www.catalyst.co.uk
Catalyst Update:
Final CRD IV Rules: Impact on
Capital Requirements for
Counterparty Credit Risk
November 2012
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.
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.
CRD IV introduces
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.

New liquidity requirements

A re-definition of what constitutes
‘capital’
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.

Amended capital deductions

Increased levels of capital required

A number of new capital buffers

The implementation of new leverage
requirements

Strengthened requirements for the
management and capitalisation of
counterparty credit risk

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.
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.
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.
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)
Clients of Clearing brokers face stringent
requirements to get capital reliefs

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
Clearing trades under CRD IV will result in
substantial capital savings (compared to bilateral trades) for buy and sell sides alike.
client):
Bilateral trading will become more expensive
with the introduction of a CVA charge and a
possible margin requirement for bilateral
trades.
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.
Bi-lateral trading of OTC Derivatives is being
dis-incentivised with

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)
1. the introduction of a CVA charge to
hedge against a deterioration in the
credit quality of institutions’
1
Buy side is defined as banks and investment firms
© Catalyst Development Ltd

The CCP, on which trades are cleared
(a) is authorised to provide Clearing
Services in the Clearing Member’s state
(b) publicly confirms that the CCP complies
with recommendations for central
counterparties published by CPSSIOSCO
(c) does not reject the 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. 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.
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

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.
The client’s 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 capital savings
(compared to bi-lateral trades) for buy and sell
sides alike.
and one or many of its clients happens.
This 4% weighting does not exist in
CRD IV.
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
impose higher (than 2%) capital requirements
for cleared trades. At this time (November
2012), no Regulator has made an
announcement in this respect.
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.
What is the impact of CRD IV?
Differences to Basel III
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.
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
(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
Clearing trades under CRD IV will result in
substantial capital savings (compared to bilateral trades) for buy and sell sides alike.
© Catalyst Development Ltd
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.
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.
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.
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 Back-up Clearing Brokers in
the event of their primary Clearing Broker going
into default or becoming insolvent.
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.
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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:

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.
What should market participants do
before the CRD IV implementation date?
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.
One of the most important tasks will be
contractually to fix relationships with Back-up
Clearing Brokers, which in turn will only agree to
assume a Back-up Clearing Broker role under
heavily limited and constraint conditions.
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.
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 released, we do not anticipate any
material change from the existing drafts.
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 re-assess - not dissimilar to the buyside clients - their future strategy in relation to
the OTC Derivatives business.
A majority of buy-side clients will not yet have
made any decisions on their long-term 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.
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.
Buy-side clients also need to review their longterm 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.
It is likely that sell-sides will initially be cautious
to offer client clearing services 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.
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
© Catalyst Development Ltd
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Conclusion
As the CRD IV and Basel III implementation
date approaches, those sell-sides and the buysides 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.
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.
Catalyst uniquely combines
teams of financial markets
experts with organisational
change specialists to deliver
enduring results. We provide
honest guidance to help you
succeed. We are catalysts for
enduring excellence.
Catalyst Development Ltd,
167 Fleet Street, London, EC4A 2EA
T +44 (0) 870 901 4155
F +44 (0) 871 433 8876
www.catalyst.co.uk
© Catalyst Development Ltd
christianlee@catalyst.co.uk
sharequehusain-syed@catalyst.co.uk
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