Proposed leverage ratio amendments have stopped short of providing a fix for the additive treatment of client collateral received by futures commission merchants (FCMs), which banks argue renders the derivatives clearing business unprofitable.
The Basel Committee on Banking Supervision is consulting on amending the method of calculating derivatives exposure, which at the moment relies on the decades-old current exposure method (CEM).
Banks see the CEM as overly simplistic and not risk sensitive, and have long called for a move to the standardised approach for counterparty credit risk (SA-CCR), which allows more exposure netting. A Basel Committee consultative document on revisions to the leverage ratio, published on April 6, officially proposes that amendment. But dealers say clearing will remain unprofitable unless initial margin received from clients is recognised as risk reducing.
"It's definitely a positive thing. CEM has a lot of shortcomings that we were concerned about, but this is not a silver bullet – it does not solve the clearing industry's problems. It helps, but there are still going to be certain client types that don't look attractive under clearing and, unfortunately, it would be the clients that regulators would most like to help. Just given the fact that we're not getting the initial margin offset, the supplementary leverage ratio might continue to be the binding constraint for supporting client business," says the head of clearing at a US bank.
To calculate a bank's leverage ratio exposure, the FCM must add the replacement cost of a derivatives position – the current market value – to its potential future exposure (PFE). The Basel Committee has proposed allowing cash variation margin to be used to reduce the replacement cost. The PFE add-on component is adjusted by setting the PFE multiplier to one, to ensure no collateral posted by the counterparty is recognised. The calculation of maturity for the PFE is based on a minimum five-day margin period of risk, which increases up to 20 days, depending on whether the transaction is margined and centrally cleared.
It's definitely a positive thing. CEM has a lot of shortcomings that we were concerned about, but this is not a silver bullet
Head of clearing at a US bank
The PFE is generated by applying a regulator-set multiplier to the notional of the trade, with the multiplier varying by underlying asset class and maturity. Allowing margin to offset the replacement cost can result in big capital savings for banks, with one example sketched out by Citi in leverage ratio analysis for Risk showing savings of more than $12 million in capital requirements between margined and unmargined SA-CCR, and a reduction of almost $42 million versus CEM.
The global head of risk at the US bank says a change to SA-CCR will result in savings of up to 50%, but this is dependent on client type.
"We're seeing pretty good benefits on the over-the-counter clearing side, to the tune of an 80% or 90% reduction for some of our clients if you include initial margin. On the futures side we see a much lower rate, with clients getting about a 30% to 40% benefit. Compared to CEM, the savings are more like 50% when not including initial margin," says the global head of risk.
Better for some, worse for others
"It's better for certain types of portfolios, but it's worse for others," adds the head of clearing. "Credit clients are going to look much better under SA-CCR, but other asset classes such as futures, commodities or equities clients are probably not going to see the same level of benefits. If you're doing longer-dated trades in the commodities and equities space, the numbers can be quite punitive."
The Basel Committee also notes in its consultation the industry's concerns over the impact of the leverage ratio on clearing businesses, which consume billions of dollars in cash initial margin from clients and must be counted towards the exposure total. No changes are proposed at this stage, but the committee says it is "carefully considering this concern" and requests supporting data from the industry. The consultation suggests a market risk quantitative impact study being conducted by the Basel Committee this month may also supply valuable information.
On the basis of that data, the BCBS will consider "whether to expand upon the measures described, which may include permitting offsetting of a clearing member's PFE with the initial margin posted by clients" on whose behalf the bank clears derivatives transactions.
"They are looking for further data on what banks' leverage ratio numbers would look like under SA-CCR with or without an offset, and it's encouraging that they continue to consider the issue. It's an uphill battle, but it's helpful they're continuing to look into it," says the head of clearing.
Lobbying efforts have long sought to do away with the current treatment of client initial margin – something the industry argues will undermine the post-crisis push to centrally clear derivatives as a result of extra capital requirements. However, these discussions have been politically fraught and so far unsuccessful, with 60% of asset managers witnessing higher clearing costs and banks exiting the business.
While several senior regulators support a change, including CFTC chairman Timothy Massad and Mark Carney, governor of the Bank of England (BoE), others have refused to budge – including Janet Yellen, chair of the board of governors at the Federal Reserve System, and Thomas Hoenig, vice-chair of the Federal Deposit Insurance Corporation (FDIC).
As a result of the political division, the head of clearing says the Basel Committee's refusal to allow an initial margin offset in its publication did not come as a surprise.
"It has been telegraphed to us a bit that the initial margin offset would be a challenge. The FDIC, in particular, has made very public comments about giving an offset and their resistance to it. So we were to some extent expecting this. However, the CFTC has been very supportive of this and the BoE has also made some public comments about the need for it. We continue to argue for it and ask regulators to consider it," says the head of clearing.
In the face of regulatory opposition, some banks have taken steps to mitigate the issue through a controversial accounting technique known as derecognition of initial margin. This is accomplished by separating client-received cash collateral from the bank's estate, to make it bankruptcy remote in the event of FCM default, and giving up any interest received. The portion of collateral that is derecognised does not have to be counted towards the leverage ratio.
The Basel Committee consultation period on revisions to the leverage ratio closes on July 6.