Capital Markets Gauge Cost of Capital in New OTC World

Terry Flanagan

Financial institutions are gauging the impact of increased capital requirements on certain business lines, with the introduction of central clearing expected to result in lower margins, increased collateral requirements and a general increase in the cost of doing business in areas such as OTC derivatives.

As many as 64% of respondents to a survey by the Professional Risk Managers’ Association feel that less than half of OTC contracts will be cleared via central counterparties, suggesting that bilateral clearing will still have a significant role to play.

While 25% of the respondents to the survey have withdrawn from capital-intensive businesses, and 58% admit that they are more selective when undertaking such business.

Philippe Carré, global head of client connectivity, SunGard

Philippe Carré, global head of client connectivity, SunGard

“The regulatory onslaught is not over,” said Philippe Carré, global head of connectivity for trading technology firm SunGard’s capital markets business. “Some banks will retreat further from capital markets activities because they can no longer justify the use of their capital base.”

So far all of the regulations have been “after the event”, said Carré, but this could change.

“The regulators already know and understand that this posteriori approach may not be so good because while it may stop what happened before from repeating, it may just not stop the next crisis and could even help precipitate it,” he said.

In the U.S., for example, the Commodity Futures Trading Commission has proposed safeguards with respect to a futures commission merchant (FCM) withdrawing futures customers’ funds from segregated accounts that are part of the FCM’s residual interest in such accounts.

The CFTC plans to require an FCM to maintain a residual interest in customer segregated accounts in an amount sufficient to cover all customer accounts that are under-margined, thereby ensuring that residual interest in customer segregated accounts exceeds the sum of outstanding margin deficits for customers, and that the funds of one customer are not used to margin or guarantee the positions of another customer.

The CFTC is concerned that such withdrawals may result in the FCM failing to hold sufficient funds to meet its obligations to its futures customers, or in the funds of one futures customer margining or securing the positions of another futures customer.

The futures industry is fighting the proposal, arguing that the CFTC’s analysis is flawed.

The analysis “appears to focus solely on the potential limitation on investment options that would be available to FCMs”, said Walter Lukken, president and chief executive of the Futures Industry Association, a trade body, in a December 28 letter to the CFTC.

To the contrary, the proposed rules are likely to require customers to pre-fund potential margin obligations and, as a consequence, will have a substantial impact on those that use the futures markets to hedge their risks, Lukken said.

The FIA is asking the CFTC to extend its comment period on the proposed rules by 30 days to February 13, while it collects and analyzes FCM financial data.

As banks begin to feel the impact of initiatives that were previously confined to silos in the risk management, “front office or the exchange margining worlds, risk managers should have an increasingly direct impact on the bank and its business model”, said Carré of SunGard. “Buy-side firms are also starting to feel the pressure to implement risk management practices that were previously the domain of their sell-side counterparts,” he added.

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