Basel’s FRTB QIS: Why the Difference?

The Basel Committee on Banking Supervision’s impact studies are useful. They provide regulators with a crucial insight into the possible effect of new capital rules, before those rules are fully finalized. The public release of those studies is also a good thing. Banks, analysts and the media are able to get an early indication of the possible aggregate impact on capital levels, and scrutinize and debate those figures.

The recent release by the Basel Committee of an interim quantitative impact study (QIS) on the Fundamental Review of the Trading Book (FRTB) was therefore greeted with some anticipation. Inevitably, comparisons were made with a recent study published by ISDA, the Global Financial Markets Association and the Institute of International Finance, and run by Global Association of Risk Professionals. Equally inevitably, there was some puzzlement about differences in the numbers.

We thought it would be helpful to explain why. Most importantly, the two reports are looking at different things. The Basel Committee’s impact study uses December 2014 numbers, and is based not on the most recent QIS conducted by the Basel Committee based on June 2015 data (known as QIS 4), but the one before (QIS 3). The Basel Committee has made changes to the framework since QIS 3, including the addition of a residual risk add-on in the standardized approach. Securitization was also not included in the scope of QIS 3, but was added to QIS 4. That means these components, which were two big contributors to the capital numbers included in the industry report, are not incorporated in yesterday’s Basel Committee release.

In comparison, the industry study represents the aggregate results of actual QIS submissions from 28 banks, as part of Basel’s QIS 4 exercise. That QIS exercise was based on submissions that were made to the Basel Committee in early October 2015. QIS 4 was run after the residual risk add-on and the securitization requirements were added to the proposed framework via QIS instructions from the Basel Committee. According to the industry study, the residual risk add-on accounts for 47% of total market risk capital under the standardized approach. The results also show a 2.2 times increase in capital requirements for securitization.

These differences (QIS 3 versus QIS 4; December 2014 data versus June 2015 data) clearly mean the two sets of results can’t be compared like for like.

In its study, the Basel Committee writes:

“Further analysis is being performed in the next trading book QIS (based on end-June 2015 data) to assess any need for further recalibration of the parameters.”

We look forward to a release on the most recent QIS exercise, and we remain committed to constructively work with the Basel Committee to finalize the FRTB framework.

An Elegant Solution

Earlier this month, buy- and sell-side market professionals participated in an ISDA conference in New York on the future of the single-name credit default swaps (CDS) market. (Don’t worry if you missed it – a similar program is being held in London on December 1.)

The session was lively and well attended. The audience heard executives from firms such as General Electric, Blackrock, BlueMountain and Citadel discuss how and why they use CDS to hedge, manage and take risk. They heard that, despite the benefits, single-name CDS trading volumes continue to decline, for a variety of reasons. And they heard about potential solutions that could reinvigorate the market.

What were the key takeaways?

In the words of one panelist, single-name CDS are “an elegant solution” that belong in the portfolio of credit risk management tools. They enable bond investors to hedge the risk that an issuer may default. They also enable investors to diversify their portfolios by taking exposure via single-name CDS to companies that may not issue bonds often, or where physical bonds are difficult to source. In other words, they deliver considerable value to market participants. But despite that value, trading volumes are declining. Some of that decline is due to misperceptions (such as a belief that the use of single-name CDS caused the crisis – it didn’t). Some is due to regulatory uncertainty, some is the result of a benign default risk environment, and some results from the overall decline in structured finance.

One important trend that holds significant potential for the market’s renewal is the move towards central clearing of single-name CDS transactions. Clearing will free up capital on bank balance sheets and could bring much-needed liquidity to the market.

Unlike CDS index trading, there is no mandate to clear single-name CDS contracts. So despite the fact that hundreds of single names are clearable, the uptake for clearing has been relatively slow to date. The onset of margin requirements for non-cleared derivatives in 2016 and beyond will likely change that and incentivize the evolution to clearing.

But in the meantime, firms are considering several different ideas to reinvigorate the market. Some think regulators should mandate clearing of the more liquid single names. Others believe a tiered pricing structure may evolve for cleared and non-cleared single names. The merits of greater electronic trading are also being debated.

One upcoming change expected to occur in December is the move from a quarterly to a semiannual roll date for single-name contracts, which should improve efficiency in the market. It’s a step in the right direction.

We will no doubt see and hear additional ideas at our December conference in London. We at ISDA believe there is a future for the single-name CDS market, and we’re working in a number of ways to make sure that future is safe and efficient for all market participants.

Well Said, Chairman Massad

On the face of it, the mandatory reporting of derivatives transaction data has seen most progress of all the market reform commitments made by the Group of 20 nations in Pittsburgh in 2009. As highlighted in a progress report published by the Financial Stability Board (FSB) last week, 19 out of the 24 FSB jurisdictions have trade reporting requirements in place, and a further three are expected to follow next year. That compares favorably with the 12 out of 24 that have clearing frameworks in place, and the eight that have made progress on electronic trading rules.

But while there has been plenty of progress, significant challenges remain. In particular, a lack of standardization and consistency in reporting requirements within and across jurisdictions has led to concerns about the quality of the data being reported. That’s not good for supervisory authorities, which may be hampered in their ability to fulfill their regulatory obligations. And it’s not good for market participants, who have to meet multiple, different reporting rules and formats, increasing complexity and costs and reducing efficiency. In this sense, progress has been slow, disappointing and frustrating.

We therefore welcome the comments made by Commodity Futures Trading Commission (CFTC) chairman Timothy Massad in a speech last week. He recognized the importance of common identifiers for entities, products and transactions to enable data to be aggregated, and highlighted the need to develop and expand their use. He pointed to an international effort by the Committee on Payments and Market Infrastructures (CPMI) and International Organization of Securities Commissions (IOSCO) to develop guidance on these identifiers – expected next year. In addition, he said the CFTC is looking at the legal issues that prevent the cross-border sharing of data – a point also picked up by the FSB in another report last week.

Importantly, he also stressed the need for standardization in what is reported in the various data fields. There are hundreds of different data fields that must be filled in by reporting institutions – the exact number differs across jurisdictions and regulatory regimes. Often, the format of this information differs from institution to institution and repository to repository. Chairman Massad noted that industry developed standardized terms had not emerged, so the CFTC would work to specify the “form, matter and the allowable values that each data element can have”. The agency plans to publish proposals on roughly 100 fields before the end of the year, he added.

This represents a big step forward, and tallies with principles published by ISDA earlier this year. One thing to stress, however: the industry has been working to develop standards, in terms of taxonomies, transaction identifiers and, most recently, an industry project to develop common product identifiers. One of the big challenges has been the differences in regulatory requirements across jurisdictions. In short, regulators in different countries have asked for different things, in different ways.

In this sense, we welcome the work being conducted by CPMI-IOSCO to develop harmonized principles for key derivatives data elements, as well as unique transaction and product identifiers. Chairman Massad stressed that the CFTC’s in-house standardization efforts would be coordinated with those of CPMI-IOSCO. That is welcome, and important. CPMI-IOSCO is still working on its data harmonization efforts and plans to publish two additional consultations on key derivatives data elements early next year – the second of which will take industry feedback from the proceeding consultations into account. It’s important the CFTC’s work is aligned with this global initiative. Global consistency in rules and requirements is paramount. From that point, industry participants can escalate their ongoing efforts to develop best practices and common standards.