August 8, 2013

?Backwards Regulation Risk Systemic OTC The Is | Should Bilateral Margin and Capital Have Come Before Clearing?

I often notice that the different regulators and the different associated interacting market participants, utilities and commentators dissociate regulations of bank capital (e.g. Basel III) and accounting rules (e.g. US GAAP, IFRS) on one hand from regulations of market practice (e.g. clearing mandate, mandatory bilateral margin) on the other.   Re-associating these may hold the key to making, rather than inhibiting systemic risk reduction happen in practice as well as resolving the cross-border regulatory discussion. In one sense, dissociation is unsurprising as the regulators responsible for each are largely separate i.e. BCBS and accounting standards boards – together with national banking prudential regulators for the former and CFTC, ESMA, SEC for the latter (though there are some overlaps e.g. CFTC /SEC regulate minimum capital for FCMs).  Also the clearing mandate is upon us – while bilateral margin rules and most of the Basel III are some way off. At extremes in theory the balance of systemic risk regulation could range between allowing banks and market participants to do whatever they like subject to holding enough capital to protect the system from their worst excesses and between prescribing very precisely what they do under strong penalties for non-compliance – leaving capital regulations straightforward and a relatively thin layer of final protection.  Common sense says that a balance needs to be struck but it is not really clear where in the regulatory system responsibility lies for striking that balance. In particular, there are specific aspects where the two need to interact quite closely: 1.  Extraterritorial / cross-border treatment for OTC derivatives regulation.  The fact that even within the US the bank regulators are typically responsible for capital regulation (e.g. Fed, OCC, FDIC) but the market regulators are typically responsible for derivatives market practice / mandates (e.g. CFTC, SEC) clearly makes even more tricky the cross-border discussion between markets regulators.  Here a balance is needed between two approaches to protecting tax payers:

  • explicit regulation of foreign subsidiaries by the home regulator which are otherwise logically in a different location, legal jurisdiction and regulatory regime, and
  • parent company minimum capitalization "in consolidation" across all the group entities as the last layer of protection from residual risks in subsidiary entities in locations and regulatory regimes which are different from the home regulator's.

Despite this crucial trade off we barely ever hear the two aspects both mentioned in the same article / discussion or blog post – the focus being on the give and take between domestic and foreign market regulator or between the banks and the markets regulator. 2.  Even more importantly though there is the interaction between OTC capitalization (bank regulators) and the bilateral margin and clearing mandates (markets regulators).  In this case we've spent what seems like 3 years or more implementing the clearing mandate, only to discover now (in my case at least) that:

  • CCP proliferation more than outweighs the CCP risk consolidation benefit unless highly flexible arrangements are created which don't exist today to allow each participant to consolidate their risk in one CCP whilst clearing at several per asset class.
  • The main benefit of CCPs in aggregate is therefore mitigation through initial margin and default fund contributions – which being naturally conservatively defined is an expensive solution.
  • The large measure of the open and uncollateralized systemic risk is contained not in cleared trades but in the pre-mandate legacy portfolios which are exempted by both the clearing and bilateral margin mandates.  Even with regard to bilateral margin this exemption will take the form of grossing up two portfolios – one initially margined and one remaining as is.

What then are the actual means to reduce these systemic risks?

  1. Crude aggregate estimates of the intent of Basel III is that this will roughly triple the counterparty risk driven RWAs and therefore capital set aside on them.  Whilst this will act as an incentive to reduce their risk, on its own this will be quite punitive without the means to respond to the incentive by reducing the risk.
  2. When putting on new trades to reduce the risk, the trades put on will either be mandated to clear (if a mandated product and client) or mandatorily subject to initial margin and effectively in a separate portfolio (if not).  In either case they will not do their job to reduce the risk.
  3. Tear-ups to reduce risk can be done in theory but this would be a highly costly approach from both a realized P&L and an infrastructure cost perspective.
  4. Portfolio backloading to clearing on a mutual elective basis may happen to some degree as the cost of not doing it outweighs the cost of doing in some cases.  The regulations do not push this though.

Of these tools clearly 2 is the most efficient – were it to be allowed.   However, at least in outline the clearing and bilateral margin mandates seem almost to focus on preventing these kind of risk reduction trades and the alternatives cost seem to point to an effect of entrenching the legacy portfolios systemic risk – only to slowly rolling off over many years as portfolios mature.   And all of this for the sake of stemming the creation of systemic risk on new trades.  It appears without more detailed estimates that one effect cancels the other out. A thought: once the bilateral margin and capital rules are in place, it would make sense to keep the clearing regulations but make clearing itself an elective choice once more to free up counterparties to reduce bilateral risk if they mutually choose to do so given the incentive to reduce the costs. Another thought: not that we have this opportunity, but in hindsight it may have been better to regulate capital and bilateral margin first and let this incentive drive clearing – limiting clearing regulations to the other aspects apart from the mandate. Should bilateral margin and capital have come before clearing?  Is the OTC systemic risk regulation backwards? Jon

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