EU prop firm capital crunch could hit market liquidity

Traders claim they would be put out of business by bank-style capital rules

  • All investment firms captured under the second Markets in Financial Instruments Directive from January 2018 would also be subject to the Capital Requirements Regulation (CRR).
  • The European Commission is mandated to devise an alternative and proportionate prudential regime suited to non-banks before then.
  • But time is tight, and market participants are sceptical the regime will be ready by the start of next year.
  • A draft proposal unveiled by the European Banking Authority (EBA) at a public hearing on July 3 includes measures that would apply parts of the CRR, such as the market risk framework.
  • The EBA maintains this would establish a level playing field between banks and non-bank market-makers, but principal trading firms warn it is entirely disproportionate, and risks making alternative liquidity providers uncompetitive.

Proprietary trading firms claim they will be put out of business if they become subject to bank-style regulatory capital rules in Europe from the start of January 2018 – a prospect that is also worrying some large exchanges, where non-bank traders are important liquidity providers.

In theory, there is a way out. All investment firms that come under the scope of the second Markets in Financial Instruments Directive (Mifid II) when it enters into force next year would also be subject to the Capital Requirements Regulation (CRR) for banks, but CRR calls for an alternative prudential regime for non-banks to be considered. The danger, according to principal traders, is that it won’t be in place quickly enough.

“We will be left in limbo come 2018. What will happen when Mifid kicks in, and the new regime, yet to be defined, is not confirmed? The standard provisions of CRR would put large parts of the non-bank liquidity community out of business straight away,” says an executive at one European principal trading firm.

And the traders are not alone. In an emailed statement, Nicolas Bertrand, head of equity and derivatives markets at the London Stock Exchange Group (LSEG), says the bourse welcomes Europe’s plans for a separate prudential regime for investment firms, as long as it is “correctly calibrated” and would support the objectives of a “more diversified system”.

“LSEG firmly believes that markets are best served by having the widest possible diversity of market participants supported by a variety of liquidity providers including investment firms acting as market-makers,” the statement continues.

There is not much for regulators to build on. A new regime for non-banks would replace a patchwork of different national rules in the EU, some of which only require fixed initial capital levels for Mifid investment firms.

The European Banking Authority (EBA) unveiled its draft prudential regime for non-banks at a public hearing on July 3, and has committed to submitting final advice to the European Commission (EC) in September. If all goes to plan, this might allow rules to be approved by the European Parliament and Council of the EU in time to enter into force before January 2018.

But the trading firm’s executive claims this timeline is impossible, and says the EC will instead need to adopt a temporary carve-out from CRR – commodity firms have already been granted such an exemption until 2020.

Regulation should remain proportionate, and we really believe proportionality is not being applied here
Piebe Teeboom, European Principal Traders Association

On the face of it, European officials should be sympathetic. A mid-term review of the Capital Markets Union, published by the EC on June 8, emphasised the aim of developing “a more diversified system in which non-bank finance efficiently complements the traditional banking channels”.

However, the EC’s aspiration for a more diversified system explicitly focuses on investment funds rather than proprietary traders. Didier Millerot, head of the banks and financial conglomerates unit at the EC, told on the sidelines of the public hearing that there were no plans at present to postpone the start of the proposed non-bank prudential regime.

Nonetheless, Millerot said the EC would be ready to “assess quickly the need” for a regulatory technical standard to delay the application of CRR to non-banks beyond the start of 2018 if the alternative regime was not ready in time.

Disproportionate response

Even if the regime is completed in time, principal traders worry the rush to finish it before January 2018 could lead to unsuitable prudential requirements. In an initial discussion paper published in November last year, the EBA emphasised the need for a proportionate regime, but non-banks claim the latest draft misses the mark.

“If you look at the logic we have always seen in European regulation, principal trading activity has traditionally been regarded as one of the least-risky activities. Regulation should remain proportionate, and we really believe proportionality is not being applied here,” says Piebe Teeboom, secretary-general of the European Principal Traders Association (Epta).

The proposal would slot non-banks into three categories: class 1 firms are part of banking groups that would be subject to the full CRR; class 3 firms would be subject to fairly limited initial capital and monitoring requirements; class 2 are those in the middle, which would be subject to modified parts of CRR and some tailor-made new rules.

Small banks with very small trading books are subject to very similar requirements, and they exist without any problems
Lars Overby, EBA

For independent trading firms then, the first question is whether they fall into the second or third buckets of the regime. The threshold that determines this would be calculated using a range of k-factors designed by the EBA, which will also serve as the basis for a dynamic risk-based capital requirement. Those k-factors include a daily trading flow (DTF) measure, and any firm where this is higher than zero will automatically be in class 2, effectively routing all independent traders to this category, regardless of size.

“The approach disregards the fact that among principal trading firms, there are very small firms with a limited number of staff who are undertaking very simple market-making activities on one or a few exchanges,” says Teeboom. “The presumption that trading on own account is inherently risky is something we completely reject.”

At the public hearing, EBA officials said the decision to include all principal trading firms was a policy choice driven by the risk the group poses collectively to market stability, and the fact that even small banks with limited trading activities will have to comply with the market risk modules of CRR.

“Small banks with very small trading books are subject to very similar requirements, and they exist without any problems,” said Lars Overby, EBA’s head of credit, market and operational risk policy, at the hearing. “The issue is the level playing field we are trying to ensure between the bank model and the investment firm model.”

Wrong indicator

So, how will the class 2 capital regime work? In its proposed form, the requirements rest on a number of k-factors divided into three categories: risk to customer, risk to market and risk to firm. For proprietary traders, the latter two categories are the crucial ones.

The risk to firm category includes counterparty and concentration risk factors, which will be measured using the CRR framework. The market category includes the DTF measure, together with a net position risk measure that will be assessed using the market risk framework of the CRR. This will switch over to the second capital requirements regulation (CRR II) once the drafting of that legislation is complete. CRR II will integrate the Basel Committee’s Fundamental Review of the Trading Book. Market participants currently expect CRR II to be finalised in 2020 at the earliest.

The EBA is now collecting data to calibrate the DTF regime, due for submission by August 3. Prop trading firms say the EBA has so far indicated it would most likely use a three-month moving average to smooth out daily fluctuations.

One regulatory source tells the DTF indicator is intended “to capture the risk of an event that would likely impact market liquidity, access or integrity, given the size of the market footprint of a trading firm”.

lars overby
Lars Overby

At the public hearing, Overby (pictured) indicated the EBA had opted for the DTF as a more practical alternative to something that might have been more risk-sensitive but harder to calculate and monitor, such as the peak risk exposure during the day. But market participants argue the DTF is just too simple to reflect actual risk – it assumes more trading signals more risk in a linear fashion.

“Our members are able to provide tight spreads in the order books by hedging their positions very carefully, and updating those positions constantly as required,” says Epta’s Teeboom. “The more precisely they have hedged their risk, the more efficiently they are able to quote competitive prices in the order book. If you have market volatility where prices change very quickly, that also means you have to update your hedges even more. That increases your trading volume, but it does not increase your risk – quite the contrary, it ensures you maintain your hedges, so we feel there is a conceptual misunderstanding here.”

In fact, he warns, the EBA proposal could increase risk by skewing incentives. Higher volatility would produce a higher DTF number as participants demand more liquidity from market-makers who are at the same time accelerating their hedge updates. This could lead to a situation where firms are being pushed towards their regulatory capital threshold. To avoid breaching the threshold, firms would either have to reduce their liquidity provision in the market – leading to greater market volatility – or hedge less dynamically, thereby raising the risk to the firm.

The executive at the principal trading firm says the DTF k-factor might be seen as some kind of proxy for operational risk posed by higher trading volumes. But he criticises the EBA’s proposal to base the DTF on notional amounts, which will have a disproportionate effect on certain types of derivatives trading.

Some of the traders have very specific business models for which they have large exposures during the day, with a high level of trades, and at the end of the day they have no or very little exposure left, for which the market risk calculation in the sense of the CRR will not produce any meaningful result
Gabriel Cardi, EBA

For example, he estimates the actual economic risk for a Euro Stoxx equity index future with gross notional of €35,000 ($41,000) would correspond to a notional of €1 million for a Euribor future. The underlying daily volatility on the Euro Stoxx could be 25 times higher than on Euribor, and minimum contract sizes are usually larger in equity index futures. “Adjusted for contract size and expected move in the market per unit of time, equity index futures are six or seven times riskier than fixed-income futures, but the notional daily trading flow does not reflect that at all,” says the executive.

“The high-frequency equity index trading activities are also a lot more systematic and a lot more prone to operational risk disasters than the reasonably old-school fixed-income market-making, where most of the trades are concluded on the phone. But based on gross notional daily trading flow, we would have far more of the capital number coming from our fixed-income activity, even though the other activities are dominant,” he adds.

Market risk challenge

Non-banks also worry about using the market risk module of CRR to measure net position risk. Gabriel Cardi, a senior policy expert at the EBA, suggested at the public hearing that some principal trading firms would be unaffected by the net position risk.

“Some of the traders have very specific business models for which they have large exposures during the day, with a high level of trades, and at the end of the day they have no or very little exposure left, for which the market risk calculation in the sense of the CRR will not produce any meaningful result,” said Cardi.

Epta’s Teeboom refutes this analysis, warning it is a “misrepresentation” to suppose principal trading firms close down all positions overnight.

“It might be true that some principal trading firms have a flat position overnight, especially if they are active only in equities. But many, if not most, are focused on futures and exchange-traded options, and they certainly do carry positions overnight,” says Teeboom.

The principal trading firm executive says his firm’s ability to provide liquidity would “suffer immensely” if it did not hold overnight positions. This means proprietary trading firms will have to implement the market risk framework for CRR. However, supervisors have already indicated that non-banks would not qualify to use CRR internal models for calculating market risk.

Prop traders will therefore need to rely on the standardised approach to market risk contained in the current CRR, which does not offer recognition for some of the common hedging strategies pursued by non-bank market-makers. Firms typically manage a portfolio of long and short risk factors that remain roughly flat over time, but individual contracts may not be exactly equivalent.

If the non-banks are forced to use the standardised methodology, and the banks are using their internal models, that is a competitive concern
Principal trading firm executive

The standardised approach, however, places contracts into specific residual time-to-maturity buckets, usually in three-month intervals. A trader might hedge long nine-month against short 10-month delta exposures that are very highly correlated, but would not be placed in the same bucket under the CRR standardised approach.

As a result, instead of offsetting each other, the exposures would be added together. This could generate some freak results, including sudden changes in capital requirements overnight as specific contracts held by the firm move out of the same time-to-maturity bucket as their offsetting trades. For rates options, the executive calculates certain positions requiring a €3 million to €4 million margin deposit with a clearing member could equate to market risk of €120 million under CRR.

No level playing field

Forcing principal traders to use only the standardised approach also undermines the idea the EBA is seeking to create a level playing field with banks, critics say. The use of internal models would allow better recognition of hedging practices in calculating market risk.

“None of the big dealers use the standardised approach. If the non-banks are forced to use the standardised methodology, and the banks are using their internal models, that is a competitive concern,” says the principal trading firm executive.

Non-banks are currently analysing how far the standardised sensitivities-based approach to market risk, which will be introduced with CRR II, will be an improvement on CRR in terms of netting efficiency for exchange-traded market-making activity. They have already concluded it will be significantly more complex than the existing CRR procedures – the new market risk rules pose a huge compliance challenge for the largest bank dealers, let alone a small proprietary trader.



One source says the pressure to subject non-banks to CRR market risk rules has come from French banks eager to squeeze what they see as unfair competition in derivatives market-making – a claim was not able to verify independently. French central bank governor François Villeroy de Galhau did recently raise concerns over some non-banks' resilience but for a different reason. “The main problem today is not the solvency of banks but the liquidity of non-banks,” he said in a speech in Paris on July 12, sounding alarm over the ability of investment funds – rather than principal traders – to withstand rapid outflows.

Epta’s Teeboom disagrees with the entire notion of seeking a level playing field between the capital requirements for banks and principal trading firms, in view of their very different business models and risk profiles.

“It is a perverse argument where the banking approach is still taken as the default approach, and it flies in the face of the objectives of having an appropriate regime for investment firms while diversifying the European capital markets away from an overreliance on bank financing,” says Teeboom.

“There are profound differences between banks and the proprietary trading activity of Epta members. Banks undertake activity with depositors’ money and thus potentially expose taxpayers if they fail and need to be bailed out with public funds. If an Epta member were to fail, only the owners of the firm and its employees would suffer,” he claims.

It is a perverse argument where the banking approach is still taken as the default approach
Piebe Teeboom, Epta

He also notes the k-factor coefficients for DTF proposed by the EBA appear punitive compared with some other risk factors. The coefficient for derivatives trades is 0.06%, and for cash trades 1.5%. The coefficient for client money held is just 0.45%, implying that cash equities trading is more than three times riskier to the market than holding client money is to customers. 

And Teeboom is especially keen the EBA’s methodology should include greater recognition of the fact non-bank market-makers almost exclusively hold derivatives positions that are cleared and fully collateralised with clearing members, effectively ensuring strict third-party risk management as part of the business model.

The EBA’s Overby told the public hearing the recognition of margin is “not completely off the table”, but it would need to be fitted into the existing framework of metrics given time constraints to finalise the regime.

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