Central Clearing Drains Bank Capital Reserves

Terry Flanagan

The move to centrally cleared derivatives is having an immediate impact on bank balance sheets as they negotiate the intricacies of the cost of collateral and the valuation of clearable trades.

Under the Dodd-Frank Act, the European Market Infrastructure Regulation (Emir) and Basel III regulations, uncleared OTC derivatives will incur Credit Valuation Adjustment (CVA) risk capital charges, default risk capital charges and minimum initial margins.

Meanwhile, market participants trading centrally cleared derivatives will be subject to capital charges for default fund contributions and central counterparty trade exposures and will also be required to fund initial margin.

“The economics of OTC derivatives are changing,” said Paul Jones, director at Markit Analytics. “There are numerous capital and funding costs that now need to be considered before executing a trade.”

Markit has enhanced its front office analytics platform to enable financial institutions to calculate the costs of funding and capital resources of their OTC derivatives trades in a single application.

Financial institutions will use Markit’s system to price novation packages and renegotiate credit support annexes (CSAs), helping them decide whether to move existing OTC derivative trades onto new Isda CSAs. Financial institutions will also be able to replicate initial and variation margin calls under various stress scenarios.

“By bringing our established CVA, risk weighted assets and initial margin solutions together, our customers can run interactive scenarios with ease to understand the tradeoffs between these components,” Jones said. “As derivatives move to a centrally cleared environment, you need to be able to assess the tradeoffs between collateral and the cost of capital.”

Determining the fair value of derivatives contracts continues to be one of the key issues for the banking sector.
Under Emir all counterparties to any derivative trade must report to an approved trade repository. The date for reporting of interest rate and credit derivatives has been pushed back from September 2013 to January 2014, as announced by the European Securities and Markets Authority (Esma).

“Esma has now made it clear that the mark to market/model valuation is included in the six month transition period after reporting go-live,” David Nowell, head of industry relations and regulatory compliance at London Stock Exchange’s UniVista, in a presentation. “Exposure data is part of the ‘counterparty data’ set.”

David Nowell, UnaVista

David Nowell, UnaVista

Valuation of derivative contracts is essential to allow regulators to fulfill their mandates, in particular when it comes to financial stability.

The mark to market or mark to model value of a contract indicates the sign and size of the exposures related to that contract, and complements the information on the original value specified in the contract.

Mark-to-Model refers to the practice of pricing a position or portfolio at prices determined by financial models, in contrast to allowing the market to determine the price.

Trade reporting threatens to be a complex process, increasing costs and administrative burden. It will require information that currently resides across the enterprise as well as outside it to be pooled together, standardized and delivered.

London Stock Exchange Group has applied to Esma for UnaVista to be a trade repository across all asset classes for both exchange traded derivatives and OTC derivatives.

UnaVista expects to be approved as a trade repository and is running a pilot service for clients to allow customers to test the service before the January 2014 live dates.

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