What's the right counterparty exposure limit to CCPs? (Finadium subscribers only)

A recent Basel Committee document revisited a big unanswered question in counterparty credit limit exposures: what should the limit be to CCPs? We evaluate the recent Basel position, provide some historical context and offer our recommendations for best practices.

The big news is that in the April 15, 2014 document “Supervisory framework for measuring and controlling large exposures,” the Basel Committee on Banking Supervision said:

“The Committee will consider the appropriateness of setting out a large exposure limit for banks’ exposures to qualifying central counterparties (QCCPs) after an observation period that will be concluded in 2016. In the meantime, the assumption is that banks’ exposures to QCCPs related to clearing activities are exempted from the large exposures framework.”

CCPs had initially been included in the Dodd-Frank version of this limit setting and this was looming as a big problem. How in fact would big banks trade with one another if they were capped at doing business with their biggest counterparties? CME Clearing was onto this issue early. In a comment letter to the Federal Reserve in April 2012, they noted that Dodd-Frank 165(e) counterparty exposure limits would “unnecessarily constrain the ability of clearing members to use CCPs. This constraint is unnecessary because CCPs are distinguishable from “single” counterparties in general. It is also inconsistent with the spirit of the clearing mandate, since it would reduce incentives to use CCPs.” This matter has been laid to rest in the CCPs’ favor, at least for an observation period.

Further, the Basel Committee says that for non-CCPs, “The sum of all the exposure values of a bank to a single counterparty or to a group of connected counterparties must not be higher than 25% of the bank’s available eligible capital base at all times. However, as explained in Section V, this figure is set at 15% for a G-SIB’s exposures to another G-SIB.”

This is a change from what the going assumption has been until now. A large problem of Dodd-Frank’ Rule 165(e) has been counterparty limits initially set at 25% for banks in general and 10% for SIFIs. Here’s a brief 2012 synopsis on Dodd-Frank 165(e) from The Clearing House.

Exempting CCPs from the counterparty exposure limits solves any hindrance in pushing more activity onto CCPs, that is for certain. The Basel Committee’s new document provides consistency with regulatory thinking across other Basel docs and should push harmonization across different regulatory jurisdictions.

All is not perfect in CCP-land, however. While we agree that CCPs are different than single-name counterparties, the fact is that they have become the next too-big-to-fail entities. We do not buy the Federal Reserve and other regulators’ arguments that in the event of a CCP failure, that Central Banks would not step in and save the day as the lender of last resort (see our April 17, 2014 post, “The solution to the fire-sale problem is buy and hold, but who will put up the cash?“). Making CCPs exempt from counterparty exposure limits exacerbates this problem.

For market practitioners, there are two choices to risk managing CCP exposures: either buy into the general fiction that CCP risk waterfalls will protect the markets under all circumstances or treat the CCP as the sum of its parts. The Basel Committee will allow option 1. Under option 2, if a CCP’s membership is made up of 15 clearing firms, firms can weight the risk accordingly. This weighting would not be for exposure limits but rather for internal risk purposes. It makes no sense for a Bank A bilateral trade to be risk managed one way but a CCP cleared trade where Bank A is a big clearing member to be risk managed in another way: the exposure has clear parallels.

The Basel Committee does great work in setting global standards and they have clarified an important point about CCP exposure limits. This is no fail-safe however, and market participants should remain vigilant about who is backing these CCPs and what might happen in case of market turmoil.

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