The material on this site is for financial institutions, professional investors and their professional advisers. It is for information only. Please read our Terms & Conditions, Privacy Policy and Cookies before using this site.

All material subject to strictly enforced copyright laws. © 2021 Euromoney, a part of the Euromoney Institutional Investor PLC.
Banking

The rising costs of unclearable OTC derivatives trading

OTC regulation threatens to shed light on Wall Street

Running parallel with the push towards central counterparty clearing are the latest initiatives from the Basle Committee on Banking Supervision to strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector. As part of its recommendations, it has proposed changes for measuring counterparty credit risk.

The new rules would require banks to set aside more capital against bilateral exposures, thereby creating an incentive to move bilateral OTC derivatives to central clearing because the charges are considered zero-risk weighted and therefore less capital intensive.

For each counterparty, there is a capital charge for the "bond equivalent" value of a stressed exposure at default (EAD). EAD calculates the net exposure of a derivatives portfolio over a one-year period, and provides a credit valuation, which is translated through a bank’s profit and loss statement, when a counterparty’s credit spreads widen. Regulators will now require banks to make the calculation over a three-year period, while also including a one-year stressed period. As a result the capital needed to be set against derivatives trading will be significantly higher. In addition, extra charges will be applied where a counterparty has more than 5,000 trades with another, the product is deemed more "complex" and where there has been a history of collateral disputes.

In addition, banks will be required to hold yet more capital against their counterparty exposures. This is determined by using EAD as the principal amount of a bond and the counterparty’s credit default swap spread as the discount rate. So the wider the credit spread of the counterparty, the more expensive it is to trade with.

"The derivatives business is going to be more capital intensive from a market-risk point of view and that probably changes capital allocation at firms," says Alexander Yavorsky, a financial institutions credit analyst at Moody’s Investors Service in New York.

"That reduces the returns on equity of such products, meaning these deals will need to be priced differently to maintain the same returns on equity as in the past. If there is no demand for that, then less of the business will get done in the non-standardized part of the market," says Yavorsky. Goldman Sachs calculates that about 15% of its derivatives portfolio is non-standardized.

Which Wall Street banks are disadvantaged or benefit from the new rules and the increase in counterparty clearing? Based on credit spreads, JPMorgan will be disadvantaged because it has tighter credit spreads than its derivatives counterparties, while a firm such as Morgan Stanley will benefit, after losing market share over the crisis. The use and operation of clearing houses will also be closely monitored, and must meet the Iosco/CPS guidelines, thus preventing the development of clearing houses aimed at bypassing the new capital rules. 

OTC regulation threatens to shed light on Wall Street

We use cookies to provide a personalized site experience.
By continuing to use & browse the site you agree to our Privacy Policy.
I agree