration costs to comply with both the leverage ratio and NSFR.

“It might have a marginal impact on their treasury operations, but that is something they already do in terms of managing their investment profile so, in reality, there won’t be much restriction. But even if the regulation doesn’t impact them, they still need to demonstrate they are following that regulation. So there is still the burden of compliance,” Kia at Deloitte says.

A source at one CCP expects an exemption to be included in the final CRR, which is now being negotiated in both the Council and Parliament of the EU.

For liquidity management, it is helpful for a CCP to get some of the margin in cash, but the leverage ratio could incentivise CCPs to accept as little cash as possible

Clearing expert

Against recommendations

The European Banking Authority (EBA) has recommended in three separate reports that CCPs with banking licences should be exempt from the leverage ratio as well as the NSFR, on condition the CCP does not participate in maturity transformation – the practice of using short-term liabilities to fund longer-dated assets.

Two of those reports were published by the EBA before the European Commission released its amendments to the CRR in November 2016, but the recommendations were not followed.

In its reports, the EBA argued CCPs do not carry out the kind of banking activities the leverage ratio and NSFR are designed to capture. CCPs are subject to requirements under Emir, which effectively restricts them from carrying out bank-like activities.

The NSFR requires banks to have a minimum amount of term funding for term assets – an attempt to make the industry more resilient to wholesale liquidity squeezes. This is expected to have less impact on CCPs than the leverage ratio, because Emir requires CCPs to invest their resources, such as margin, into high quality, highly liquid assets. These would include government bonds, or repo transactions backed by government bonds.

Although the Basel Committee text on the NSFR would impose a required stable funding factor of 5% on government bonds, this was cut to zero in the EC’s draft CRR II text, so such investments would have no effect on the NSFR of a clearing house. However, there would still be a 5% required stable funding factor on repos backed by government bonds (down from 10% in the Basel text).

“Margin payments for a CCP are business as usual, and the CCP always pays out as variation margin what they receive from the other side. So variation margin-wise, the CCP is always flat. The only issue that could arise is if they invest cash initial margin in repos and the counterparty defaults, then it could cause a funding issue,” says the clearing expert.

The EBA also states that CCPs don’t typically participate in maturity transformation, which the NSFR is designed to discourage.

“LCH welcomes and supports the recommendations from the EBA that CCPs should be exempted from the leverage ratio and NSFR requirements, and we will work closely with the relevant regulatory bodies as they finalise the legal framework following the CRR review,” says a spokesperson for LCH.

Eurex declined to comment for this article.