The swaps clearing mandate under the European Markets Infrastructure Regulation is not viable unless regulators relent on Basel III leverage ratio requirements that treat client segregated margin as a levered asset on the balance sheet, the Futures Industry Association in Europe has warned.
Ahead of its annual European International Derivatives Expo to be held in London this week, the industry group – representing 170 firms involved in listed and centrally cleared derivatives markets – is calling on regulators to recognise the exposure-reducing effect of client segregated margin that is held by clearing brokers to back cleared over-the-counter derivatives trades.
“This is essential, to ensure that: there is sufficient balance sheet capacity among clearing brokers to clear the derivatives that are declared subject to mandatory clearing under EMIR; there is sufficient end-user choice in the range of clearing members through which it can clear, and to mitigate the risk of further significant reduction in the availability of clearing,” noted the industry group in its review of the cumulative effect of European derivatives reform.
As part of the G20 commitments that were signed in 2009, global leaders agreed to implement mandatory clearing for all standardised OTC derivatives in addition to reporting all trades to registered data repositories and executing the bulk of transactions through registered electronic platforms.
The industry body has joined a widening call for global regulators to consider the cumulative impact of a rash of new derivatives regulations, including Dodd Frank in the US, EMIR in Europe, the capital requirements directive (CRD IV), and MiFID, which is set to go live in 2017.
The body notes that many regulations do not sit comfortably together, with EMIR and CRD IV proving to be contradictory with respect to the swaps clearing obligation.
“EMIR and CRD IV do not mutually re-enforce the G20 objective of increasing the extent to which derivatives are cleared via CCPs,” the FIA notes.
“Whilst EMIR seeks to promote central clearing, the CRD IV-mandated regulatory capital costs and leverage ratio requirements applicable to central clearing have directly resulted in clearing brokers leaving the industry, thereby reducing access to central clearing.”
Clearing brokers have struggled to make clearing economics work in the current environment. Basel III requirements become binding in 2018, but banks are required to start reporting under the new rules this year.
Last month, Nomura became the latest in a string of firms to throw the towel in on its international OTC client clearing business, following in the footsteps of BNY Mellon, RBS and State Street, which all exited the business over the last couple of years.
Others are believed to be reconsidering their commitment to a low-return business that is acting as a drag on scarce capital resources as banks come under extreme shareholder pressure to boost returns.
“The feedback from our members is that this trend will continue,” the FIA warns.
The leverage ratio may also increase the risk that clients will be unsuccessful in transferring positions in the event of a clearing member default, as non-defaulting brokers may not have the balance sheet capacity to provide the necessary back-up.
To address the growing threat, the FIA supports a change in the way that balance sheet leverage is calculated. It recommends replacing the Current Exposure Method for leverage exposure under Basel III with a new Standardised Approach for Counterparty Credit Risk (SA-CCR) model that would recognise the leverage reducing nature of margin held to back derivatives trades.
Industry recognition of issues surrounding the leverage ratio appear to be gaining some traction with regulators. CFTC chairman Timothy Massad recently noted that the supervisor is involved in dialogue with other regulators on the issue, while the Basel Committee Leveraged Working Group is believed to be close to making some concessions on methodology.
Last week, the European Commission extended its transitional period by another six months for capital charges on bank exposures to CCPs under the Capital Requirements Regulation. The transitional period was due to end on June 15 and will now be extended to December 2015 to reflect the fact that CCPs are still in the authorisation and recognition process, with the US still to be deemed equivalent under EMIR.
As part of its review of European derivatives legislation, the FIA also notes that exchange traded derivatives should be exempt from EMIR reporting rules and the MiFIR pre-execution and straight-through processing regime, to bring the regulation closer in line with the OTC-focus of Dodd Frank.
“The G20 commitments called for OTC derivative contracts to be reported to trade repositories – there was no expectation of requirements in the G20 commitments for exchange-traded derivatives to be reported to trade repositories,” the FIA noted.
