Will leverage ratio cause an FCM concentration crisis?
Risk magazine editor Duncan Wood makes a good point in his article The invisible incentives of clearing (subs. required) – the FSB / BIS ignored leverage ratio effects in concluding that incentives are in place for clearing both on banks self-clearing their trades and on FCMs clearing trades for clients.
- RC due to client IM: Client IM paid to the CCP on behalf of the client features as a margin receivable in the replacement cost (RC) element of leverage ratio exposure. Can be up to 15% of notional for an unhedged long-dated IRS position. On an average portfolio with netting effects it would be less than this fraction of gross notional.
- PFE add-on due to client notional: Client notional drives potential future exposure (PFE) "add-on" in the leverage ratio exposure via a grid of add-on percentages driven by asset class, product and time to maturity. In Rates this can be up to 1.5% of notional for a trade above 5 years to maturity. The crude Current Exposure Method (CEM) PFE add-on formula doesn't allow for realistic PFE netting. Instead you apply the netting ratio ("NGR") in the current exposure (i.e. the degree of offset of PVs on out of the money trades vs. in the money trades) and floor the result at 40% of the gross. There's also no way for initial margin to reduce the PFE in the calculation and in fact it increases the Replacement Cost component being a receivable from the CCP. In summary, the leverage exposure is 40% or more multiplied by an average percentage in the 0% – 15% range times client cleared trade gross notional. Even for Rates where addon % only ranges up to 1.5% this can turn into a tidy sum when notionals are in the many trillions.
- The FCMs role means all capital costs are incremental – Unlike a dealer they are not involved in bilateral trading. Therefore there is no comparatively expensive set of bilateral capital costs from which clearing then gives relief e.g. higher bilateral IM due to longer MPOR or grossed up replacement cost and NGR given less cross-counterparty netting or higher RWA on uncollateralized trades in bilateral.
- The quantum of cleared client notional and risk grows much larger e.g. by 10x (say US grows by 4x, EU + Asia combined are 1.5 x US, so global client cleared notional = 10x today)
- Some FCMs cannot increase fees enough to become economic in ROE terms or simply cannot put up enough capital to support the business
- Some FCMs follow the examples of RBS and BNY and State Street and pull the plug on the business with clients moving to remaining FCMs
- Perhaps some are left without porting FCMs or an FCM defaults and porting doesn't work given dis-incentivized by capital costs
- FCM consolidation turns into a run for the exit
- At best, clients end up paying several times higher clearing fees and are exposed to high porting risk
- At worst, we are left with only a handful of FCMs for each major CCP, non-existent porting and a model that ceased to function
This sounds scary but only happens if the numbers in aggregate drive it there. So far we've seen sample portfolios or trades not the full economics of the FCMs still in the game which of course are private.
- Bank accounting policy change. Citi and UBS both said publically they had taken cash client IM off balance sheet and out of replacement cost under US GAAP rules by changing accounting policy and passing on the interest earned from the CCP directly to the client. Not sure if this works under IFRS (EU accounting standard). If it does this may obviate the need for the first rule change above.
- Client margin optimization. It is well known that FCMs are working on providing these services. The FCMs own needs given leverage ratio may be greater than the clients need. Hedge funds generally optimize IM closely anyway but anecdotally many real-money clients remain comfortably off with regard to available IM funding given they are often have a ready supply of unleveraged eligible bond inventory. This may change in future but not a burning issue today.
- Riskless client portfolio compression. Client clearing notional outstanding plateaued in the second half of 2014 (see chart below). Given SwapClear client notional trended down does this indicate progress with client compression (TriReduce, SwapClear Coupon Blending, SEF portfolio RFQs from Bloomberg, TradeWeb and TrueEx) or just a general slow down in the market and a loss of clearing volume share to CME? If it is compression the clients' benefits here are unclear or limited to operational cost savings. These may be minimal given clearing is quite efficient operationally already compared with bilateral CSAs.
Global Rates Client Cleared Open Interest ($m notional)