Many market participants fear that the combination of new Basel III collateral requirements and impending OTC derivatives regulations could go too far in trying to protect the market against systemic risk, potentially leading to higher costs for end-users.
The concerns follow the publication on 2 November of a second consultative paper by the Basel Committee, which proposes that banks apply a 2% risk weighting against their central counterparty (CCP) exposures, a requirement that did not exist under Basel II.
“Are we paying extremely high insurance premiums against events that happened in the past, but may well be different to events that bring down the system in the future?” questions Gert Raeves, research director at consultancy TowerGroup. “The new model of risk mitigation is not being challenged, but some think it’s too much given the huge operational burden that will be imposed on the industry on many levels.”
The sheer volume of measures being put in place by regulators to protect against systemic risk increases both uncertainty over the collective impact of the new rules and the possibility of unintended consequences.
The Basel III collateral requirements are in tune with the greater amount of risk that central counterparties will have to shoulder following new regulations – the Dodd Frank Act in the US and the European market infrastructure regulation – that will require the majority of OTC derivatives to be centrally cleared.
The consultation paper proposes a method for CCP members to capitalise their default fund exposure to a clearing house using a risk-sensitive approach based on the actual financial resources of each CCP and its hypothetical capital requirements. The paper also says that non-qualifying CCPs would be subject to a minimum 20% risk weighting. Non-qualifying CCPs are defined as those that do not meet the principles laid out by the Committee of Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) relating to the stability of financial market infrastructures. This includes banks that continue to trade derivatives off-exchange.
The Basel consultation period ends on 25 November, with implementation scheduled for January 2013. The committee notes that while CCPs bring benefits to OTC derivatives markets, they can lead to a concentration of counterparty and operational risks. “If these and other risks to which CCPs are exposed are not well managed, a CCP presents systemic risk that arises from its own potential failure,” read the paper.
However, the paper does recognise that the risk of a clearing house default is low, which explains its decision to pick a low-value risk weighting of 2%.
Raeves says an expected increase in new clearing houses following the new OTC derivatives rules will further encumber market participants if collateral requirements are not adequately managed.
“Managing the Basel requirements without an effective industry-wide mechanism to manage collateral in a streamlined way is a huge undertaking and will lead to the less efficient use of collateral,” he said.
The Basel III requirements follow comments from the Bank of England’s deputy governor in charge of financial stability, Paul Tucker, who stressed the need for an effective resolution regime for CCPs and other financial market infrastructures.
“Orderly resolution is what is needed when a CCP is bankrupt, when we all need somehow to avoid the chaos that follows a standard liquidation of assets and closing out of positions,” Tucker is reported to have said at a conference in Brussels last month.
Diana Chan, CEO of EuroCCP, the European cash equities clearing subsidiary of US post-trade utility DTCC, adds that ability of clearing houses to handle increased levels of risk will depend on the ability of regulators to coordinate their various initiatives.
“Combined, EMIR, Dodd Frank, Basel III and the CPSS-IOSCO principles will determine the minimum risk management standards for CCPs,” said Chan. “But these initiatives are still not finalised. It is crucial that they are in sync and avoid opportunities for regulatory arbitrage.”
She adds that the CPSS-IOSCO principles must be implemented in a “timely and standardised fashion” to avoid the flight of transactions to jurisdictions that impose lower standards on CCPs.