What we know about cross-product, risk-based netting and CCPs (Premium Content)

In our recently released research report, “Prime Brokerage: Towards a New Target Operating Model for Financing,” we presented a model on how banks could move client transactions off-balance sheet using a CCP. We gave a couple of examples of specific trades including a collateral upgrade. About an hour after the report went out, we received a call from a client wanting to know more. Was this a future state or something that is happening now? We knew we needed to do more homework before responding. We’re now ready with part 1 of the answer.

Our story so far: in our May 2015 report on prime brokerage financing, we said:

Prime brokers have the option to trade individual securities on CCPs but the process may be cumbersome. In one scenario, it is possible to conduct a GCF repo trade on Eurex Repo directly with an approved buy-side market participant, get cash, then provide that cash back to a client. The prime broker still faces off against the hedge fund in a bilateral relationship. This is not yet an ideal mechanism for the prime broker to fund multiple positions.

We then laid out how a two-sided, multi-product on-exchange collateral upgrade trade would work. The challenge then to a bank is how to execute this trade without getting run over by risk-based capital requirements. To be clear: the bank gets the 2% risk weight from the CCP and can net margin where possible on the CCP. We are talking about just the risk-based capital netting side that would need to occur at the bank for this to be a viable transaction on a widely used basis.

We know the rules of netting are:

  • Are trades executed under a master agreement that allows for netting?
  • Is the settlement system the same?
  • Are counterparties the same?
  • Are maturities the same?

If yes to all these questions, trades can be netted.

We also know that US and European rules are different. European IFRS rules require simultaneous settlement, a headache if ever there was one. For more on netting rules, see the Finadium report, “Netting Rules for Repo, Securities Lending and Prime Brokerage,” September 2014.

That’s the history. Here’s what we know going forward:

We spoke with a number of CCPs and smart market participants about the issue over the last week. We found that THERE ARE CASES TODAY where firms are able to cross-net products traded on the same or linked CCPs. These products are all traded with the CCP under one agreement where the signer is the same legal entity. That is to say, the signer to the CCP agreement cannot be different divisions of the same bank. The products are all based on the same underlying types of securities (ie, equities or fixed income). Other CCPs are working towards this set up very actively, even aggressively you might say. The functionality for allowing risk-based netting on the bank side is largely in place. This is, in our view, a matter of sorting out the accounting and legal mechanics more than it is an operational or functional issue. At times this is an internal project, in other instances it requires a formal recognition by accounting standards bodies.

We have two documented cases of firms allowing this type of netting. We do not however have permission to write up these cases and are working through the appropriate internal channels to get this complete. We have asked for this permission to write up at least an anonymized version of what is going on. If approved, we will provide our findings on Securities Finance Monitor. That will be part 2 of our response.

We also found instances where banks were not allowing cross-product, risk-based netting on a CCP. The reasons for this were entirely based on internal interpretations of accounting rules. There is no one standard yet that would allow cross-product netting based on a set of circumstances related to CCPs (even though IFRS has given CCPs a pass when it comes to the simultaneous settlement requirement.) This is the next big step.

If and when banks approve risk-based netting of cross-product positions that are netting eligible on a CCP, this would enable the collateral upgrade trade we described in our prime brokerage report to be conducted with a much reduced balance sheet impact than without the netting. Our client was right to ask how, where and if this was possible. Our answer is yes, its possible, and we expect its popularity will grow as banks need greater flexibility and ask accounting standards boards, and internal accounting and legal teams, to sign off. Without a generally established acceptance of cross-product, risk-based netting, there will be a substantial inequality between banks that allow netting and banks that don’t.

Related Posts

Previous Post
Mark Carney and Bertrand Badré: Keep finance safe but do not shut out the vulnerable
Next Post
SunGard Files Registration Statement for Proposed Initial Public Offering

Fill out this field
Fill out this field
Please enter a valid email address.


Reset password

Create an account