The Leverage Ratio: A Threat to Liquidity?

At an event in Washington, DC jointly hosted by FIA last week, Federal Reserve Governor Jerome Powell discussed the unintended consequences of including initial margin in the leverage ratio: “Take central clearing for clients: this is something we want and we think makes the world a better place, but we apply the leverage ratio to the initial margin posted by clients which makes it more expensive. We see clients getting out of the client clearing business, so we are undermining the clearing mandate.”

In comments made at the World Federation of Exchanges’ IOMA Clearing & Derivatives Conference, John Fennell, chief risk officer of OCC, noted that the leverage ratio is eroding liquidity in capital markets.  He expanded on these ideas in a recent blog, noting that, “the application of the Leverage Ratio, which neglects to consider the hedging benefits between options and other attributes unique to options, will result in vastly increased capital requirements for general clearing members offering clearing services to market makers and liquidity providers. This will fundamentally threaten clearing members’ business models and impact the liquidity and stability of global financial markets.”

In comments at the CFTC’s Market Risk Advisory Committee (MRAC) meeting this week, FIA PTG’s representative, Sebastiaan Koeling of Optiver explained why clearing member concentration due to the leverage ratio is particularly troubling in options markets.  In a follow-up interview, Koeling elaborated: “There are only three clearing firms that have the ability to provide cross-margining for trading firms that make markets in both equities and options. If one of these clearing firms were to default or stop offering this service, the other two would be unlikely to take on its customers due to the impact of the leverage ratio.”

Bob Wasserman of the CFTC’s Division of Clearing and Risk articulated a common criticism of the leverage ratio:  “The biggest part of this battle is the refusal to recognize the risk-reducing elements of margin.”

Dale Michaels, executive vice president, financial risk management at OCC, told the MRAC that the leverage ratio is already impacting the ability to clear clients, saying the threat “is no longer theoretical. Even in peace time, clearing members are asking business to leave.”

FIA PTG is an association of more than 20 firms that trade their own capital on exchanges in futures, options and equities markets worldwide. FIA PTG members engage in manual, automated, and hybrid methods of trading, and they are active in a wide variety of asset classes, including equities, fixed income, foreign exchange and commodities. FIA PTG member firms serve as a critical source of liquidity, allowing those who use the markets, including individual investors, to manage their risks and invest effectively. FIA PTG advocates for open access to markets, transparency, and data-driven policy.

For more information, contact Heather Vaughan at +1 202-466-5460.