The new standardized approach to counterparty credit risk (SA-CCR) comes into effect for European banks in June.
It is designed to improve the risk sensitivity of CCR by differentiating between margined and unmargined, as well as bilateral and cleared, trades.
Under Basel Committee on Banking Supervision standards, a trade through a central counterparty clearing house (CCP) attracts a minimum lower margin period of risk of five days for client cleared trades and 10 days for house trades, compared with up to 20 days under bilateral trading.
Potential capital savings derive from CCPs being subject to strict risk management and default management requirements, and having rulebooks that are intended to protect clearing members and financial markets, especially during periods of volatility.
“The ability for clearing members to opt into daily trade settlement, as opposed to collateralization of trades, provides further potential for capital relief,” says Kah Yang Chong, EMEA lead for FX product management at LCH, a London-based clearing house.
Given the netting benefit of clearing, cleared trades should be materially cheaper than uncleared trades from a capital perspective – assuming the related cost of posting initial margin is managed appropriately.
This contrasts with the current exposure method (CEM), where capital is driven by notional and there are only small differences between a cleared and uncleared trade.
“Capital costs will therefore be driven by net risk and some model inefficiencies, where risk cannot be netted across hedging sets or product types,” explains Tobias Becker, head of business development at Quantile, an interest rate compression and initial margin optimization company.
For example, FX forwards on crosses (such as GBP/EUR) are not netted with similar FX risk on forwards versus USD (such as GBP/USD and EUR/USD).
Portfolio diversification
The new regulation is also much more sensitive to portfolio diversification. Under CEM, potential future exposure reduction from diversification is capped at 60%, but with SA-CCR, offsetting trades of the same currency can fully net against each other.
Institutions that take a bilateral trade and move it to a cleared position under SA-CCR will benefit from capital being more closely aligned with the net counterparty risk.
However, Justin Klug, president at Capitolis, a balance-sheet optimization software provider, observes that this capital might be exempt from initial margin.
“It is just another permutation of existing rules,” he says. “Risk-based capital benefits will come at the expense of increased margin requirements.”
FX futures and OTC clearing stand to benefit from the switch
Tobias Becker, Quantile
As for what this means for FX futures and over-the-counter (OTC) FX clearing, CME Group global head of FX products Paul Houston reckons the move away from the CEM will have a notable impact on bilateral FX positions – and could be a catalyst for the wholesale clearing of deliverable forwards, including the forward leg of FX swaps.
“Based on discussions with banks and our own analysis, cost- and capital-efficient clearing solutions such as FX futures and G10 NDFs [non-deliverable forwards] may well be further utilized as mechanisms to mitigate the capital costs of maintaining uncleared bilateral FX exposures,” says Houston.
“However, we anticipate dealers will make decisions on a more holistic basis than capital alone, including considering the counterparty risk management benefits of central clearing.”
One potential outcome is the continued evolution of clearing solutions as a portfolio management tool to help optimize the pockets of bilateral FX activity that are attracting the highest capital requirements, as well as the extended use of FX futures as a hedging tool that is complementary to OTC forward and swap activity.
“For those institutions who feel comfortable with their capital, this won’t feel relevant,” says Klug at Capitolis. “But those who watch their capital closely will want to clear as much as possible.”
Bigger incentive
SA-CCR should create a much bigger incentive to clear FX, since CCPs and exchanges are the ultimate netting nodes of the financial system, where participants meet and exchange risk against a single counterparty.
“As SA-CCR rewards such risk centralization, FX futures and OTC clearing stand to benefit from the switch,” adds Becker at Quantile.
LCH is working with several dealers and clients on clearing solutions for FX forwards to complement its OTC FX clearing offering and maximize margin and capital benefits, with the objective of identifying capital-intensive trades that can be cleared.
SA-CCR benefits margined and diversified portfolios, but for unmargined and directional portfolios, the capital can be larger, notes Allan Cowan, managing director in financial risk analytics at IHS Markit.
“This is particularly true for short-dated FX portfolios, owing to the larger supervisory risk weight applied to these trades,” he says.
[SA-CCR] is changing industrial logic on risk-based capital
Justin Klug, Capitolis
Analysis conducted by CME in October on the impacts of SA-CCR on hypothetical interbank FX forward books of 20 large banks ranged from a 44.5% increase in the capital requirement to a 20.5% decrease.
Variables included book construction, client franchise, trading partners and diversity of the book in terms of pairs and duration.
Becker identifies two segments of the market that will lose out.
“Firstly, uncollateralized trading will see an immediate uplift in capital consumption via the introduction of the 1.4 alpha multiplier, which increases capital from unsecured exposure by 40% compared with the previous standardized model,” he says.
Directional exposures versus counterparties, which are neither offset nor where counterparties participate in active multilateral risk management, could also see an increase in capital consumption, especially for short-dated FX exposures.
“For FX risk, SA-CCR has no notion of term structure when modelling the potential future exposure, so a three-month FX forward will have the same potential future exposure as an equivalent 30-year cross-currency swap,” adds Becker.
“This is in contrast to the CEM model, where such add-ons for potential future exposure would strongly increase with the tenor of the underlying transaction.”
According to Klug, SA-CCR has the potential to transform how the industry optimizes.
“Those firms who trade FX institutionally don’t know what they are going to do yet, given how different this landscape is going to look under the new regulation,” he concludes.
“It is changing industrial logic on risk-based capital. Many firms are now grappling with how to implement this new approach, while staying focused on the need to effectively manage, optimize and tighten their capital.”
