In theory, it should be difficult to find anybody – from the top investment banker to the managing director of a small or medium-sized enterprise – who would not welcome the recent announcement that planned rules on leverage ratios and collateral for many international banks have been eased by the Basel Committee on Banking Supervision. In practice, though, FX participants live in perennial fear about regulatory standards, despite the fact that balance-sheet pressures on banks, emanating from Basel, are less onerous than feared.
Of some benefit to banks in Europe in particular is the acceptance of netting agreements for each trading counterparty, based on specific currency pairings, maturity, and instrument type, Simon Hills, executive director at the British Bankers’ Association in London, tells Euromoney. This allows banks to offset the value of different assets and liabilities taken on with a single trading partner, reducing the size of their assets when they calculate whether they meet the rule.
This will be a big boon for the quarter of large global lenders that would have failed to meet a June version of the leverage limit had it been in force at the end of 2012, according to data published by the Basel Committee in September.
Additionally positive for the banks, adds Hills, is that certain off-balance-sheet items will also be treated more favourably, and regulators have eliminated some double-counting of derivatives products, including FX, and have made it easier to count a certain type of central bank loan against regulatory standards.
This latter change amends the rule, published last year, designed to force banks to hold enough easy-to-sell assets to survive a 30-day credit squeeze. The amendments to the measure, known as a liquidity-coverage ratio (LCR), widen the possibility for banks to use committed liquidity facilities from central banks to meet the rule.
It will be left to national regulators to decide whether to “make use” of the flexibility, and central banks remain “under no obligation to offer such facilities,” says Stefan Ingves, chairman of the Basel Committee, and the LCR is scheduled to begin being phased in as a binding rule starting next year.
The fact that US banks might be subject to a more stringent leverage ratio of 5% equity to assets and 6% for US bank subsidiaries, according to rules being finalized in the country, against the 3% proposed in Europe, should not, though, open up significant regulatory (and trading) arbitrage opportunities, says Alex Merriman, head of market policy for SIX Securities Services in London.
In any event, all in all, these recent proposed changes would mean banks not having to find an additional amount of key capital of the order of $200 billion at a time when there are still widespread concerns about the supply of credit and economic growth, according to industry sources.
In addition, of course, these new proposals by the Basel Committee are only one tiny part of the overall regulatory architecture that was supposed to have come into effect from last January, but which appears to be as lacking in definitive guidance as it ever was.
January 1 2013 heralded the formal introduction of the Basle III directive (in conjunction with the Dodd-Frank, Mifid II, and Emir rules), which was supposed to have moved the traditionally bilaterally traded OTC FX derivatives markets into a mandatory electronically executed environment, but there still appears to be a long way to go before finalization of the new regulatory architecture, says Jeremy Stretch, head of currency strategy for CIBC in London.
In some key respects, however, although this new operating environment is very similar to the previous long-established exchange-traded derivatives market, there are still concerns over the levels of initial and variation margins required to be posted by market players, and the effect that this will have for accessible – and eligible – capital to enable such trading, despite the recent announcement by the Basel Committee.
“The debate over the leverage ratio is by no means over yet,” Stretch adds. “We now have a common definition from Basle – the next question is how high it will be set. We would argue that 3% is too low and it needs to be raised,” says Thierry Philipponnat, secretary-general of Finance Watch in London.
With eligible balance-sheet collateral now so precious, there appears to be a disincentive to use more exotic structures, even if they are the most appropriate for hedging purposes, because they are incrementally more expensive than vanilla ones, highlights Georges Bory, managing director of Quartet FS in Paris.
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This is particularly pronounced for real-money institutional investors (insurance companies and pension funds primarily) that have not historically been required to post initial margin for bilateral OTC trades conducted under Isda Credit Support Annex agreements, says Stretch. In practical terms, according to industry estimates, the level of initial margin required for longer-dated and more exotic FX products could rise from just the few tens of basis points required now to nearer the 18% to 20% mark of the nominal value of the contract involved.
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Indeed, research carried out by the Investment Management Association identified as “not unusual” the requirement for CCP-eligible collateral equivalent to 20% of the investment value of test portfolios in order to be able to meet initial and variation margin obligations on typical OTC derivatives strategies under mandatory clearing. Moreover, the impact of proposed Emir requirements for collateralization of OTC derivatives trades was calculated to result in an annualized yield drag of 2% for pension funds and 2.5% for insurance funds, due principally to the allocation of 10% to 20% of portfolio assets to cash or near-cash to meet potential variation margin calls.
In short, with a notional $600 trillion of derivatives outstanding in the market, Tabb Group estimates that there is a $1.6 trillion to $2.5 trillion shortfall in eligible collateral in the trading world as a result of the change in regulations.