Catalyst Update:
Final CRD IV Rules: Impact
on Capital Requirements for
Counterparty Credit Risk
November 2012
Catalyst
167 Fleet Street
London EC4A 2EA
www.catalyst.co.uk
© Catalyst Development Limited
Strengthened requirements for the
management and capitalisation of
counterparty credit risk
Introduction
In July 2011, the European Commission
published a proposal version of the
Capital Requirements Directive, which is
the European implementation of the Basel
III rules and provides a much needed
refresh
of
the
existing
capital
requirements framework.
Requirements for more detailed public
disclosures of regulatory capital bases.
Understanding and preparing for the
challenges created by this new regulation
will drive the key strategic and operational
decisions required to consolidate and
build competitive positioning for all
market participants.
All European entities will have to comply
with CRD IV, while their counterparts in
other jurisdictions (ie the US) will need to
comply with their local Basel III
implementation.
This paper looks at the impact of the
currently proposed CRD IV text on both
buy1 and sell sides, with regards to the
strengthening of capital requirements to
reduce counterparty credit risk on trade
exposures.
A vote on the final text by the Commission
was expected to take place during 2012,
but has been repeatedly delayed and at
the time of writing (end November 2012)
has still not been released.
What is known is that EU Member States
have to transpose, and firms of the
financial service industry have to apply,
the CRD from January 1, 2013, although
the UK FSA is postponing the
implementation date of CRD IV to July 1,
2013. It is likely that other EU member
states will follow.
Incentivisation of Central
Counterparty Clearing
Under CRD 1V rules, material capital
savings can occur for institutions entering
their trades into clearing, either through
Clearing Brokers or through a direct CCP
Membership.
CRD IV introduces
Bilateral trading will become more
expensive with the introduction of a
CVA charge and a possible margin
requirement for bilateral trades.
New liquidity requirements
A re-definition of what constitutes
capital
Amended capital deductions
The objective of recent regulation has
been to reduce risks across the board and Central Counterparty Clearing is seen
as the means to that end.
Increased levels of capital required
A number of new capital buffers
The implementation of new leverage
requirements
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firms.
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Bi-lateral trading of OTC Derivatives is
being dis-incentivised with
The CCP, on which trades are cleared
(a) is authorised to provide Clearing
the need for high capital requirements
(any bilateral trade will receive a
minimum capital weighting of 20%, which
can be much higher if there is a
substantial element of trade activity to
counterparties A+ and below and/or for
longer maturity products)
state
(b) publicly confirms that the CCP
complies with recommendations
for
central
counterparties
published by CPSS-IOSCO
(c) does not reject the trades
the introduction of a CVA charge to
hedge against a deterioration in the credit
quality of institutions counterparties for
bilateral OTC derivatives (and possibly, if
the IOSCO proposal from July 2012 is
accepted, the introduction of a margin
requirement for bilateral trades)
However, clients of Clearing Brokers who
are not direct members of CCPs face more
stringent requirements in order to receive
capital reliefs.
The CCP and the Clearing Broker of the
clients have to guarantee portability of
assets and positions in the event that the
Clearing Broker defaults.
Clients of Clearing brokers face stringent
requirements to get capital reliefs
The Portability guarantee is accompanied
by the implied requirement that the client
provides the Clearing Broker and the CCP
with a minimum of one Back-up Broker to
which to port positions. A Back-up
Clearing Broker contractually bound to a
client is exempt from the capital
requirements for counterparty credit risk
exposure for those assets.
Large Exposure limits trade exposures
to a single counterparty or group of
connected counterparties of above 25%
will require additional capital (on a scale
from 200% to 1250%) to cover the
counterparty risk.
Conversely, capital requirements for
cleared trades are slightly raised to 2%
(from currently 0%) if certain prerequisite
criteria are fulfilled by the Clearing Broker,
the CCP (and the buy-side client):
The Clearing Broker has to provide
asset and position protection for all
clearing related transactions. If assets are
protected from a default of the Clearing
Broker, then exposures to the collateral
are exempt from capital requirements.
Clearing trades under CRD IV will result in
substantial capital savings (compared to bilateral trades) for buy and sell sides alike.
assets and positions need
to be segregated from other clients and
from the CB s own positions and assets at
the Clearing Broker and the CCP level.
So on a simplistic basis, clearing trades
under CRD IV will result in substantial
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capital savings (compared to bi-lateral
trades) for buy and sell sides alike.
impose higher (than 2%) capital
requirements for cleared trades. At this
time (November 2012), no Regulator has
made an announcement in this respect.
Differences to Basel III
Global players with entities in other
jurisdictions will find it difficult to
implement one approach due to regional
implementation differences of the Basel III
rulebook.
The CRD IV proposal differs from the Basel
III regulations with regard to the Capital
requirements for counterparty risk in
mainly three points:
The EC applies a 0% weighting as a
stabilising measure (most likely politically
motivated) for trade exposures to
selected Central Banks and Sovereigns.
What is the impact of CRD IV?
Mandatory
clearing
of
clearable
derivatives will drive buy-side clients in
either of two directions, (1) to move out
of products which are subject to
mandatory clearing or (2) to choose
Clearing Brokers which offer Client
Clearing services for the relevant products
and fulfil the CRD IV requirements to
qualify the client for capital relief for trade
exposures.
Basel III includes a Loss Protection for
clients as part of the qualification criteria
for the application of a reduced risk
weighting of 2% for centrally cleared
trades a Clearing Broker must provide its
clients protection from losses due to
(a) its own default/insolvency
(b) the default/insolvency of one or
many of its clients; and
Global players with entities in other
jurisdictions will find it difficult to
implement one approach due to regional
implementation differences of the Basel III
rulebook.
(c) the joint default/insolvency of
itself and one or many of its
clients.
Basel III consists of a 4% risk weighting
for cleared trades in the event that the
Portability, Segregation, Asset Protection
criteria are satisfied, but clients are only
provided a Loss Protection in the case a
joint default/insolvency of the Clearing
Broker and one or many of its clients
happens. This 4% weighting does not exist
in CRD IV.
Clients resisting a change of their portfolio
to include more clearable OTC
transactions will not only suffer high
capital requirements but also be subject
to CVA charges and possibly margin
requirements for remaining bilateral.
Differences to Basel III will prevail in
future, and possibly widen. Despite a
single
European
rulebook
being
introduced in the near future, local
regulators have been given the right to
Clearing Brokers in turn will struggle to
satisfy the increased demand for Client
Clearing Services and for increasing
number of client requests to act as Backup Clearing Brokers in the event of their
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primary Clearing Broker going into default
or becoming insolvent.
released, we do not anticipate any
material change from the existing drafts.
Specifically, portability will be a big issue
for Clearing Brokers. Accepting a client
portfolio from a defaulting Clearing
member will most likely result in an
additional default fund contribution by
the CCP, which in turn would require
more capital to be held against it.
A majority of buy-side clients will not yet
have made any decisions on their longterm OTC strategy. However, as the
implementation deadline approaches, it is
imperative that the buy-sides are either
ready to implement the changes needed
to receive capital relief, or pull out of the
OTC market altogether. There is a risk,
that buy-sides who wait too long, will very
quickly be forced out of the OTC market.
There are many other challenges to be
addressed by sell-side institutions
resulting out of the counterparty credit
risk measures stipulated by CRD IV. These
include:
Buy-side clients also need to review their
long-term trading / investment strategy
and assess whether they want to
restructure their portfolio to take
advantage
of
reduced
capital
requirements for cleared trades and
substitute non clearable transactions with
economically similar clearable ones.
indirect clearing responsibilities
(for clients of intermediary
Clearing brokers)
higher quality asset requirements
by CCPs (which will stress a
Clearing
Brokers
ability
to
transform ineligible collateral from
a client into eligible ones)
disappearing benefits of and
profitability in relation to offering
client clearing services, regulatory
uncertainty (such as the Danish
Compromise from April 2012)
regulatory
implementation
variations in different regions,
compliance with other non
harmonised regulation.
It is imperative to conduct this assessment
at the earliest possible timeframe, as
contractual reviews and (re-)negotiations
with Clearing Brokers traditionally take
their time, especially if less favourable
criteria, such as portability, need to be
included in order to provide buy-side
clients the sought after capital relief for
cleared transactions.
The majority of Buy-side clients have not
made any decisions yet on what their next
steps will be. Buy-sides waiting for final
regulations to be defined could face being
eviction from the OTC market.
What should market participants do
before the CRD IV implementation date?
Despite regulatory uncertainty, and the
possibility of further requirements to be
added to the final text, it is crucial that all
market participants are fully prepared in
advance of the implementation date.
Although the final text has yet to be
One of the most important tasks will be
contractually to fix relationships with
Back-up Clearing Brokers, which in turn
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will only agree to assume a Back-up
Clearing Broker role under heavily limited
and constraint conditions.
which will provide capital relief to most
buy-side clients, and that a secondary
market of intermediary Clearing Brokers
will develop. This will be accompanied by
technological,
infrastructure
and
operational challenges within each market
participant.
Generally the Clearing Broker offerings
are being geared towards the larger hedge
funds and asset managers. Medium and
smaller banks with OTC derivatives
portfolios face the choice of either
applying for direct membership of CCPs or
terminating their use of OTC derivatives.
Conclusion
As the CRD IV and Basel III
implementation date approaches, those
sell-sides and the buy-sides which adapt
to the changing regulatory requirements
the best will be reaping the highest
benefits, either in the form of capital
savings or increased business flow.
Sell-sides will initially have to focus on
understanding the raft of new regulations
with regard to Derivatives Clearing,
specifically with a focus on regional
implementation differences, and then reassess - not dissimilar to the buy-side
clients - their future strategy in relation to
the OTC Derivatives business.
It is therefore imperative for both sides to
assess their own long-term trading
strategy and to choose their next steps as
early as possible - or be forced into a
decision by the market.
It is likely that sell-sides will initially be
cautious to offer client clearing services
Another impact of the regulation is that
those OTC products for which no clearing
solution exists (such as cross currency
swaps) may become more expensive and
thus less economic to use. Users will be
seeking to proxy the economic impact of
these products through the use of
exchange traded or vanilla swaps.
Catalyst Contacts
Christian Lee
Head of Risk & Clearing
+44 (0) 870 901 4155
christianlee@catalyst.co.uk
Shareque Husain-Syed
Senior Consultant
Risk & Clearing Practice
+44 (0) 870 901 4155
sharequehusain-syed@catalyst.co.uk
Sell-sides are cautious in their approach to
offer client clearing services until final
regulations and regional differences are
fully understood.
Catalyst is a specialist consultancy working
exclusively in Capital Markets. We re-engineer
operating models, deliver programmes of
change and develop leadership & management
capability in Technology, Operations and
Central Counterparty Clearing.
www.catalyst.co.uk
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