A Roundup of Key Business, Technology and Regulatory Developments

Mar 8, 2016


Leverage Ratio

The Bank of England has urged European policymakers to review the treatment of derivatives trades in the leverage ratio calculation used to determine the amount of capital required for banks. The central bank warned that the current framework could make central clearing costly and said it supported allowing clients initial margin to offset potential future exposure on centrally cleared client transactions.

“The leverage ratio is a simple measure and there should be a high bar to making adjustments to it,” the Bank of England wrote in its official response to the European Commission's "call for evidence" on financial reform. “Nonetheless, we should also be aware of the potential for unintended consequences, including for market liquidity.”

The central bank noted that while the leverage ratio does not normally allow collateral to reduce exposures, it supports an exception to allow initial margin to reduce leverage exposures for centrally cleared client trades “to ensure continuity and affordability of client clearing services." The central bank noted that many small financial firms that typically use derivatives for hedging purposes "are encountering difficulties gaining access to clearing, with many clearing providers unwilling to take on their business due to the low value of transactions these firms undertake, in conjunction with the operational costs of on-boarding and continuing to serve clients’ clearing activity.”

“The Bank therefore thinks that the leverage treatment of derivatives exposures for centrally-cleared client transactions within the leverage ratio exposure measure needs to be reviewed."

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CCP Equivalency

After years of discussion, the European Commission and the Commodity Futures Trading Commission in February ironed out their differences on the regulation of clearinghouses in the U.S. and Europe. The agreement paves the way for Europe to recognize U.S. clearinghouses and allows European firms to use these clearinghouses in time for the upcoming implementation of mandatory clearing for over-the-counter derivatives. 

"This is an important step forward for global regulatory convergence. It means that European CCPs will be able to do business in the United States more easily and that U.S. CCPs can continue to provide services to EU companies," said Jonathan Hill, European Commissioner for Financial Services, Financial Stability and Capital Markets Union. "It has taken a long time, but it is good news that after more than three years of discussion, we are now able to provide certainty for the marketplace."

European Member States signed off on the deal in a Commission expert group meeting of the European Securities Committee on Feb. 24. The European Commission can now move ahead to adopt the decision formally.

The European Commission said that market participants may continue clearing OTC contracts through U.S. CCPs before the June 21 date, even though they have not been recognized yet. This will allow market participants to use U.S. CCPs to meet "front-loading" requirements. In addition, the European Securities and Markets Authority is consulting on the possibility of allowing EU CCPs to apply an alternative standard for client margining that would allow EU CCPs to meet CFTC requirements.

The agreement between the U.S. and EU calls on U.S. clearinghouses to meet certain new requirements, such as shifting to a two-day liquidation period for setting initial margin on clearing member proprietary positions, maintaining "cover-2" default resources and adjusting initial margin models to mitigate pro-cyclicality. The agreement specifies, however, that these conditions will not apply to agricultural derivatives traded and cleared in the U.S. 

As part of the accord, the CFTC also agreed to develop a determination of "comparability" that will conclude that a majority of EU requirements are comparable to CFTC requirements. This will provide the basis for EU CCPs to meet certain CFTC requirements under a substituted compliance approach. The CFTC also will develop a streamlined process for EU CCPs to register with the CFTC.

"Our agreement is critical to ensuring that our global derivatives markets remain robust, while keeping our financial system as stable and resilient as possible," said CFTC Chairman Tim Massad. “It is a significant milestone in harmonizing regulation of these markets.” 

FIA President and CEO Walt Lukken welcomed the agreement. “The approach agreed by the CFTC and the European Commission reflects the global nature of our industry and the mutual recognition of the industry’s core regulatory jurisdictions to develop a common and unified approach,” Lukken said, adding that FIA encourages regulators to pursue a transparent process in addressing such key developments.

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FX Clearing

Two international regulatory bodies—the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions—issued a statement on Feb. 5 regarding liquidity issues related to the clearing of deliverable FX instruments.

The statement focused primarily on the issues arising from the settlement process. The two regulatory groups emphasized that clearinghouses are responsible for settlement, which in the case of a deliverable FX instrument involves the simultaneous settlement of obligations in more than one currency. Clearinghouses therefore must maintain "highly reliable liquidity resources" to cover the settlement of cleared transactions in all settled currencies in a default situation, the statement said. The statement also outlined several issues that the two groups expect clearinghouses to address in their liquidity arrangements.

Currently several clearinghouses offer clearing for non-deliverable currency forwards. These instruments are cash-settled and do not pose the types of settlement issues flagged by the regulatory groups. However, CLS Bank, the financial institution that handles settlement for a majority of transactions in the global foreign exchange market, announced last year that it would work with clearinghouses on providing settlement services for the clearing of deliverable foreign exchange products, starting with FX options. CLS made the announcement jointly with LCH.Clearnet, which is currently the leader in NDF clearing and is working to introduce clearing for FX options.

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Liquidity Trends

Central bank officials working under the auspices of the Bank for International Settlements released two reports on Jan. 21 that analyze trends in global fixed income markets.

One report examines liquidity in sovereign and corporate bond markets and related futures markets and finds "signs of greater fragility" in liquidity in benchmark bond markets. The report cites three causal factors: the increased use of automated trading, the reduction in bank risk appetites and "unconventional monetary policies" that have increased the risk of crowded trades.

The other report focuses specifically on electronic trading and its impacts on price discovery and market structure. The report finds that while electronic trading improves market quality during normal times, it may lead to "less robust liquidity" during times of stress. The report looks at case studies from the U.S., German and Japanese fixed income markets and discusses challenges for policy makers, including data disclosure, trading practices and risk management. 

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CCP Rating

Moody's Investors Service in January published a new methodology for rating global clearinghouses. As part of the methodology, Moody's established a new type of rating, a "clearing counterparty rating," which reflects its opinion of a CCP's ability to fulfill its clearing obligations as well as a CCP's member default management capabilities and the expected financial loss in the event of the obligation not being fulfilled.

Moody's said that clearinghouses have shown a strong history of default avoidance, but noted that the risks they face have evolved significantly in recent years, with clearing volumes undergoing a ten-fold increase and the products that they clear becoming increasingly complex. 

The methodology builds on Moody's existing methodologies and leverages the rating agency's experience in analyzing the credit profiles of both clearinghouses and their members. As part of this methodology implementation, Moody's will be assigning CCRs to currently rated clearinghouses and/or clearing services and withdrawing their long-term issuer ratings. When clearinghouses offer multiple, distinct clearing services, it will assign ratings at the clearing service level within the clearinghouse in order to capture the different risks that each faces. 

In February Moody's issued its first ratings under the new methodology, assigning a Baa1 CCR rating to Asigna, the derivatives clearinghouse that supports derivatives markets in Mexico.

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Cross-Border Oversight

The Securities and Exchange Commission on Feb. 10 adopted rules setting out how the agency will determine whether or not a non-U.S. security-based swap dealer must register with the agency.

“These final rules are integral to the SEC’s regulation of the security-based swap market, marking a key milestone in the completion of our regime for overseeing dealers,” said SEC Chair Mary Jo White.

The rules are largely unchanged from the SEC’s proposal released in 2015. They focus on the location of personnel arranging, negotiating or executing a security-based swap transaction on behalf of a dealer to determine which of those transactions should be included in a threshold when determining if a firm must be registered as a security-based swap dealer.

The rules take effect on April 19, but compliance is not required until the later of 12 months or when rules setting out how security-based swaps must be counted are finalized. 

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