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Derivatives caught in regulatory crossfire
August 5, 2013 / 11:30 AM / 4 years ago

Derivatives caught in regulatory crossfire

LONDON, Aug 5 (IFR) - Regulators are denying derivatives dealers a crucial tool to manage down swaps exposures and shrink their assets, even as they force banks to adopt stricter than expected leverage ratio rules that will cause balance sheets to balloon.

The tendency of derivatives to hugely inflate balance sheets has come under close scrutiny over the past couple of months, as it has become clear that regulators are unwilling to water down a requirement for banks to meet a 3% leverage ratio by January 2018.

Deutsche Bank’s balance sheet, for example, grows by 60% to EUR1.9trn if benefits associated with netting of derivatives and related collateral are removed.

With such large numbers in play, bankers are becoming increasingly frustrated with regulators for failing to allow more vanilla derivatives to be centrally cleared, which would help net down exposures and shrink balance sheets.

“We’re very concerned about the impact of the leverage ratio on our derivatives books and we’ve been planning how to tackle this for some time. Like with Basel III capital ratios, the focus will be on banks hitting those targets very quickly, which will mean focus on balance sheets and on getting those gross books down,” said Tim Gately, head of European credit trading at Citigroup.

Banks have zeroed in on derivatives books as a crucial plank in their strategy to shed assets. Deutsche Bank announced up to EUR170bn in deleveraging through compressing derivatives and pushing contracts through central clearing in its second-quarter results plan - more than half of the assets it is looking to shed to hit its new targets. Barclays has earmarked up to GBP35bn of savings on future derivatives exposures.

Many long-dated, illiquid swaps trades with corporates and sovereigns will prove tricky to unwind. But the vanilla flow books do provide some low hanging fruit. Under the current proposals, a long position in CDS, for example, can only be offset against a corresponding short position if it is of an equal or longer maturity.

“That becomes problematic for dealers with big CDS books, where there will be little maturity mismatches all over the place,” explained the head of credit trading at a European bank. “When you gross up all the little mismatches, it can become a fairly big number.”

The cleanest way for banks to net down their exposures is to send them through a central clearing house.

“Central clearing is the only way the CDS market can survive given the role of derivatives in the leverage ratio,” said the European bank’s credit trading head.


The leverage ratio is the latest in a long line of regulatory sticks and carrots to force clearing of over-the-counter derivatives, from a straightforward regulatory mandate to capital requirement and hugely punitive margin rules for uncleared trades.

Much of the interest rate swap world - which makes up about two-thirds of the overall derivatives market - is already being pushed through central clearing, although there is some concern over the viability of clearing more complex contracts such as swaptions.

In the credit world, conversely, banks are becoming increasingly frustrated at regulators’ refusal to sign off on clearing of financial and sovereign credit default swaps, which account for about 40% of their CDS trading volumes. Clearing these contracts has been in the pipeline for almost two years now.

With the leverage rules looming large, banks argue that they are now caught between a rock and a hard place. How are they expected to net down their risk if regulators won’t allow them to clear the contracts?

“The hold-up at CCPs is frustrating as that would be the cleanest way to handle this, but there are lots of other things that can be done,” said Citigroup’s Gately. “Trade compression is effective, and banks are now incentivised to co-operate more in this process. The average duration of these portfolios is three to four years, which also helps as risk rolls off over time.”

The correlation between the buyer or seller of protection and the underlying credit in the transaction makes clearing sovereign and financial CDS more complex than other contracts.

If a US bank sells protection on another US bank, there is a good chance that its ability to pay out on the CDS will be hampered by its peer going into default. As a result, the clearing house should demand more margin to cover the risk of the credit quality of the counterparty deteriorating in lock-step with that of the underlying credit.

“In terms of one US bank writing protection on another, I don’t think there’s a black or white answer as to what’s the right amount of margin,” said Athanassios Diplas, a special adviser to the ISDA board.


Wary of the potential dangers of clearing these contracts, regulators tend to err on the side of requiring more margin than other participants deem necessary.

“We believe there is a workable, commercially viable solution,” said Chris Edmonds, president of ICE Clear Credit, which is currently working with regulators on the matter and is cautiously optimistic that the contracts should begin clearing in the first half of 2014.

Diplas is also sanguine that a compromise can be found, saying: “Regulators realise CDS is an important risk management tool. People used it through the crisis to manage their exposure and it provided protection. It’s a question of how to safely manage the jump default risk among correlated names.”

There are other issues that still need hammering out. The correlation between the underlying entity and the currency of the collateral is another thorny issue, as well as how clearing interacts with bankruptcy regimes in different jurisdictions.

“Part of what is taking time is the fact we’re working with multiple regulatory regimes that have various opinions on how certain levels of risk should be treated, and what that means for the capital requirements,” said Edmonds. (Reporting by Christopher Whittall, editing by Helen Bartholomew)

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