FX: Banks urged to consolidate trading books as leverage ratio bites

By:
Solomon Teague
Published on:

TriOptima has called on banks to do more to create currency hubs in their trading books, allowing for greater efficiency in managing their balance sheets.

Banks can notably increase their leverage ratios if they consolidate their trading books into currency hubs, according to TriOptima, a technology vendor.

Reorganizing their trading books into groups by currency will allow banks to eliminate more trades in their compression cycles, it says, making them stronger in the eyes of regulators and freeing up capital they can use elsewhere.

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Peter Weibel,
triReduce

TriOptima’s compression service allows groups of institutions to aggregate their trades and eliminate those that offset each other. This is one way banks can improve their leverage ratios – the relationship between their core capital and total assets, which European regulators advise should be at least 3%.

Portfolio compression enables counterparties to reduce the gross notionals of their outstanding portfolios without fundamentally changing their market positions.

Eligible trades for all the counterparties are aggregated so any offsetting trades can be eliminated or replaced, while maintaining risk neutrality. This enables counterparties to reduce overall notional amounts, while enhancing capital efficiency.

Peter Weibel, CEO of triReduce, TriOptima’s compression service, says: “We are already seeing a trend towards banks creating hubs of their trading books, through which they channel their trades they wish to compress.

“Banks should be making every effort to continue with these efforts because the smaller the book fragmentation, the more efficient their compression results and the more beneficial it will be for their leverage ratios.”

In one recent cycle, 18 SwapClear members compressed 40% of outstanding notional and 49% of outstanding trades in Polish zloty interest-rate swaps and forward-rate agreements using triReduce. The local and international participants eliminated Z2.6 trillion ($654 billion) in the risk-constrained, multilateral triReduce cycle for unlinked transactions.

Weibel says reducing over-the-counter (OTC) derivative outstanding notional amounts is a substantial contributor to achieving the leverage ratio goals of individual institutions and to enhancing stability in the financial markets.

“The zloty market provides an interesting example of how compression efficiency increases in a concentrated market,” he says.

“It is a similar story also for South African rand and Mexican peso. This again demonstrates the great potential compression has to reduce outstanding notional amounts, particularly when there is little book fragmentation.”

In the larger currency markets, such as dollars, euros, yen and sterling, banks’ trading books are more fragmented, which reduces the efficiency of compression.

However, Weibel says the zloty example illustrates the kind of potential triReduce’s risk-constrained compression could have across the trading book, if those trading books were organized into hubs rather than being spread across silos.

In some ways, the major currencies have even greater potential for compression than the zloty, given their greater liquidity.

Compression cycle

On average, there are around 20 to 30 participants in a compression cycle, but there can be as many as 50 institutions participating in those compressing larger currency trades. The more institutions there are in a compression cycle, the more chances there are for trades to be offset and the greater the potential compression.

The multilateral compression service for OTC derivatives, which was established in 2003, can be used in portfolios of cleared and uncleared interest-rate products in 27 currencies, credit default swaps, commodity swaps, inflation swaps, cross currency swaps and FX forwards.

Currently, TriOptima delivers triReduce compression for cleared trades in collaboration with clearing houses (CCPs) around the globe, as well as to CLS members for FX forwards. It expects to agree deals with more CCPs in coming months, as the number of CCPs in Europe is projected to grow.

The challenge in the near-term is for banks to reorganize their divisional structures and trading books to manage trades, such as FX, centrally, which would allow them to more efficiently compress trades using a service such as TriOptima.

Banks are in different places in terms of the organization of their trading books.

David Clark, chairman of the Wholesale Markets Brokers’ Association, says: “Some banks have acute cases of silo-itis – their businesses are scattered, by geography or product – which makes it harder for them to coordinate.”

Many banks developed this silo structure in the days before the financial crisis, when it made sense to book trades off-balance sheet to reduce the capital costs associated with these trades.

However, since 2008 it has become clear the capital costs of treating trades in this way had been substantially underestimated. The cost in terms of credit and market risk was higher than the capital that had been set aside under the older Basel rules, while the operational cost, arising from the fines regulators imposed on some banks, was even greater.

Banks were also under considerable pressure to cut costs, and many are now living with the consequences of the decisions they took in the period after the financial crisis. Some banks cut their IT budgets, which has made it difficult to execute IT-intensive solutions to their problems, such as compression.

Clark says: “The difference between the banks that are ahead in creating these trading hubs and those that are lagging behind is evident in the business models that they have and how dependent they are on the use of capital. There are clearly some banks, particularly in Europe, that were less advanced and those are the ones that don’t have enough capital now.”

Where banks can corral their exposures into certain areas, banks are better able to identify their risks, and thereby effectively manage them. When it comes to compression, be that in the currency, rates or fixed-income books, hubs can eliminate unnecessary trades and reduce market, credit risk and operational risk.

The Bank for International Settlements’ most recent global OTC derivatives market statistics show interest-rate notionals fell 23% between December 2014 and June 2015, from $563.3 trillion to $434.7 trillion outstanding.

TriOptima argues this was achieved largely as a result of the increasing use of compression, and states market participants have eliminated more than $750 trillion in notional principal outstanding using triReduce.

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Cameron Goh,
SwapClear

Cameron Goh, head of clearing solutions, SwapClear and listed rates at LCH.Clearnet, says: “Capital requirements for banks continue to be a major incentive for firms to compress their swaps books and drive down notional outstanding.

“As a result, our members and their clients have a healthy appetite for the capital and operational efficiencies that can be achieved through compression, and we expect demand for these services to continue to grow.”

However, Russell Dinnage, senior consultant at GreySpark, says: “For some banks, it may be cheaper to replicate the OTC options or non-deliverable-forward liquidity on their trading books by replicating it on futures exchanges.”

While fighting this “silo-itis” is essentially an operational and technological issue, it is being dealt with at a grass-roots level within banks, but given the prominence of the question of capital liquidity among regulators, it is also of concern at the board level.

Repo market

It is also relevant far beyond compression. While banks have rehypothecated their assets for a long time, the Basel III leverage ratio is encouraging them to increase this activity as a way to use capital more efficiently.

It is especially prevalent in the repo market, as negative yield has undermined the economics of the business of short-term, overnight lending.

Dinnage says: “Negative yields on fixed-income assets are also affecting the ability of banks to secure funding in the overnight lending markets. This encourages rehypothecation,” which, he notes, involves a global coordination of data management across all of a bank’s trading desks.

“It does not make sense for each desk to operate separately by segregating its value-at-risk modelling data, for example,” adds Dinnage. “It is also important for the manager of each trading desk to have access to a common dashboard and to agree to standard practices for data management.”

However, with banks under pressure to increase lending and lead the economy back to greater health globally, it can be difficult for them to find the time and resources to dedicate to these questions of internal organization.

Dinnage says: “Banks must conceive of data, be that their own data, market data or clients’ data, as an asset. This typically means that banks must undo a framework of silos and find a way to share data between those silos.

“Banks understand this reality, and the solution to any operational data-management issue typically boils down to a buy or build decision.”

Given the fact of reduced IT budgets for many banks, which makes it prohibitively expensive for even larger banks to develop solutions for things such as compression in-house, for many the answer is to turn to technology providers to provide solutions.

TriOptima’s compression service is another example of a non-bank institution using its dominant market share to establish itself as a quasi utility.

However, this does not let banks off the hook when it comes to organizing themselves optimally, to ensure the systems provided by the technology providers are as efficient as possible.