EC official offers hope to prop traders on capital rules

Official sees problems in draft regulation, says EU council and parliament are discussing them

3 signs - k-NPR - Getty - montage.jpg (4.86 MB)
Draft regulation includes key metrics known as k-factors montage

A European Commission official has extended a possible olive branch to beleaguered principal trading firms, which are worried proposed capital requirements will drive them out of the European Union altogether.

The requirements form part of what is commonly known as the investment firms regulation, due to be finalised by April 2019. After the European Banking Authority (EBA) sent the EC its recommendations, the commission approved the draft legislation in December and passed on the package to its co-legislators – the Council of the European Union and the European Parliament.  

However, an EC official acknowledged problems with the proposed rules at a conference on June 6.  

“It is difficult to necessarily employ effectively in the way it is articulated. We handled the file for a very brief time between the work of the EBA and the work of the co-legislators, so our assessment was that we did not have time to reopen the issues to see how it could be rendered more workable,” said Hannes Huhtaniemi from the EC directorate of financial services and capital markets union.

He noted that some of the issues were now being looked into by the council and parliament, although discussions were still at a very early stage.

The new prudential rules would apply to all firms defined as investment firms under the second Markets in Financial Instruments Directive (Mifid II), which came into force at the start of this year. The EU decision-making bodies had planned to finalise the rules in time for Mifid II but, as that was looking unlikely, the EC pledged to at least approve the draft version by December 2017. The EBA only submitted its opinion on the file – after several rounds of consultation – at the end of September 2017, giving the EC just two months to prepare its own proposal.

We’ve looked at the CMG models, and none of the numbers are coming in higher than FRTB, so the ‘higher of’ is a redundant alternative
Marco Bragazzi, Tower Research Capital Europe

Under the regulation, principal trading firms would have to calculate their capital requirements based on two key metrics known as k-factors: one for net position risk (NPR) and one for daily trading flow (DTF).

The EC accepted the EBA’s proposal to calculate k-NPR using two different methods and to apply the higher of the two numbers. The first method uses elements of the Basel III market risk framework, the Fundamental Review of the Trading Book, and the second uses the haircuts applied to the collateral provided by proprietary trading firms to their clearing members – the so-called clearing member guarantee (CMG) method.

Marco Bragazzi, finance director of non-bank electronic trading firm Tower Research Capital Europe, said at the conference: “Looking at real-life portfolios that firms trade on, we’ve looked at the CMG models, and none of the numbers are coming in higher than FRTB, so the ‘higher of’ is a redundant alternative.”

Bragazzi is a member of an FIA European Principal Traders’ Association working group whose work will feed into discussions on the proposed prudential rules at the EC, the council and the parliament.

Since clearing member margin requirements are themselves subject to prudential rules, prop trading firms suggest the CMG is an appropriate regulated metric for determining capital requirements, and is more proportionate than the FRTB measure, given that non-banks are not putting depositors’ money at risk.

Options hit hard

Chris Rhodes, the global head of financial derivatives at Ice, added that notional values in derivatives vary widely depending on asset class, so the regulation would suit some asset classes better than others. For instance, a trader of European interest rate derivatives could hit €1 million ($1.2 million) in notional from around 250 lots of butterfly trades – a neutral options strategy incorporating long and short positions with the same expiry dates – compared with average daily volumes of 2.5 million lots.

As a result, Rhodes said there is no correlation between the FRTB and CMG outputs for some products, even though they are both meant to capture the same risk of the trading activity for the market.

Consequently, unless the “higher of” wording is removed, all EU principal trading firms will be subject to the FRTB. Bragazzi said the impact of this compared with current capital requirements such as the UK’s ‘full-scope’ regime – which is based on the EU’s capital requirements regulation (CRR) – varies according to asset classes and trading strategies. 

“There are some marginal winners: if you are only trading cash equities or futures, you may get some benefits from this. But if you are an options trading firm, this can multiply your [capital] requirements by potentially 10 to 100 times what you are currently calculating [under the UK regime]… It can potentially hinder businesses to the extent they want to move away from certain asset classes,” said Bragazzi.

He added that a decision by the EC to follow the EBA’s advice and impose the new k-factors effectively on all prop trading firms would capture any new entrant to the market immediately, hindering competition and liquidity provision: “For those firms, it is a significant burden.”

Moreover, the systems requirements for calculating the FRTB capital numbers are substantially larger than for CRR, Bragazzi warned.

One caveat is that the Basel Committee’s latest consultation on proposed amendments to the sensitivities-based approach to calculating FRTB market risk capital could ease the burden in some cases. However, Bragazzi said these numbers would still be higher than the CMG ones, and in some cases higher even than those produced under the UK full-scope regime.

The EC’s Huhtaniemi pointed out that the commission has proposed using a 65% scalar on FRTB outputs – which is intended as a transitional measure in the European version of the FRTB for banks – and making it permanent for non-bank investment firms. Nonetheless, he said policymakers recognised the industry’s concerns about the k-CMG method being effectively redundant within the rules as they are currently drafted.

“The views you’ve heard here have been very well voiced in Brussels to those who follow these debates, so they would be aware of the need to address it. We see [k-CMG] still has a place in the framework – it is just a question of articulating how it can be made more usable,” said Huhtaniemi.

K-DTF factor worries

The k-DTF factor is also causing concern among prop trading firms, because it would be extremely volatile as trading volumes change and would therefore complicate the process of capital planning. Ice’s Rhodes warned it could conflict directly with the market-making obligations enshrined in Mifid II, which requires market makers to provide prices on a continuous basis, even during stressed periods when trading volumes could be much higher.

“If you create a disincentive in terms of capital planning, relating to DTF for market-makers, they will ultimately choose to offer less liquidity if they are based in Europe, and that will be to the detriment of European markets. It would be somewhat ironic if the majority of liquidity for these markets came from outside Europe – that is the ultimate implication of poor calibration of these models,” said Rhodes.

Markus Ferber, who is the parliamentary rapporteur on the investment firms regulation, produced draft amendments in April that include modifications to the functioning of k-DTF. Bragazzi said those modifications would create a longer look-back period and remove some of the peak trading days from the calculation, potentially smoothing the volatility of capital requirements.

The EC’s Huhtaniemi acknowledged that the DTF factor was another element the EC did not have time to examine fully before adopting its own draft of the regulation.

“Since then, we have heard these comments…and perspectives that it could be inconsistent with some of the liquidity provision contractual obligations that trading firms have under Mifid. So that is certainly well-noted, and some of the points that Ferber’s amendments go some way towards trying to trim the excessive impact of the DTF factor,” Huhtaniemi said.

Editing by Olesya Dmitracova

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