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Cash-22 – The regulatory conundrum

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From May 2016, Category 2 firms (including most of the UK’s largest insurers) will enter the frontloading period for interest rate swaps as part of central clearing under the European Market Infrastructure Regulation (Emir). All new trades will need to be centrally cleared, with variation margin posted in cash only. In comparison, many firms currently have the option to post cash, gilts or even other bonds for their existing trades. In the past, insurers might have relied on their ability to use the repo market to convert gilts into cash, but this is under threat from changes to banking regulations.

Banking regulations

Implementation of the Basel III recommendations imposes threefold constraints on banks: risk-based capital; leverage; and liquidity. Much has been made of the need to reduce risk-weighted assets, reducing balance-sheet utilisation from long-dated investments. In part, at least, the focus has now shifted towards leverage. 

The leverage ratio was designed as a simple, non-risk-based measure aimed at preventing banks from building up excessive leverage. It compares qualifying Tier 1 capital with a ‘leverage exposure’ encompassing both on- and off-balance-sheet exposures, insisting that a minimum ratio be maintained.

Crucially, where collateral is used to reduce counterparty exposures, the bank is restricted in its ability to recognise these arrangements (with concessions for cash collateral). 

Leverage ratio impacts on repo and swaps

If an insurer wishes to use repo to turn gilts into cash, a bank will hedge itself by entering into its own repo transaction. The leverage ratio imposes restrictions on the bank’s ability to net these positions against one another, and so the leverage exposure increases. To maintain a minimum leverage ratio, a charge will be levied to cover this increase. 

A simple ‘back of the envelope’ calculation suggests repo costs could increase by as much as 50 to 100 basis points versus current risk-based capital charges where collateral can be netted against exposure.

There is a direct consequence for swaps transacted bilaterally when non-cash variation margin can be posted to the bank under the terms of the credit support annex (CSA). In the past, cash and gilts might have been considered broadly equivalent, given the previously negligible cost of repo, but market prices already suggest this is changing. The bank can hedge the swap exposure by transacting the opposite position with a clearing house. The clearer requires the posting of cash collateral so, if the bank receives gilts, it will enter a repo to convert these into cash, incurring the increased charges described above.

Accelerating towards cash-only

Emir will require insurers to clear their interest rate swaps, and banking regulations may make pricing less attractive for derivatives where non-cash collateral can be posted. To avoid the latter situation, one option is for firms to move to cash-only CSAs – a number of liability-driven investment practitioners have already adopted this approach. 

Another option is to align to a cash-only CSA by clearing ahead of the Emir timelines. Traditional access to clearing is via a broker, but this brings with it a number of additional risks and costs. Recently, some brokers have increased fees to cover the leverage ratio costs levied on the client margin on their balance sheets. Others are ’offboarding’ clients where profitability does not meet new leverage ratio thresholds. 

A third option might be to become a direct member of a clearing house. In the past, firms have shied away from this as there are additional requirements that come with membership. For example, as well as setting up the systems required to clear trades, clearing members must make payment of a default contribution and participate in auctions. 

A number of major clearing houses are now looking more closely at direct access models, whereby the client takes a form of clearing membership and outsources the operational, default fund and default management obligations to a bank that has the infrastructure to provide this service.


Central clearing and the leverage ratio provide strong incentives for insurers to prepare themselves for the management of hedging portfolios in a world of cash-only collateral and higher cost of repo. Thorough consideration of the costs and benefits of different options will be vital.

From the movement to cash-only CSAs to the most efficient ways to execute cleared transactions or provision of contingent liquidity solutions, RBS can help firms understand their collateral management requirements and obligations, optimising the transition into the new regime. 

The statements and opinions expressed in this article are solely the views of the authors and do not necessarily represent the views of The Royal Bank of Scotland plc and/or their affiliates (“RBS”). This article is for the use of intended recipients only and the contents may not be reproduced or disclosed in whole or in part without RBS’s prior express consent. No assurance of any kind is made as to the accuracy or completeness of the information contained in this article. This article is published for information purposes only and is subject to update. Views expressed herein are not intended to be and should not be viewed as advice or as a recommendation, or as an offer or solicitation to buy or sell any investment. RBS accepts no liability whatsoever for any losses arising in any way from the information contained in this article. The Royal Bank of Scotland plc. Registered in Scotland, No. 90312. Registered Office: 36 St Andrew Square, Edinburgh EH2 2YB. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and Prudential Regulation Authority. Copyright ©2015 The Royal Bank of Scotland plc. All rights reserved.

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