One of our big themes for 2014 and 2015 has been netting rules: what they are now, how they are evolving, and how banks (and hence hedge funds, insurance companies, asset managers and corporations) can take advantage of rules to create the lowest cost, most optimal outcomes. We have some new information to report on netting and CCPs, and commentary on what it all means.
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1) Last month the Basel Committee published Frequently asked questions on the Basel III leverage ratio framework, an update to an October 2014 publication. The section on Exposures and netting of securities financing transactions (SFTs) had a new question of note:
Q3. The Basel III leverage ratio framework refers to the “final contractual exposure” as a replacement for “gross SFT assets recognised for accounting purposes” for SFT assets cleared through qualifying central counterparties (QCCPs). Could you please define “final contractual exposure”?
Answer: “Final contractual exposure” as set out in footnote 19 of the Basel III leverage ratio framework refers to the exposure to the [Qualifying CCP – QCCP] after the process of novation has been applied. However, banks can only net cash receivables and cash payables with a QCCP if the criteria in paragraph 33(i) are met. Any other netting permitted by the QCCP is not permitted for purposes of the Basel III leverage ratio.
Our commentary: First off, paragraph 33(i) is just the same rules of netting that we all know and appreciate (same counterparty, same settlement date, etc.). So if the CCP novates, then the netted down exposure is the final contractual exposure. We understand that CCPs are doing all that they can do meet 33(i) requirements. Most banks know to do this also. Do banks need to validate this figure if the CCP reports back a consolidated number? Maybe not. It seems like its enough for the CCP to say “here’s your final contractual exposure” and call it a day. The CCP model wins again over bilateral transactions.
2) How much business can the sell-side net with the buy-side on CCPs? We’ve been thinking about the promise of the buy-side joining CCPs for securities finance transactions, and while we see great benefits, there will continue to be major markets where CCPs are not available or will take some years to get going. Eurex is the only concrete example, and a recent press release noted that “there are eight Clearing Members now participating in our Lending CCP service – three of which joined in the first half of 2015.” That’s definitely progress. One trick for mass adoption will be whether beneficial owners need to have internal discussions with their boards about CCPs or whether the existing limited powers to act on their behalf given to agent lenders will suffice. If agents can make the CCP decision on their own then this will be very positive. Its still some ways away from a mass movement though, and we may never see UK securities on loan anywhere (thanks, CREST). There is no word yet from the Options Clearing Corp on their plans for including agent lenders. We’d also like to see the DTCC GCF platform for the buy-side go live. As we noted yesterday, the Comprehensive Approach to credit risk management for bilateral SFTs looks pretty nasty. CCPs may let market participants avoid this problem and be the best solution for the market to thrive going forward. But if that’s too complicated, then the OTC derivatives market may beckon.
As an aside, we’d like to see agent lenders figure out how to not bother their clients about moving from securities lending to OTC derivatives (which they will hate en masse), but instead lend the security to themselves then do an OTC derivatives transaction with the street.
3) The UK’s PRA proposed implementing the Leverage Ratio (“Implementing a UK leverage ratio framework,” July 2015) requires reporting of both an end-period leverage ratio and an averaged leverage ratio. “Requiring an averaged figure for a firm’s leverage ratio across the reporting period should largely eliminate incentives to adjust this ratio on any specific date, as any increase achieved is likely to have little impact on the averaged figure.” Ie, this ought to be the end of window dressing. The daily averaged reporting of the Leverage Ratio means that banks will pay close attention to netting on a daily basis. We have long expected this to happen, and this will have important consequences for bank permissiveness with their balance sheets on all trading days, not just end of month or end of quarter.
This is not how it works in the US. The PRA notes that “By contrast, the Supplementary Leverage Ratio adopted in the United States to implement the Basel III standard text requires reporting and disclosure of leverage ratios based on the daily average of on-balance sheet assets and the monthly average of off-balance sheet exposures.” This seemingly counter intuitive decision was made to reduce operational difficulties but may be revisited in the future. This too has implications for averaging out netting costs.[/emember_protected ]