For most of us in the northern hemisphere, April denotes the real start of spring, and with it, the opportunity for a little spring cleaning. The Basel Committee on Banking Supervision has marked the season with some spring cleaning of its own, reopening its leverage ratio for consultation this month.
ISDA welcomes this development – and it’s something we’ve been calling on for some time. The leverage ratio has been a cause for concern for derivatives market participants since its finalization in early 2014, in large part because of how it would affect client clearing. That’s because the leverage ratio, as currently formulated, doesn’t recognize that properly segregated client collateral reduces exposure for firms that provide clearing services. This means the amount of capital required to support client clearing services is not appropriately calibrated with the risks of that business. The end result: the economics of client clearing becomes extremely difficult for clearing members that provide this service, which runs counter to the objective set by the Group-of-20 nations to encourage central clearing.
The latest paper proposes a number of changes to the leverage-ratio calculation. It suggests replacing the current exposure method (CEM) with the standardized approach for counterparty credit risk (SA-CCR). On the face of it, this is a helpful change: the CEM is a fairly blunt methodology that doesn’t differentiate between margined and non-margin trades, and doesn’t recognize netting in any meaningful way. In comparison, SA-CCR is more risk-sensitive.
It’s disappointing, though, that the Basel Committee chose not include the issue of whether to recognize collateral posted by counterparties within the spring clean. The consultation offered a good opportunity to obtain evidence and consider the impact of recognizing segregated client margin as an offset to potential future exposure (PFE, one of the key components of the leverage-ratio calculation) under SA-CCR. ISDA maintains that properly segregated initial margin posted by a counterparty is not a source of leverage and risk exposure for a bank. On the contrary, it reduces exposure by covering losses that may be left by a defaulting counterparty.
The good news is that the Basel Committee has said it will specifically look at this issue with regards to client clearing. Over the coming months, it will collect data via an additional quantitative impact study to help determine the impact of the leverage ratio on client clearing. Depending on the result, it may consider allowing a clearing member’s PFE to be offset by initial margin posted by a client for cleared trades.
Among the other notable features of the proposal is a decision to maintain the margin period of risk (MPOR) in line with the SA-CCR, where the level depends on whether the transaction is cleared and collateralised, among other things. Under this approach, a cleared transaction subject to daily margining would attract an MPOR of five days – a reduction in the time horizon that should decrease clearing-member PFE compared to the CEM.
It’s too early to provide detailed feedback at this stage, but ISDA welcomes the opportunity to respond on this, and we will work with our members over the weeks and months to provide facts on the cost of not recognizing the risk-reducing impact of margin.
Clearing has become an extremely important feature of the derivatives market. As such, it’s vitally important we get this measure right.