Basel III: Liquidity Constraints to Persist

Terry Flanagan

Although Basel III will not be fully implemented until 2019, buy-side market participants fear that high capital requirements under Basel III are not commercially sustainable for clearing firms, and that they will likely be passed onto clearing customers in the form of higher clearing fees or other charges.

In a Jan. 8 letter to the Basel Committee, the Managed Funds Association expressed concern with the treatment of segregated initial margin for centrally cleared derivatives exposure under the supplementary leverage ratio.

If only a few clearing firms can meet these higher capital requirements on an ongoing basis, it could result in a smaller pool of firms offering client clearing services, which would reduce customer choice and harm competition in the market for client clearing services, the MFA said.

“The Basel III capital requirements on swaps clearing are quite onerous and are putting the whole clearing of swaps under a lot of stress,” Sam Priyadarshi, head of fixed income derivatives at Vanguard, told Markets Media. “FCMs and their large buy-side clients, as well as clearinghouses, are appealing to U.S. bank regulators to not include client segregated margin in the leverage ratio, so the capital requirements will be not as onerous. If FCMs have to increase clearing costs for swaps, then many clients will choose not to trade swaps, so liquidity will drop, which would be detrimental to the market.”

Clearinghouses are experiencing an increase in demand for compression services, which reduce the notional exposures of clearing members.

“Three or four years ago, compression was an operational nice to have,” said Cameron Goh, head of clearing solutions for LCH.Clearnet’s SwapClear. “Before 2014, our previous record for notional compressed in one year was $97 trillion, but in 2014 alone we compressed a record $292 trillion. This is largely due to the leverage ratio bringing capital efficiency front of mind for financial institutions.”

Sam Priyadarshi, Vanguard

Sam Priyadarshi, Vanguard

Goh added, “Basel III and certainly the introduction of the leverage ratio have had a tremendous effect on the uptake of compression services. The reporting requirements piqued a number of banks’ interest in compression services.”

Banks are struggling with different methodologies to assess market prices, and whether there’s an actively traded secondary market with more than two committed market makers that also has a large number of committed non-market maker participants, according to Ilaria Vigano, global head of regulatory and accounting products, enterprise solutions, at Bloomberg.

“It will only be through additional guidance or enforcement actions that these differing interpretations will be resolved,” said Vigano. “Certainly though, we continually see banks updating their business model to dedicate significant amounts of resources to regulatory compliance.”

Basel III is a challenge for banks primarily because so many important details change between the initial proposals and final technical guidance. “It can be a full time job examining and comparing Basel III guidance to the individual countries’ enabling legislation and rules,” said Vigano. “Timelines never match up across country lines, and you can almost certainly bet that compliance requirements will change once you think you’ve fully understood them.”

Even once rules have been fully implemented for banking institutions by 2019, it’s widely expected that tailored parts of the risk management, leverage and capital requirements will also migrate to the buy side.

“In the U.S., the Financial Stability Oversight Council is studying the risks asset managers pose to the economy, primarily with the leverage they take on through fund offerings,” said Vigano. “Regulators globally are also looking at the shadow banking world with a watchful eye and may seek to implement capital requirements on certain products like repurchase agreements and securities lending transactions – these may have implications for both the buy side and sell side.”

Basel III continues to be a catalyst for risk technology initiatives and expenditure across many regions, according to Chartis, a provider of research and analysis covering the global market for risk management technology.

Basel III guidelines require financial institutions to perform more calculations and submit more data to regulators than ever before; all the while meeting greater pressure to increase their capital, liquid assets and collateral, Chartis said in a report. This increased workload means many institutions have to allocate limited risk and finance resources to regulatory tasks rather than pursuing business goals.

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