Finadium: Regulatory Costs of OTC Derivatives vs. Securities Finance Transactions

This Finadium report evaluates regulatory costs in order to determine whether internal balance sheet treatment will push the market towards OTC derivatives in place of Securities Finance Transactions (SFTs, including securities loans and repo). We already observe this happening in securities lending and ask whether evolving regulations will speed the market in this direction.

This report is an analysis of regulatory capital costs that appear to impact market preferences towards OTC derivatives versus physical financing. We evaluate the cost of the Liquidity Coverage Ratio, the Leverage Ratio and capital demands arising from the standardized approach to measuring counterparty credit risk (SA-CCR) to make a determination of whether, in a base case scenario, banks would prefer to conduct their prime brokerage business as a swap or as a Securities Finance Transaction (SFT), specifically as a securities loan. We find that regulatory costs currently favor OTC derivatives in our base case scenario for specific, identifiable reasons, a result that seems contrary to regulatory intentions.

The outcome of this decision at each individual bank is extremely important to financial markets. A physical financing transaction means that volume continues to flow to physical markets. This includes stock exchanges where retail investors and retirement savers make their purchases. A move towards OTC derivatives takes volume out of the underlying markets except for when hedging is required.

While differences will exist between banks, market participants and regulators may want to understand how these calculations are made and the sensitivity of each bank to inputs and outputs.

This report is part of the Finadium Executive Briefing series, providing briefings and analysis to the financial markets industry.

Finadium subscribers with Finadium.com logins can log in to access this report.

For non-subscribers, more information on this report and subscription information is available on the Finadium reports home page.

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