US dealers slam capital hit on clearing for unreal CVA risk

Fed would diverge from Basel standards by imposing CVA capital on client-cleared trades

  • US prudential regulators have diverged from international standards by proposing a capital charge for CVA on client-cleared trades.
  • Clearing banks argue the US agency clearing model means there is no CVA incurred on client-cleared trades, and some don’t even have the systems in place to measure it.
  • If the CVA charge is included in the final rules, market participants warn it could increase costs for clients and cut the provision of clearing services that have already been depleted by exits from the business.
  • US regulators have also decided to include agency clearing in the surcharge for systemic banks, suggesting they are sceptical about the balance sheet relief that can be achieved by the agency model.

US banks warn that proposed prudential regulations could force them to capitalise a risk from their clearing clients that may not even exist. Sources say it could increase costs for end-users of cleared products, and potentially reduce capacity in the business at a time when US markets regulators are looking to broaden clearing mandates.

“We’re concerned that if this rule moves forward without change, there might be further concentration in the market and less liquidity,” says a regulatory expert at a large US futures commission merchant (FCM). “Clients may have to pay more if costs have to be mutualised beyond the banking industry as a result of this.”

In July last year, US prudential regulators unveiled their notice of proposed rulemaking (NPR) for implementing the final set of bank capital reforms written by the Basel Committee on Banking Supervision following the financial crisis – dubbed the Basel III endgame. Tucked away in footnote 428 is a specification on which trades should be capitalised for the risk of credit valuation adjustment (CVA) – a discount to the accounting value of an over-the-counter position based on a decline in the creditworthiness of the other counterparty.

To equalise a client-cleared trade to an OTC bilateral and say there’s some kind of CVA risk really doesn’t make sense
Jacqueline Mesa, FIA

The US Federal Reserve recognises that when a bank “that is not a clearing member” engages in a cleared trade, it is facing the central counterparty (CCP), rather than the other participant in the trade, so it does not need to consider the creditworthiness of the other participant. But there’s a sting in the tail: if the bank is acting as a clearing member on a client trade, “the exposures would be included in CVA risk covered positions”. 

In a principal clearing model, the clearing member takes back-to-back opposing positions between the client and the CCP, so the bank could be deemed to have an exposure on the client leg of the trade that might incur CVA. However, US FCMs clear most trades using an agency model, where the client faces the CCP directly and the clearing member acts only as a guarantor.

“Client-cleared activity is not on balance sheet for a clearing member, and it’s not something we are accounting for CVA on,” says a senior clearing source at a second large FCM. “So to take something where we don’t have that risk, and have to capitalise against risk that doesn’t exist, doesn’t make sense.”

It is possible to make the case that where the clearing member guarantees the performance of its client to the CCP under the agency model, the guarantee constitutes a contingent liability for the bank that might attract accounting valuation adjustments if the client becomes riskier. However, since the guarantee is usually off-balance-sheet for accounting purposes, the regulatory expert at the first FCM argues that it represents a default risk only, and is therefore already covered by the counterparty credit risk framework.

“If the client were to default, we would have to make the CCP whole, and we are already capitalising for it,” says the regulatory expert. “The capital rules prior to this NPR require banks to capitalise for that default risk.”

Squeezed margins

In a comment letter to the US Federal Reserve published on January 16, the Futures Industry Association cited a study of six of its member firms showing the Basel III endgame proposals would increase aggregate capital requirements for clearing services by $2.01 billion, of which $723.6 million was attributable to the extra CVA capital charge. 

“The whole reason behind the move to clearing is to get rid of that credit risk,” says Jacqueline Mesa, the chief operating officer of the FIA. “So to then equalise a client-cleared trade to an OTC bilateral and say there’s some kind of CVA risk really doesn’t make sense.”

It absolutely will impact liquidity and users’ ability to hedge, and will ultimately have ramifications for the broader stability of the markets
Senior clearing source at a large FCM

The implications of the extra CVA charge could be magnified because the Basel III endgame proposal also incorporates sweeping changes to the overall capital stack that banks must calculate. At present, CVA falls under the advanced approaches stack, but most large banks are bound by the so-called Collins floor of standardised approaches, which does not include CVA at all. However, the NPR would create a new enhanced risk-based approach that would include CVA, and is expected to be higher than the Collins floor for most banks.

“CVA is fully additive under the enhanced risk-based approach, which is expected to become the binding capital constraint under the new rules,” says Panayiotis Dionysopoulos, head of capital at the International Swaps and Derivatives Association.

Reduced clearing capacity

Pushing up the costs of clearing will run counter to legislators’ decade-long objective of encouraging the clearing of more OTC derivatives following the 2008 financial crisis. The profile of the clearing business – low-risk, low-margin – means any increase in capital can have an outsized impact on the economics of clearing services, says Dionysopoulos.

The result, the senior clearing source at the second large FCM says, could fly in the face of regulatory efforts to widen central clearing as a way of tackling systemic risk. Most recently, the US Securities and Exchange Commission has introduced clearing requirements for US Treasuries cash and repo markets. 

“By significantly increasing the capital footprint associated with cleared activity ... it absolutely will impact liquidity and users’ ability to hedge, and will ultimately have ramifications for the broader stability of the markets,” says the senior clearing source at the second large FCM.

Higher capital requirements for clearing could also deter banks from bidding for a failing rival’s cleared derivatives books. A regulatory source at a third large FCM points to the rescue of Credit Suisse as a reminder that clearing members may need to step in if one member of a CCP runs into trouble. In the case of Credit Suisse, its acquisition by UBS avoided problems for the clearing houses, but if a member defaults, CCPs will first try to sell its portfolio to non-defaulting members. 

“Banks’ willingness to take on those ported positions and increase the size of their cleared business” is directly affected by the amount of extra capital they will need to hold, says the regulatory source at the third FCM: “It’s going to be a really hurting thing for banks to sign up for.” 

If positions cannot be ported to other clearing members, the CCP has to liquidate the portfolio and mutualise potential losses among other members, generating greater systemic risk. 

Unlevel playing field

There has been longstanding tension between markets and prudential regulators in the US over the perceived punitive capital requirements for central clearing. In particular, markets regulators have been riled by the refusal of prudential regulators to implement a Basel exemption that would allow banks to exclude client initial margin posted to CCPs from the leverage ratio. The European Union introduced this exemption as part of its capital requirements.

“If you look over the last 10 years, the number of banks that provide the [clearing] service has halved, partly due to other regulatory challenges like the leverage ratio,” says the regulatory source at the first FCM.

In a similar vein, if the NPR is adopted as a final rule, the US would be the only jurisdiction to subject client-cleared trades to CVA capital requirements. The EU’s capital requirements regulation and UK bank capital laws contain an explicit exemption for these trades, and the FIA’s Mesa says European regulators have no plans to change this when they implement Basel III. 

The Fed’s proposed changes to the capital buffer for global systemically important banks (G-Sibs) constitute another example of gold-plating international standards that will hit client clearing. The proposal would bring agency clearing into the complexity and interconnectedness indicators for systemic risk for the first time. This would increase the size of the G-Sib surcharge applicable to the clearing business. The FIA estimates this amendment would add a further $5.2 billion in capital requirements, on top of the Basel III endgame changes. 

The largest FCMs had previously been urging European CCPs to mirror their US peers and accept the agency clearing model, in order to make the clearing business more capital-efficient. However, the combined clampdown through the CVA charge and the G-Sib surcharge suggests US prudential regulators are sceptical about the balance sheet relief that agency clearing can achieve.

The Fed declined to comment for this article. The consultation period closed on January 16. Regulators are now assessing responses, and have so far said they intend to publish a final rule in time for an implementation date in July 2025.

Update, February 26, 2024: This story has been updated to include attribution to Panayiotis Dionysopoulos

Editing by Samuel Wilkes and Philip Alexander

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