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Article: Will leverage ratio cause an FCM concentration crisis?

04 March 2015 | Jon Skinner



Risk magazine editor Duncan Wood makes a good point in his article The invisible incentives of clearing (subs. required) - the FSB / BIS ignored leverage ratio effects in concluding that incentives are in place for clearing both on banks self-clearing their trades and on FCMs clearing trades for clients.
 
The FSB's Eighth Progress Report on Implementation of OTC Derivatives Market Reforms (November 7th 2014) and the BIS report it summarizes Regulatory reform of over-the-counter derivatives: an assessment of incentives to clear centrally (October 2014) are pretty readable even for a layman.  The BIS reason for excluding leverage ratio: because in the BIS reports words (page 3) it was "not readily quantifiable".  
 
I understand the impatience to not delay publication as I was involved in an early version of the quantitative impact study (QIS) in 2011 on which the report is based and the QIS was re-started at least once already.  However, leaving out leverage ratio seems to be significant in particular for FCMs.  
 
Is leverage ratio the only FCM reg capital cost?  Afraid not
 
FCMs also have Basel III risk-based capital costs (to the extent client risk is not offset fully by IM or drives default fund capital) and CFTC minimum capital (8% of client and house IM) to worry about.  These are clearly in the background at present.  So let's concentrate on leverage ratio first.
 
The leverage ratio omission might have been justifiable if all participants self-cleared...
 
Self-clearing banks should expect the leverage ratio to improve on clearing a trade.   This is because there is greater likelihood that the trade will net (reducing both the replacement cost and in turn via the net to gross ratio the PFE).  The BIS study also presumed bilateral IM was in place meaning that the total initial margin paid would go down both because of lower MPOR for cleared trades IM methodology and because of greater netting.  
 
We might quibble would be that the bilateral IM mandate is not live at least until December 2015 which means that cleared IM would be an increase in leverage ratio exposure (decrease in the ratio). This is a short-lived effect assuming bilateral IM comes in on schedule in Dec 2015 or a year or two afterwards so let's ignore for now.
 
FCM leverage ratio 101
 
Real quick: leverage ratio is Tier 1 capital divided by leverage ratio exposure (LRE).  LRE consists of - as with all credit risk measures - the sum of current exposure (replacement cost or "RC") and potential future exposure ("PFE add-on").  In clearing variation margin neatly nets off against trade valuations in the RC because it is in trade currency and settled net passing all accounting regime standards.  This leaves us with three parts to the problem:
 
  • RC due to client IM: Client IM paid to the CCP on behalf of the client features as a margin receivable in the replacement cost (RC) element of leverage ratio exposure.  Can be up to 15% of notional for an unhedged long-dated IRS position.  On an average portfolio with netting effects it would be less than this fraction of gross notional.
  • PFE add-on due to client notional: Client notional drives potential future exposure (PFE) "add-on" in the leverage ratio exposure via a grid of add-on percentages driven by asset class, product and time to maturity.  In Rates this can be up to 1.5% of notional for a trade above 5 years to maturity.  The crude Current Exposure Method (CEM) PFE add-on formula doesn't allow for realistic PFE netting.  Instead you apply the netting ratio ("NGR") in the current exposure (i.e. the degree of offset of PVs on out of the money trades vs. in the money trades) and floor the result at 40% of the gross.  There's also no way for initial margin to reduce the PFE in the calculation and in fact it increases the Replacement Cost component being a receivable from the CCP.  In summary, the leverage exposure is 40% or more multiplied by an average percentage in the 0% - 15% range times client cleared trade gross notional.   Even for Rates where addon % only ranges up to 1.5% this can turn into a tidy sum when notionals are in the many trillions.
  • The FCMs role means all capital costs are incremental - Unlike a dealer they are not involved in bilateral trading.  Therefore there is no comparatively expensive set of bilateral capital costs from which clearing then gives relief e.g. higher bilateral IM due to longer MPOR or grossed up replacement cost and NGR given less cross-counterparty netting or higher RWA on uncollateralized trades in bilateral.
The CEM mathematics here are relatively approachable - unlike for RWA.  So much so that we can comfortably simplify and consider an FCMs leverage exposure as largely increasing linearly with client IM and notional.  Now put that together with rates portfolios that have half lives of about 5-7 years and note that we're less than 2 years into the US clearing mandate and the EU / Asia mandates haven't started yet.  It's not hard to imagine a many times multiple over today of client cleared notional and IM.  And FCMs leverage ratio exposure and capital usage with it.
 
What's at stake here?
 
The worst case is that a drag on ROE is more severe than can reasonably be rectified by increasing client fees and there is a significant exodus from the business and an FCM concentration crisis.  The FCA (UK markets regulator) has raised this as a concern according to this Risk article (subs. required). My sketch of the possible scenario would be:
  • The quantum of cleared client notional and risk grows much larger e.g. by 10x (say US grows by 4x, EU + Asia combined are 1.5 x US, so global client cleared notional = 10x today)
  • Some FCMs cannot increase fees enough to become economic in ROE terms or simply cannot put up enough capital to support the business
  • Some FCMs follow the examples of RBS and BNY and State Street and pull the plug on the business with clients moving to remaining FCMs
  • Perhaps some are left without porting FCMs or an FCM defaults and porting doesn't work given dis-incentivized by capital costs
  • FCM consolidation turns into a run for the exit
  • At best, clients end up paying several times higher clearing fees and are exposed to high porting risk
  • At worst, we are left with only a handful of FCMs for each major CCP, non-existent porting and a model that ceased to function

This sounds scary but only happens if the numbers in aggregate drive it there.  So far we've seen sample portfolios or trades not the full economics of the FCMs still in the game which of course are private.

Lobbying crescendo

A crescendo has built up of public letters from among others FIAISDACME and Risk magazine articles (subs required) invoking among others Citi's clearing business, a house committee, the CME futures exchange and even Tim Massad himself.   One notable point in passing is that this applies to cleared futures as well as cleared swaps e.g. eurodollar futures have the same notional x add on % calculation as a swap of the same notional and maturity.  On the other hand it's also worth noting that futures notional automatically nets down unlike swaps where trade compression is needed to achieve similar results. 
 
The main point of the above lobbying is to adjust the Basel III leverage ratio rules in three ways:
 
1.  Allow segregated cleared client IM to be exempt from leverage ratio replacement cost inclusion.  Discrete to client clearing and very logical: bank regulators could do this rapidly.
 
This point was raised in the final draft comments but the Fed register entry for the final US rules dismisses the suggestion without explanation.  Bank regulators already conceded that FCMs don't have exposure on the leg of the client trade facing the CCP.  All this is saying is that they don't have exposure on the IM paid to the CCP either.  This is unique to client clearing and doesn't apply in the bilateral case (where a bank does have exposure to the IM it pays away (to the custodian if segregated or the counterparty if not).  Even Chairman Massad is behind it (see above article link).  No word from bank regulators just yet.
 
2.  Adopt Standardized Approach to Counterparty Credit Risk (SA-CCR) (margined) instead of CEM in the leverage ratio calculation.  Not discrete to client clearing but is the stated intent of bank regulators: may take time to get there.
 
The improvement also applies to bilateral portfolios and provides significant benefits there too.  SA-CCR refers to the Standardized Approach to Counterparty Credit Risk which is a more sophisticated approach which still doesn't rely on internal firm models to calculating derivatives exposure.  The relevant effects are to make PFE add on % and netting more realistic (whilst still conservative). The Citi article above implies significant reductions from this measure alone which are unsurprisingly greatest on less directional Rates portfolios.  The bank regulators stated intent is to do this but only after BCBS to finalizes both the method and its application to leverage ratio.  Then national bank regulators to incorporate (and banks have to implement).  Could be a couple of years or more.
 
3.  Allow client IM to offset PFE on client portfolios.   Not discrete to client clearing but is logical for both bilateral and cleared: may offend the principle of the leverage ratio and even if not may take a long time to get there.
 
Success here may also require a similar argument to be won for bilateral IM to be allowed to offset PFE on bilateral portfolios (since the exposures are essentially the same as an FCM facing a client).  Whilst logical on its face this may offend against the point that the leverage ratio should be easy to calculate and a blunt / simple instrument.  Offsetting initial margin against an exposure measure is not generally a simple matter of subtraction but requires a risk based approach which SA-CCR doesn't even encompass.  Not sure I fancy the changes in what may become a discussion of principles as well as practice.
 
Are there tools FCMs can use apart from capital rule changes?
 
  • Bank accounting policy change.  Citi and UBS both said publically they had taken cash client IM off balance sheet and out of replacement cost under US GAAP rules by changing accounting policy and passing on the interest earned from the CCP directly to the client.  Not sure if this works under IFRS (EU accounting standard).  If it does this may obviate the need for the first rule change above.
  • Client margin optimization.  It is well known that FCMs are working on providing these services.  The FCMs own needs given leverage ratio may be greater than the clients need.  Hedge funds generally optimize IM closely anyway but anecdotally many real-money clients remain comfortably off with regard to available IM funding given they are often have a ready supply of unleveraged eligible bond inventory.  This may change in future but not a burning issue today.
  • Riskless client portfolio compression.  Client clearing notional outstanding plateaued in the second half of 2014 (see chart below).  Given SwapClear client notional trended down does this indicate progress with client compression (TriReduce, SwapClear Coupon Blending, SEF portfolio RFQs from Bloomberg, TradeWeb and TrueEx) or just a general slow down in the market and a loss of clearing volume share to CME?  If it is compression the clients' benefits here are unclear or limited to operational cost savings.  These may be minimal given clearing is quite efficient operationally already compared with bilateral CSAs.

Global Rates Client Cleared Open Interest ($m notional)

 
 
 
(Sources: ClarusFT CCPView, LCH SwapClear)
(Note: February is a week short of a complete month.  Other CCPs total less than 0.2% of open interest and have been excluded)
 
The main question in both cases is how an FCM can persuade its client to do either or both of these things given it is the client's prerogative not the FCMs.  In theory there are some banks who client clear in preference to the burden's of CCP membership.  In practice not sure if there is materiality here as those banks may not be advanced approaches banks in Fed parlance and therefore not immediately subject to leverage ratio disclosures.  Perhaps though FCMs in combination with the original dealers who traded with clients can join together to put riskless unwind packages together and process them through one of the SEF compression tools (albeit allowing the possibility that the original dealer is out bid in RFQ3.  Perhaps there are indirect ways to incentivize this to happen?
 
Will capital rule changes be enough?
 
On the proposed numbered changes above: with a following wind we can hope for solutions to 1 (sooner - by rule change or at least bank accounting policy change) and 2 (later - by rule change).  3 though looks less promising.  
 
If we discount 3, will solutions to 1 and 2 be enough?  Well, the numbers in the Citi article above give a hint by indicating substantial annual client clearing fee increases even after they have tackled the IM replacement cost problem by accounting policy changes and even after SA-CCR is implemented in the leverage ratio.
 
Perhaps clients can tolerate these increase but remember leverage exposure is not the only FCM capital cost driver.   As the global clearing mandate rolls out and matures, client risk may become a substantial driver of total risk in CCPs and therefore of risk driven FCM capital charges.  These include the CFTC's minimum capital rule (8% of total IM) and/or the FCMs default fund capital charge.  
 
So my view is that there's considerable doubt that capital rule changes will get us there.
 
Can we directly de-risk FCMs through a model change?
 
Accounting policy, client margin optimization and client compression may have their place but seem to lack solid incentives on clients to move there at least not quickly.  My question therefore is: what would it take to actually de-risk FCMs?  After all they're supposed to be agency businesses (but have some nasty principal risks).  Why not go all the way and make them pure agents without counterparty exposure to their clients or the CCP on client business?  This might enable the substantial removal of the client driven capital burden directly.  In this way they could improve ROE not by excessive increases in the R but by substantial reductions in the E.   Not saying this will be easy but if successful it will actually reduce the risk and give a fundamental reason to reduce the capital required to support the business.  
 
How we might de-risk FCMs by altering the client clearing model will be the subject of a future post.
 
For now I welcome feedback below or in person at jon.g.skinner@gmail.com.