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Two regulations in particular will combine to make clearing too punitive, particularly in Europe, said market participants, speaking on a panel at the ISDA annual European conference in London yesterday.
The first is the leverage ratio, contained within Basel III but only now being fleshed out by regulators. Under the European, principal-driven clearing model, a transaction where a client clears via a clearing member would be classed as two trades – client with clearing member and clearing member with central counterparty (CCP). Market participants believe both sides would count towards the bank's leverage exposure – significantly inflating capital requirements.
The other element is the proposed revisions to the capital treatment of bank exposures to CCPs, which are intended to replace interim rules published in July 2012. These rules were criticised heavily by participants on the panel, who argued a dollar-for-dollar capital requirement for default fund contributions was excessive.
"Under the current proposals, banks will have to hold 100 per cent of the minimum default contribution's size in capital. The reason for this is because regulators want any potential massive default to be contained, and for participants to be able to continue clearing. But to the industry, this just looks like capital on capital. If banks have to hold 100 per cent of the default fund in capital, then the question should be that if clearing is so unsafe as to require that much capital to be held against the exposure, why mandate it in the first place? This does not create incentives to clear trades", said Ulrich Karl, CCP director in the financial institutions group at HSBC.
The sentiment was echoed by Athanassios Diplas, senior adviser to the ISDA board and principal at Diplas Advisors LLC, who argued the proposals effectively treat default fund contributions like the first-loss tranche of a collateralised debt obligation (CDO), when in fact they are the most senior part of the default waterfall.
"When you talk about the default contributions of non-defaulting clearing members, it is only to be used in the event that all other resources have been exhausted. That includes the defaulting member's variation margin, initial margin and own contribution to the default fund, followed by the capital slice of the clearing house. Only then will the other members' default fund be used. To use an analogy, this is like taking the super-senior tranche of a CDO, but treating it like a first-loss equity tranche. That is illogical and creates perverse incentives, and makes it very difficult for firms to provide clearing services for clients", he said.
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