Regulatory Initiatives Impacting Funding, Collateral, and Capital Costs

July 7, 2016

Following the 2008 financial crisis, the banking sector witnessed a plethora of regulatory changes. While these regulatory prescriptions cover every dimension of the banking world, the OTC derivatives (OTCDs) market has borne the brunt due to the derivatives' opaque and complex nature.

by Quantifi & Cognizant

 

Regulatory Landscape

Some regulations such as the Dodd-Frank Act2, EMIR3 and the BCBS/IOSCO4 Margin Requirements of Uncleared Derivatives are directly targeted at OTCDs, several others, especially the leverage ratio, also have far-reaching implications for the OTCD market. Figure 1 presents a timeline of major regulations impacting the OTCD market.

 

Regulatory Landscape Timeline Diagram

Figure 1: Regulatory timeline for OTCD players

 

These changes are leading to structural alterations in the OTCD markets, consequently placing significant cost pressure on OTCD trading and clearing activities. This section provides an overview of the various recent regulatory developments that dictate the cost and profitability of OTCDs.

 

An overview of the various recent regulatory developments that dictate the cost and profitability of OTCDs.

Figure 2: Risk components of cost of trading OTCDs

Mandatory Central Clearing of Standardized OTCDs

EMIR in the EU region and the Dodd-Frank Act for the U.S. are the major regulations covering the central clearing obligation. The implementation of mandatory central clearing for standardized OTCDs requires market participants to adhere to the CCPs' stringent requirements including initial and variation margins (IMs and VMs). Margins, in particular, IMs, which are not prevalent in bilateral deals, lead to significant funding cost for collateral.

Margin Requirements for Non-Centrally-Cleared OTCDs

Even after the full implementation of clearing mandates, there would be a portion of OTCDs that remain non-clearable. With an objective to incentivise central clearing and make the residual non-cleared OTCD markets more resilient, global regulators have issued margin requirements for uncleared derivatives (MRUDs). Starting September 2016, for non-centrally-cleared OTCD transactions, large banks will be required to exchange daily IMs and VMs with counterparties.

Prudential Regulations

Bank Exposures to CCPs

The final policy framework for the treatment of exposures to CCPs was released in April 20146 by BCBS in consultation with CPMI7 and IOSCO, and will come into force from January 2017. Notably, a new 2% risk weight is applicable to the eligible clearing members for exposures to qualifying CCPs; Basel III capital standards apply for the transactions facing clients.

Basel III Standards

Basel III reforms are a comprehensive set of regulatory measures designed to improve banks' resilience and strengthen their risk management and governance. They affect different aspects of banks' balance sheet management - capital, liquidity, and leverage. Introduced as part of Basel III, CVA capital charge corresponds to the capitalised risk of the future changes in CVA. CVA capital charge adds significantly to the cost of trading non-collateralized OTCDs.

Finally, the uneven progress of cross-border regulatory implementation has exacerbated OTCD players' woes. Some notable examples include uneven product coverage and availability of CCPs across various global jurisdictions; fragmentation of liquidity pools as seen in the euro IRS inter-dealer market threshold differences in MRUD between the U.S. and EU, etc.

Recommended Whitepapers

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