13 October 2014

Financial News: Out-of-step regulators are walking swaps market into trouble

The cost of European banks' exposures to swaps in foreign jurisdictions could soar in mid-December because of a failure by European and US regulators to formally recognise each other’s post-crisis rulebooks.

The issue is set to come into sharp focus this year because of capital treatments arising under Basel III – a set of standards applied across jurisdictions to ensure banks are adequately capitalised. Under the Basel rules, which are being implemented in Europe via the Capital Requirements Directive IV, banks are able to hold a lower level of collateral against trades that are passed through EU-approved clearing houses – also known as qualifying central counterparties, or QCCPs.

While a bank’s exposure to an EU-based CCP or a QCCP is subject to a 2% risk-weighted capital charge, this jumps much higher if the clearing house is not approved by the EU. Before any foreign clearing house can be granted QCCP status, the regulatory regime under which it operates must be deemed equivalent to that in the EU by the ESMA, with a final decision made by the European Commission. Although the EC and the CFTC promised to resolve cross-border issues under their Common Path Forward, announced in July, and are talking daily, formal recognition has not yet been reached. Market participants fear that it will not be achieved by December, when a grace period allowing banks to apply lower risk weightings to non-QCCP cleared trades expires. The December deadline is itself an extension of six months from the date originally set under CRD IV.

According to Simon Puleston Jones, chief executive of futures lobby group FIA Europe, the cost for EU clearing members in terms of regulatory capital with respect to exposure to US CCPs will increase by as much as 150 times if equivalence is not reached by that date.

The core issue in this instance is the differences in margin requirements for futures contracts. Unlike the US, Emir introduces concepts such as anti-pro-cyclicality buffers and additional margin requirements in respect of liquidity or concentration risk. Indirect clearing will be key to effective implementation of the European Market Infrastructure Regulation. Emir is the EU’s response to a commitment made by G20 countries in 2009 to reduce risk in over-the-counter markets, primarily through the adoption of central clearing and trading obligations, as well as reporting requirements. However, one of Emir’s biggest issues is how it encourages smaller institutions to begin clearing their trades for the first time.

Many firms cannot afford to become a direct member of a clearing house, and will typically turn to clearing members to clear trades on their behalf. However, it is often uneconomical for direct clearing members to offer clearing services to smaller clients. But regional banks are reluctant to provide these services because of the impact that different bankruptcy rules across EU member states have on resolving defaults.

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