Regulating Central Counterparties Is Crucial in Avoiding TBTF

The Basel Committee on Bank Supervision released Thursday an important final regulatory capital standard for banks' exposure to central counterparties — institutions that clear and settle trades between financial firms.

While the standard will not take effect until the beginning of 2017, it is of substantial importance to all banks globally as they transition their multitrillion-dollar derivatives portfolios to central counterparties. Banks' derivatives businesses will be significantly affected as banks have to manage carefully not only margin requirements but also capital allocated based on the riskiness of a central counterparty. Moreover, banks' clients, often known as end users, will also be influenced, since banks will want to pass on any additional compliance and auditing costs to them.

Central counterparties have been increasingly in the spotlight since the G-20 decided at its November 2009 Pittsburgh summit that one way of reforming global derivatives markets was to require that banks transition about 85% of the almost $700 trillion over-the-counter global derivatives market to clearing entities.

Since then, central counterparties have been growing in size and in volumes — and that has caught the attention of regulators. Their interconnectedness to the entire global financial sector was made clear by the fact that the Basel Committee worked on the regulatory capital standard closely with the International Organization for Securities Commissions and the Committee on Payment and Settlement Systems.

Stefan Ingves, chairman of the Basel Committee and governor of Sveriges Riksbank, hailed the revised capital requirements for bank exposures to central counterparties as "another important step towards fulfilling our reform agenda." That statement alone should tell all financial institutions that there are more regulations to come.

Ingves made note that their joint work "shows that international standard-setting bodies, through close collaboration, can combine disparate perspectives and arrive at relatively simple solutions for complex issues." These three regulatory bodies had proposed the guidelines in August 2013 and finalized them in only nine months.

The final regulatory capital standards incorporate four key changes that will affect banks active in derivatives markets. The Basel Committee now has a single, new approach for calculating capital requirements for a bank's exposure that arises from its contributions to the mutualized default fund of a qualifying central counterparty, or QCCP.

A QCCP is an entity that is licensed to operate as a central counterparty, including a license granted by way of confirming an exemption, and is permitted by the appropriate regulator to operate as such with respect to the products offered. Clearing member banks will apply a risk weight to their default fund contributions determined according to a Basel prescribed risk-sensitive formula that considers: the size and quality of a qualifying central counterparty's financial resources; the application of those resources in the event one or more clearing member defaults; and its counterparty risk to credit exposure.

Second, where a bank acts as a clearing member of a central counterparty for its own purposes, a risk weight of 2% must be applied to the bank's trade exposure to the centralized counterparty in respect of OTC derivatives, exchange-traded derivative transactions, securities financing transactions and long-settlement transactions. A risk weight of 2% will hardly be a problem for banks to meet; yet before the crisis, banks were not required to risk-weight central counterparties.

Importantly, according to the final standard, regardless of whether a central counterparty is classified as a QCCP, a bank has the responsibility to insure that it maintains adequate capital for its exposures. Additionally, a bank should consider whether it might need to hold capital in excess of the minimum requirements if, for example, its dealings with a central counterparty give rise to more risky exposures or if it is unclear that it meets the definition of a QCCP.

Under the final standard, the standardized approach for counterparty credit risk, as opposed to the Current Exposure Method, will be employed to measure the hypothetical capital requirement of a nonqualified central counterparty. For the U.S., this will be a challenge, since under Dodd-Frank, financial institutions are prohibited from relying solely on ratings, which is the main part of Basel's standardized approach.

Lastly, the final standard also includes guidelines for the treatment of multilevel client structures whereby an institution clears its trades through intermediaries linked to a central counterparty.

No doubt, it will not take long for financial professional associations and central counterparties to declare the final standard as too onerous. Yet, as taxpayers, we need to remember that the main purpose of regulatory capital requirements for banks' exposures to central counterparties is to prevent these entities from becoming the next institutions deemed "too big to fail."

Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm. She is also a faculty member at Financial Markets World and the New York Institute of Finance.