The world’s largest central counterparties are wading through a tough period of regulatory uncertainty, with capital requirements, default fund contributions and Basel III topping their list of concerns.
Representatives from major CCPs including ICE, CME and LCH.Clearnet bemoaned the unintended consequences of Europe’s capital requirements squeezing clearing providers out of the market, at the Futures Industry Association Expo in Chicago last week.
Despite a regulatory push under the European Markets Infrastructure Regulation forcing OTC products to be centrally cleared, heads of the CCPs believe the Basel III capital requirements are conflicting with those intentions. The increased burden is putting an increasing strain on clearing members.
“I find it of great concern that the client clearing model is getting much less attractive and carrying much more costs in the way it is set up,” said Thomas Book, CEO of Eurex Clearing. “That is certainly not within the objectives of regulators.”
RBS and BNY Mellon have both exited the derivatives clearing space in Europe over the past year, while the number of futures commission merchants in the US continues to dwindle.
The cost of providing clearing weighed up against the profitability of the services has forced participants out of the market and could continue to do so with additional Basel III requirements on the horizon.
“We have had an unintended consequence for the economics of being a clearing participants,” said Peter Hiom, deputy chief executive officer, ASX.
“Brokerages have been competed away. We don’t have hundreds of clearing participants, we have 20. We don’t have to lose many before we start to worry.”
One of the main concerns for Sunil Cutinho, senior managing director and president of CME Clearing, is the leverage ratio under Basel III, which raises the bar for banks’ capital requirements even higher.
“The problem is not the leverage ratio itself it is the treatment of clearing under it,” said Cutinho.
“It is very bad from a systemic perspective. Every clearing member is expected to carry their clients’ exposure on their books, and those exposures are based on a very flawed and very simplistic table. It does not give the clearing member an offset of margin against that risk which is very counterintuitive…these rules are driving bank-affiliated clearing firms to get rid of the least leveraged part of their business.”
Pressure is also mounting on CCPs to increase their ‘skin-in-the-game’, the amount of its own financial resources they commit in the event of a member default.
Regulators and central banks are urging clearing houses to put up more capital, however the main concern from CCP chiefs is how much to contribute.
“We have to be clear about what it is there for,” said Michael Davie, chief executive officer, LCH.Clearnet. "Primarily it has to drive behaviour, our job in a default is to protect the surviving members and the CCP so it doesn’t go under and do that with a minimum amount of fuss. The quantum of the skin-in-the-game has to be sufficient that the clearers are just doing the right thing.”
With no prescribed amount of ‘skin-in-the-game’ set by regulators, clearing houses are still evaluating how much to contribute themselves.
Hiom noted that ASX’s contributions account for 65% of its guarantee fund, while CME said it has in excess of USD$350 million.
The panel, which also included the heads of the London Metal Exchange Clearing House and ICE Clear Europe, concurred that ‘skin-in-the-game’ is necessary as an incentive to implement the best risk management systems.
“If you are taking the first loss you have greater incentive to actually make sure you perform default management correctly,” added Cutinho.
“It is all a question of incentives, everything in clearing is structured around incentives.”