Counterparty Credit Risk - November 2012 Catalyst 167 Fleet Street London EC4A 2EA www.catalyst.co.uk Catalyst Development Limited
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Catalyst Update: Final CRD IV Rules: Impact on Capital Requirements for Counterparty Credit Risk November 2012 Catalyst 167 Fleet Street London EC4A 2EA www.catalyst.co.uk © Catalyst Development Limited
Introduction Strengthened requirements for the
management and capitalisation of
In July 2011, the European Commission counterparty credit risk
published a proposal version of the
Requirements for more detailed public
Capital Requirements Directive, which is
disclosures of regulatory capital bases.
the European implementation of the Basel
III rules and provides a much needed Understanding and preparing for the
refresh of the existing capital challenges created by this new regulation
requirements framework. will drive the key strategic and operational
decisions required to consolidate and
All European entities will have to comply build competitive positioning for all
with CRD IV, while their counterparts in market participants.
other jurisdictions (ie the US) will need to
comply with their local Basel III This paper looks at the impact of the
implementation. currently proposed CRD IV text on both
buy1 and sell sides, with regards to the
A vote on the final text by the Commission strengthening of capital requirements to
was expected to take place during 2012, reduce counterparty credit risk on trade
but has been repeatedly delayed and at exposures.
the time of writing (end November 2012)
has still not been released.
What is known is that EU Member States Incentivisation of Central
have to transpose, and firms of the Counterparty Clearing
financial service industry have to apply,
the CRD from January 1, 2013, although Under CRD 1V rules, material capital
the UK FSA is postponing the savings can occur for institutions entering
implementation date of CRD IV to July 1, their trades into clearing, either through
2013. It is likely that other EU member Clearing Brokers or through a direct CCP
states will follow. Membership.
CRD IV introduces
Bilateral trading will become more
New liquidity requirements expensive with the introduction of a
CVA charge and a possible margin
A re-definition of what constitutes requirement for bilateral trades.
capital
Amended capital deductions
The objective of recent regulation has
Increased levels of capital required been to reduce risks across the board -
A number of new capital buffers and Central Counterparty Clearing is seen
as the means to that end.
The implementation of new leverage
requirements
1
firms.
2Bi-lateral trading of OTC Derivatives is The CCP, on which trades are cleared
being dis-incentivised with
(a) is authorised to provide Clearing
the need for high capital requirements
(any bilateral trade will receive a state
minimum capital weighting of 20%, which
(b) publicly confirms that the CCP
can be much higher if there is a complies with recommendations
substantial element of trade activity to for central counterparties
counterparties A+ and below and/or for published by CPSS-IOSCO
longer maturity products)
(c) does not reject the trades
the introduction of a CVA charge to
However, clients of Clearing Brokers who
hedge against a deterioration in the credit
are not direct members of CCPs face more
quality of institutions counterparties for
stringent requirements in order to receive
bilateral OTC derivatives (and possibly, if
capital reliefs.
the IOSCO proposal from July 2012 is
accepted, the introduction of a margin The CCP and the Clearing Broker of the
requirement for bilateral trades) clients have to guarantee portability of
assets and positions in the event that the
Clients of Clearing brokers face stringent Clearing Broker defaults.
requirements to get capital reliefs
The Portability guarantee is accompanied
by the implied requirement that the client
provides the Clearing Broker and the CCP
Large Exposure limits trade exposures with a minimum of one Back-up Broker to
to a single counterparty or group of which to port positions. A Back-up
connected counterparties of above 25% Clearing Broker contractually bound to a
will require additional capital (on a scale client is exempt from the capital
from 200% to 1250%) to cover the requirements for counterparty credit risk
counterparty risk. exposure for those assets.
Conversely, capital requirements for The Clearing Broker has to provide
cleared trades are slightly raised to 2% asset and position protection for all
(from currently 0%) if certain prerequisite clearing related transactions. If assets are
criteria are fulfilled by the Clearing Broker, protected from a default of the Clearing
the CCP (and the buy-side client): Broker, then exposures to the collateral
are exempt from capital requirements.
Clearing trades under CRD IV will result in assets and positions need
substantial capital savings (compared to bi- to be segregated from other clients and
lateral trades) for buy and sell sides alike. from the CB s own positions and assets at
the Clearing Broker and the CCP level.
So on a simplistic basis, clearing trades
under CRD IV will result in substantial
3capital savings (compared to bi-lateral impose higher (than 2%) capital
trades) for buy and sell sides alike. requirements for cleared trades. At this
time (November 2012), no Regulator has
Differences to Basel III made an announcement in this respect.
The CRD IV proposal differs from the Basel Global players with entities in other
III regulations with regard to the Capital jurisdictions will find it difficult to
requirements for counterparty risk in implement one approach due to regional
mainly three points: implementation differences of the Basel III
rulebook.
The EC applies a 0% weighting as a
stabilising measure (most likely politically
What is the impact of CRD IV?
motivated) for trade exposures to
selected Central Banks and Sovereigns. Mandatory clearing of clearable
derivatives will drive buy-side clients in
Basel III includes a Loss Protection for
either of two directions, (1) to move out
clients as part of the qualification criteria
of products which are subject to
for the application of a reduced risk
mandatory clearing or (2) to choose
weighting of 2% for centrally cleared
Clearing Brokers which offer Client
trades a Clearing Broker must provide its
Clearing services for the relevant products
clients protection from losses due to
and fulfil the CRD IV requirements to
(a) its own default/insolvency qualify the client for capital relief for trade
exposures.
(b) the default/insolvency of one or
many of its clients; and
Global players with entities in other
(c) the joint default/insolvency of jurisdictions will find it difficult to
itself and one or many of its implement one approach due to regional
implementation differences of the Basel III
clients.
rulebook.
Basel III consists of a 4% risk weighting
for cleared trades in the event that the
Portability, Segregation, Asset Protection
criteria are satisfied, but clients are only Clients resisting a change of their portfolio
provided a Loss Protection in the case a to include more clearable OTC
joint default/insolvency of the Clearing transactions will not only suffer high
Broker and one or many of its clients capital requirements but also be subject
happens. This 4% weighting does not exist to CVA charges and possibly margin
in CRD IV. requirements for remaining bilateral.
Differences to Basel III will prevail in Clearing Brokers in turn will struggle to
future, and possibly widen. Despite a satisfy the increased demand for Client
single European rulebook being Clearing Services and for increasing
introduced in the near future, local number of client requests to act as Back-
regulators have been given the right to up Clearing Brokers in the event of their
4primary Clearing Broker going into default released, we do not anticipate any
or becoming insolvent. material change from the existing drafts.
Specifically, portability will be a big issue A majority of buy-side clients will not yet
for Clearing Brokers. Accepting a client have made any decisions on their long-
portfolio from a defaulting Clearing term OTC strategy. However, as the
member will most likely result in an implementation deadline approaches, it is
additional default fund contribution by imperative that the buy-sides are either
the CCP, which in turn would require ready to implement the changes needed
more capital to be held against it. to receive capital relief, or pull out of the
OTC market altogether. There is a risk,
There are many other challenges to be
that buy-sides who wait too long, will very
addressed by sell-side institutions
quickly be forced out of the OTC market.
resulting out of the counterparty credit
risk measures stipulated by CRD IV. These Buy-side clients also need to review their
include: long-term trading / investment strategy
and assess whether they want to
indirect clearing responsibilities
restructure their portfolio to take
(for clients of intermediary
advantage of reduced capital
Clearing brokers)
requirements for cleared trades and
higher quality asset requirements substitute non clearable transactions with
by CCPs (which will stress a economically similar clearable ones.
Clearing Brokers ability to
transform ineligible collateral from It is imperative to conduct this assessment
a client into eligible ones) at the earliest possible timeframe, as
disappearing benefits of and contractual reviews and (re-)negotiations
profitability in relation to offering with Clearing Brokers traditionally take
client clearing services, regulatory their time, especially if less favourable
uncertainty (such as the Danish criteria, such as portability, need to be
Compromise from April 2012) included in order to provide buy-side
regulatory implementation clients the sought after capital relief for
variations in different regions, cleared transactions.
compliance with other non
harmonised regulation.
The majority of Buy-side clients have not
made any decisions yet on what their next
What should market participants do steps will be. Buy-sides waiting for final
before the CRD IV implementation date? regulations to be defined could face being
Despite regulatory uncertainty, and the eviction from the OTC market.
possibility of further requirements to be
added to the final text, it is crucial that all
market participants are fully prepared in One of the most important tasks will be
advance of the implementation date. contractually to fix relationships with
Although the final text has yet to be Back-up Clearing Brokers, which in turn
5will only agree to assume a Back-up which will provide capital relief to most
Clearing Broker role under heavily limited buy-side clients, and that a secondary
and constraint conditions. market of intermediary Clearing Brokers
will develop. This will be accompanied by
Generally the Clearing Broker offerings
technological, infrastructure and
are being geared towards the larger hedge
operational challenges within each market
funds and asset managers. Medium and
participant.
smaller banks with OTC derivatives
portfolios face the choice of either Conclusion
applying for direct membership of CCPs or
terminating their use of OTC derivatives. As the CRD IV and Basel III
implementation date approaches, those
Sell-sides will initially have to focus on sell-sides and the buy-sides which adapt
understanding the raft of new regulations to the changing regulatory requirements
with regard to Derivatives Clearing, the best will be reaping the highest
specifically with a focus on regional benefits, either in the form of capital
implementation differences, and then re- savings or increased business flow.
assess - not dissimilar to the buy-side
clients - their future strategy in relation to It is therefore imperative for both sides to
the OTC Derivatives business. assess their own long-term trading
strategy and to choose their next steps as
It is likely that sell-sides will initially be early as possible - or be forced into a
cautious to offer client clearing services decision by the market.
Another impact of the regulation is that
those OTC products for which no clearing Catalyst Contacts
solution exists (such as cross currency Christian Lee
swaps) may become more expensive and Head of Risk & Clearing
+44 (0) 870 901 4155
thus less economic to use. Users will be christianlee@catalyst.co.uk
seeking to proxy the economic impact of
these products through the use of
exchange traded or vanilla swaps. Shareque Husain-Syed
Senior Consultant
Risk & Clearing Practice
+44 (0) 870 901 4155
sharequehusain-syed@catalyst.co.uk
Sell-sides are cautious in their approach to
offer client clearing services until final
regulations and regional differences are
Catalyst is a specialist consultancy working
fully understood. exclusively in Capital Markets. We re-engineer
operating models, deliver programmes of
change and develop leadership & management
capability in Technology, Operations and
Central Counterparty Clearing.
www.catalyst.co.uk
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