Across all asset classes and from retail to sophisticated clients, new regulations agreed at the international, regional and national level are occupying an increasing share of business managers’ time. The Banker crystallises the latest thinking on the acronyms that are keeping financial market participants awake at night.

AIFMD

The EU Alternative Investment Fund Managers’ Directive is due to be transposed into national legislation by July 22, 2013. Existing managers can be given up to one year to apply to become fully authorised under AIFMD, which will allow them to passport their funds across the EU.

“There is uncertainty because the understanding of the transitional period or the phasing in of certain requirements for existing managers is not harmonised across the EU. In addition, some countries may not transpose the legislation in time,” says Jiri Krol, deputy chief executive and head of regulatory affairs at the Alternative Investment Management Association (AIMA).

Alternative fund managers must also appoint a depository institution that can be held legally liable for any loss of assets from funds, even if the loss occurs at a sub-custodian contracted by the depository. Mr Krol says this is likely to discourage non-European funds from moving onshore in the EU.

CRR

The Capital Requirements Regulation is central to the EU’s CRD (Capital Requirements Directive) IV. The European Banking Authority (EBA) published a 'near-final' technical regulation in June 2013, setting out definitions for hybrid capital instruments' alternative Tier 1 (AT1) and Tier 2.

“The regulatory environment is now ready for banks to start issuing new-style hybrid capital, and we are expecting €5bn to €10bn of new AT1 and Tier 2 issuance by the end of 2013, and a further €25bn to €35bn next year depending on market conditions,” says A J Davidson, head of hybrid capital at Royal Bank of Scotland Markets.

One bone of contention is the mechanism for writing up principal on hybrids, once a bank returns to profit after a write-down event. The EBA looks set to cap how much of the new capital generated can be used not only for writing up the hybrids, but also for restarting coupon payments on them. This could effectively force banks to choose between the two, which will give bank hybrids a riskier profile from the viewpoint of long-only fixed-income investors.

CVA

The internationally agreed Basel III capital regulations include capital charges for counterparty risk on in-the-money derivative trades that are not centrally cleared – known as contingent valuation adjustment (CVA). However, the EU’s CRD IV, due to come into force in January 2014, looks set to deviate significantly from the international agreement by exempting banks from capitalising CVA risk on trades with sovereigns, corporates or pension funds.

A further concern about CVA risk is that the management methods mandated by Basel III do not always coincide with the way that banks measure their own risks internally.

“Basel III requires banks to calculate the CVA risk in a segregated book with designated hedges assigned to that specific book, as opposed to being part of the whole trading book. That is a break from the way banks would calculate it economically,” says Eduardo Epperlein, global head of risk methodology at Nomura.

DVA

Even more contentious than CVA, debt valuation adjustment (DVA) reflects the value of a bank’s out-of-the-money derivative liabilities depending on the bank’s own credit risk posed to counterparties. The Basel Committee on Banking Supervision (BCBS) is proposing to deduct this from Tier 1 equity separately from any measurement of CVA risks.

“Basel III does not allow DVA to be included in the bank’s overall value-at-risk calculation. But since DVA is normally a natural hedge to CVA, by excluding it from the broader trading book risk calculation, banks could be managing two opposing goals and inadvertently increase the economic impact of CVA and DVA,” says Mr Epperlein.

EMIR

The European Market Infrastructure Regulation (EMIR) that pushes the use of central counterparties (CCPs) for derivatives clearing entered force in March 2013. The demand for extra collateral in the system as a result of rerouting trades through CCPs is gradual, says Michel Bine, global head of short-term rates and treasury at Société Générale Corporate & Investment Banking (SG CIB) in Paris.

“More trades are being cleared, but mostly by investment banks looking to reduce capital consumption from counterparty risks. That means the netting of positions cleared on CCPs has also increased, which is keeping down the collateral needs,” he says.

What has already increased sharply is the technology investment needed to manage electronic derivatives trading. Systems must be able to price in real time the counterparty risks and collateral requirements associated with bilaterally cleared trades and with centrally cleared trades through different CCPs on both sides of the Atlantic, all of which have different collateral and netting rules.

“This is a massive transformation of pricing tools worldwide that will affect profit margins especially for smaller players, and it could lead to a consolidation that will benefit the stronger players,” says Mr Bine.

MiFID2

Achieving final EU agreement on a revised Markets in Financial Instruments Directive (MiFID) is proving difficult, although the Irish presidency of the EU Council appears to be making progress. The central thrust of MiFID2 is to increase market transparency across all assets, just as the first directive aimed to do for equities. A compromise proposal in June suggesting a cap on equity trading in so-called unlit venues (as opposed to exchanges) could trouble buy-side participants.

“Our general concern is that some of the MiFID interventions may decrease liquidity, so we would want to make sure that the transparency requirements take into account any potential impact on liquidity. Once the directive moves to level two [detailed rule-making], we would expect to be active discussing block trade and reporting delay thresholds in all the asset classes that are now to be regulated,” says Mr Krol at AIMA.

PD2

The EU’s second Prospectus Directive (PD2) will apply to all financial products issued after June 30, 2013. The aim is to protect retail investors, but there is little evidence that prospectuses running to hundreds of pages will help achieve that. Curiously, the European Commission has failed to link PD2 to the 'suitability' criteria under MiFID, which splits investors into three categories of sophistication: retail, professional and eligible.

Paradoxically, PD2 could greatly complicate the relationship between structuring banks and their most sophisticated institutional clients. The problem is exacerbated because the European Securities Markets Authority is struggling to ensure that each national regulator allows banks to passport structured products to all EU members once one regulator has approved them. This could force banks to produce a new prospectus when selling an existing product to a client in a new country.

“The number of potential products is unlimited, because solutions for institutional investors are bespoke, so a bank could structure hundreds of new issues each week. We try to match the regulatory requirements of PD2 with the need for flexibility by using building blocks in our prospectuses, to give clients products that fit market conditions in a short time-to-market,” says Pierre Lescourret, head of structuring for cross-asset solutions at SG CIB.

SEFs

The final US Commodity Futures Trading Commission (CFTC) rule-making that brought swap execution facilities (SEFs) into existence in May 2013 means predictions of the demise of US over-the-counter (OTC) derivatives trading may be premature. But the risk remains that market participants will be pushed into listed futures that attempt to replicate swap economics simply to reduce their regulatory requirements. Trading technology giant Bloomberg, which is registering as a SEF, commenced a lawsuit against the CFTC in March 2013, alleging that the regulator’s “disparate treatment of futures, on the one hand, and financial swaps, on the other hand, has improperly created an opportunity for arbitrage” that threatened the viability of SEFs.

Eric Litvak, head of regulatory strategy at SG CIB, says OTC markets are important for product innovation and maintaining competition with the incumbent exchanges. He views it as an undesirable outcome if market participants elect to move to futures rather than OTC swaps not for the benefits of transparency and standardisation, but simply to avoid unequal regulatory burdens. He is also concerned about the rules on whether a given swap contract is “made available to trade” (MAT) on a SEF. Once a contract is deemed MAT, market participants must trade through the SEF rather than bilaterally.

“As things stand, each SEF itself can declare a new swap contract MAT, and the CFTC has just 10 days to object. This is not really enough time for a proper risk/reward or impact study, and SEFs have an interest in declaring as many contracts as possible MAT even if the liquidity is not there on the SEF,” says Mr Litvak.

VaR

There is a growing regulatory consensus on both sides of the Atlantic that the pre-crisis value-at-risk (VaR) calculation, which measures maximum potential losses for a given period to within a 99% level of confidence, is inadequate. This has led to the adoption of so-called stressed VaR in the interim Basel deal (popularly called Basel 2.5), which requires the inclusion of the worst one-year event in the past, producing a figure that is typically two to three times higher than simple VaR.

The ongoing BCBS Fundamental Review of the Trading Book is pushing toward the adoption of 'expected shortfall', which attempts to measure the potential losses that could result from the 1% tail-risk.

“The difficulty is that, if banks use one year of historic VaR data to build an expected shortfall model in an oversimplified way, there would be very few data points in the tail and the resulting risk measure could be extreme and volatile. Regulators may choose to recalibrate VaR to a 95% confidence level, using expected shortfall on a larger tail to improve the stability of the model,” says Nomura's Mr Epperlein.

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