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October 30, 2013

Deja vu? Latest Basel III CCP capital rules may make CCP membership uneconomical | Risk.net Clearing Member poll

Risk.net conducted a poll of clearing members, a big majority of whom think CCP membership will become uneconomical under newest proposed risk-based and leverage ratio capitalization of CCP related portfolios.

Risk's article summarizing this Leverage and CCP capital proposals will hurt clearing (subs required) echoes the message in the joint ISDA / GFMA / trades association letters here and here on the topic.

In a nutshell, the trades associations letters headline the following points:

  • Removing the cap in the 2012 rules and redesigning the "two member default" fund risk based capitalization methods to become more risk-sensitive has failed to appropriately reflect the risk, over-capitalizing by at least 25x-40x depending on method used.
  • Leverage ratio rules punish rather than incentivizing use of collateral, understate PFE (Potential Future Exposure) netting benefit because of CEM (Current Exposure Method) rather than NIMM (Non-Internal Model Method) and capitalize exposures on CCP-facing client legs which don't normally legally exist.

Paraphrasing the overall message, banks / the trade associations are saying they are incentivized to pull out of being clearing members and instead clear through a third party because the above costs outweigh portfolio netting benefits and low risk weights for trade exposures to CCPs.   BCBS has continually stated it is not intending for this to happen (after all who would the dealers clear through given the lack of a glut of non-banks members despite the opening up by CCPs).

As we go around this loop again – I'm curious on the sizing of the CCP capitalization which result from the newest rule.  I'm also provoked to ask which of the following paths we're on:

A.  We home in on a final rule which is a balanced, risk-sensitive, prudent and capital efficient solution which incentivizes CCPs to be robustly set up and doesn't excessively or punitively charge banks to want to be clearing members and to provide client clearing.

B.  In fact,  CCPs are not a safe as we thought and this is what is really driving high capitalization charges not inappropriate rule designs.

Answers on a (virtual) postcard please (and any publicly available quantitative estimates too if available).

More details for those interested

The 2012 CCP default fund capital rule contained two alternative methods:  Method 1 which aims to capitalize based on CCPs default resources, member exposures, and the effect of the default waterfall; while Method 2 was a catch all which capitalized default fund contributions at 1250% (i.e. $1 of capital for each $1 of default fund contributions) with a cap of 20% of member trade exposures.

The 2013 CCP default fund capitalization version replaces Method 1 with the Tranches Approach and Method 2 with the Ratio Approach.   Among many comments in the trade association letters the Ratio Approach – even though it incorporates the new NIMM method which is acknowledged as more risk sensitive – is still said by the trades associations to be over-capitalized by between 25x and 63x because of the basis around "cover*" – the minimum default fund contribution level set by IOSCO/BCBS without regard for the remote likelihood of default of all the members.   The Tranches method is preferred although even it is said to be calibrated at 40x too much based on a key constant factor being overstated.

In addition it is mooted that trade exposures previously capitalized at 2% for QCCPs are now capitalized at between 2% and 5% with 5% being more likely given CCP incentives.

For leverage ratio CCP trade portfolio exposures are calculated as replacement cost (RC) plus potential future exposure (PFE) add-on.   The trades associations letter headlines are:

  • Collateral exposure reducing effects are not recognized, collateral pledged is grossed up and collateral re-hypothecation is subject to many conditions
  • Counterparty netting is allowed but in the PFE term the effect is limited by the CEM like method proposed (rather than say a NIMM type method)
  • The CCP facing leg of client cleared trades are treated as a full exposure when normally the client (not the member) is legally on the hook for its portfolio when a CCP fails.

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