Regulators have looked to central clearing as a solution for many ills in the derivatives market, but banks are now saying that they may be unable to offer a clearing house connection to clients because of costs imposed by another new regulatory measure: the leverage ratio.

For the past five years or so, regulators across the globe have endeavoured to knock the over-the-counter (OTC) derivatives market into a shape more closely resembling the exchange-based equities market – more standardised, more transparent, and above all, less risky. 

This has brought about the introduction of central clearing for the vast majority of standardised OTC contracts. Under this plan, the market moves away from the highly fragmented, bilateral relationships that prevailed pre-2008 to a structure where central counterparties (CCPs) scoop up the credit risk and, using the collateral and default fund contributions from their members, make everybody whole again if one participant goes bust. 

One flaw in the widespread use of clearing is that direct access to clearing houses is fearfully expensive. Members pay entry fees, make default fund contributions, and in some cases theoretically have an unlimited commitment to provide the CCP with cash to keep it upright during severe market stress when a number of other clearing members may have defaulted. Then there is the sizeable task of connecting all the necessary trading and risk management software.

Choppy waters 

The upshot of all this is that the only firms with the financial muscle to join as clearing members are large dealer banks. Buy-side participants must access a CCP via a ‘client clearing’ relationship with their bank, referred to in this instance as a futures clearing merchant (FCM). If a buy-side firm is a participant to a clearable trade, it inputs the details into the bank’s system, which then passes it on to be cleared at the CCP. The bank then handles any collateral payments that need to be made via the CCP to the counterparty on the other side of the trade during its lifetime. Buy-side clients must also submit an initial margin fee with every trade that is kept in a segregated account by the bank to be used in the event of the default of either participant to the trade. 

This is where, currently, the client clearing model hits choppy waters. The latest version of the Basel III leverage ratio, agreed in November 2014, treats these initial margin payments as exposures, meaning that banks must assign capital towards them. 

“For the purposes of calculating the leverage ratio exposure, initial margin collected from clients and held in segregated accounts count towards the collecting entity’s exposure,” says Eric Litvack, head of regulatory strategy at Société Générale in London. “This is despite the fact that initial margin actually reduces exposure as it provides funds that can be used in the event of a client default.”

An endgame scenario 

Client clearing is already a low-margin business, and dealers are worried that this extra expense may kill off the entire enterprise. Supervisors appear to have shot themselves in the foot by attaching a high regulatory capital cost to a process that they deem vital for the safety of global derivatives markets. 

The Basel leverage ratio currently stands at 3%, though individual member countries are given free rein to apply a higher treatment if they wish. The Bank of England has already warned banks that it may install a leverage ratio of 4.95% by the end of this decade, and regulators in the US, where support for the measure is strongest, use a 6% measure for their largest banks. The Basel Committee has announced that it aims to re-calibrate and finalise its minimum standard for the ratio in the next 18 months, a process that could see it increased beyond 3%. 

Regarding the practical impact of the ratio, Mr Litvack says: “A trade with a notional value of $100m might call for $15m of initial margin, depending on the risk profile of the instrument. As soon as it hits the segregated account, that $15m is counted as leverage ratio exposure. If the leverage ratio is set at 4%, say, that means I need to put up $600,000 of capital toward that exposure.” 

For a large bank with a significant number of clearing clients, that figure will rapidly increase as new trades are added to the book. Many banks originally viewed the provision of client clearing as a service that could be subsidised by run-of-the-mill execution services. This view has evolved in recent years as the true cost of operating such a business become clearer. Client clearing margins are tight, and banks, though coy on the subject, are beginning to implement pricing mechanism for the service. The leverage ratio issue means that these mechanisms will have to be reassessed. 

“To achieve a reasonable rate of return on the equity capital required, absent a reduction in the exposure calculation, the return on the balance sheet assets would need to be considerably higher than current levels. Even with an ambitious cost-to-income ratio, the target return on assets would need to rise closer to 100 basis points” says Mr Litvack.

Mass pull out 

Clients may baulk at paying up, and if banks cannot square this circle, they will be forced to pull out of providing the service. Some banks have already done so. The client clearing businesses of Bank of New York Mellon, State Street, Royal Bank of Scotland and Nomura have already bitten the dust. Bill Stenning, managing director for clearing, regulatory and strategic affairs at Société Générale, is worried about over-concentration in the market. 

“What number is too small a number of client clearers? For sure, there could be a severe capacity problem by the end of next year, when clearing will be mandatory for most market participants,” he says. “We are probably not yet at the stage of having too few providers, but that may soon change if we continue down this road. In the end, too much concentration is not the friend of clearing. Already, about 50% of OTC derivative client collateral in the US is held by the top three FCMs, and close to 75% is held by the top six."

There are signs that regulators recognise this problem. Timothy Massad, chairman of the US Commodity Futures Trading Commission (CFTC), recently stated that segregated initial margin should be treated differently to other run-of-the-mill exposures under the leverage ratio. A US Congressional committee has also called for an exemption for initial margin. However, a final decision may not be reached until 2017 at the earliest. For proponents of the leverage ratio, its blindness to risk is its strongest feature, as unlike capital modelling it cannot be easily gamed by banks. There are fears that allowing one exception to this rule would open the door to a host of others. 

“I expect this issue to be at least partially, though possibly not wholly, addressed” says Mr Litvack. “The eventual definition has to be sufficiently robust, fair and applicable across all jurisdictions. Clearing is an important step forward for the market, so the regulatory costs that surround it must be manageable.” 

Equivalency regimes 

While banks and regulators clash over the leverage ratio, there is just as much toing and froing over the clearing rules within the regulatory community. One of the main problems is the perceived overreach of US supervisors in their definition of who counts as a ‘US person’ and is thus under the remit of US clearing rules. 

Guidelines written for the Dodd-Frank Act by the CFTC state that any buy-side fund with a principal place of business in the US, or that has more than 50% of its investors based in the US, is defined as a US person. The latter criteria sweeps up a number of European funds that are also subject to the clearing rules found in the European Markets Infrastructure Regulation. Currently, the two regimes have markedly different approaches to a number of clearing processes, such as segregation of client collateral. Any fund that falls under both frameworks will find it impossible to clear trades without being in breach of one of them. 

“No one wants to break one set of rules. It’s not a palatable option,” says Adam Jacobs, global head of markets regulation at the Alternative Investment Management Association in London. “But, that is one option available if some funds want to clear any trades at all. Another is to prevent US investors from making up more than 50% of the fund’s size, but with so much investment flooding into Europe from the US these days, that would be very hard to do without stunting the growth of the fund.” 

US and EU regulators have frequently spoken of the ‘Path Forward’, a project that is supposed to smooth out differences between regulatory regimes on each side of the Atlantic. However, little progress has been made on a number of issues, including the problems surrounding the US persons rule. The CFTC has refused to budge from its strict approach in other areas, most notably in refusing to compromise on an equivalency regime for European trading platforms that want to offer services to US clients under the swap execution facility format. 

One unforeseen consequence of the US persons rule might be to further limit the pool of client clearers for funds that fall under its remit. “European dealers might not want to touch European funds that are defined as US persons because they won’t want to be snarled up in US regulations themselves and get caught in horrible overlap of requirements. We might end up seeing a complete bifurcation of clearing liquidity between Europe, the US and other regions, which I don’t think is something the regulators envisaged at all,” says Mr Jacobs.


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