June 13, 2012 | George Ballenbacher, Kinetix Trading Solutions | tabbFORUM

Life would be complicated enough if all a bank had to worry about in the derivatives space was Title VII of Dodd-Frank. Instead, banks are approaching a dangerous intersection where Dodd-Frank, various bank regulatory rules and Basel III all come together.

There are no traffic lights or stop signs here, so understanding the interplay of forces and keeping a sharp lookout are all that will protect you from a nasty accident.

To make our way safely through this intersection, we have to know what each regulation covers, whom it applies to and what it says.

The Dodd-Frank Act

Section VII of the DFA applies to all swaps market participants and requires that trades in any product accepted for clearing by any DCO must be cleared, with the single exception of end-user exempt (EUE) trades. For these trades, one party must be a non-financial entity and the trade must serve to hedge a commercial risk. Margin requirements for cleared trades are set by the clearinghouse (CCP) and approved by the Commodity Futures Trading Commission or Securities and Exchange Commission, depending on who regulates the product.

The DFA also sets up margin rules for uncleared swaps, both in uncleared products and EUE trades in cleared products. These rules are not as prescriptive as CCP margin rules, particularly relating to how much initial margin (IM) must be collected, and how often variation margin (VM) must be determined. And here’s where things start to get interesting.

The Banking Regulators

A group of banking regulators (primarily the Federal Reserve, the Federal Deposit Insurance Corp and the Office of the Comptroller of the Currency) have proposed a set of rules on margin for uncleared trades in the same instruments but only for banks (including BHCs). For these institutions, the banking regulators’ rules trump the DFA rules.

The banking rules specify margin requirements (for both IM and VM) based on the type of counterparty the bank has done business with. There are up-front margin requirements for high-risk counterparties, either using a table the regulators provide or a regulator-approved formula established by the bank.

The low-risk counterparties, however, have a different margin scheme. For low-risk financial counterparties (like pension funds and endowments) no margin (either IM or VM) is required until the bank’s exposure to each counterparty reaches something like $30 million or 0.2 percent of the bank’s tier 1 capital, and then only to the extent the exposure exceeds the limit. For low risk non-financials (who are largely end users) no IM or VM is ever required.

So here we have our first complication. In uncleared products, banks appear to have an advantage over non-banks when dealing with low-risk counterparties. On the assumption that no low-risk entity wants to post IM and VM under the DFA, why would they ever do an uncleared trade with a non-bank? In EUE trades, banks also have an advantage with non-financials, since the DFA requires non-banks to collect both IM and VM and the bank regulators do not.

Basel III

If only that was all there was to it!

Instead, the Basel Committee on Bank Supervision (BCBS) has issued capital rules (Basel III) for banks worldwide. Although the Basel III rules apply to much more than derivatives positions, they do have a lot to say about this subject.

The relevant part of Basel III is the section on counterparty credit risk, which will become effective Jan. 1, 2013. As an indication of the complexity of this section, it is called “Effective EPE with stressed parameters to address general wrong-way risk.” It contains language such as: “To determine the default risk capital charge for counterparty credit risk as defined in paragraph 105, banks must use the greater of the portfolio-level capital charge (not including the CVA charge in paragraphs 97-104) based on Effective EPE using current market data and the portfolio-level capital charge based on Effective EPE using a stress calibration.” Got that?

To simplify, Basel III requires banks to hold capital against risk-weighted assets (RWAs). Derivative positions are considered RWAs. The capital charge is determined by the credit quality of the asset, in this case the counterparty. Interestingly, Basel III recognizes that CCPs are risky counterparties, albeit not as risky as bilateral counterparties. Thus every bank-held derivatives position, cleared and uncleared, will carry a capital charge, depending on the perceived riskiness of both the instrument and the counterparty.

Finding Our Way

So what does all this mean for bank and non-bank dealers in derivatives?

For cleared trades, banks will be at a slight disadvantage to non-banks, because banks will have a small capital charge against their cleared position (as well as a capital charge for the CCP’s default fund, which shouldn’t change because of position changes) while non-banks would not.

In closing open positions, banks will have a higher incentive to clear at the CCP holding the open position because, in addition to freeing up IM, the trade would also free up capital.

In uncleared trades with low-risk counterparties, banks will have a decided advantage over non-banks, since the banking regulations have much lower IM and VM requirements than DFA does.

In deciding whether to do EUE trades bilaterally or insist on clearing, banks will have to weigh the lower IM and VM requirements of the uncleared trade against the higher capital requirements, a calculation that non-banks won’t have to make.

For banks, the interplay of capital and margin requirements will occur on every trade, and will be too complicated to attempt manually, so risk management systems will have to be beefed up to handle these calculations in real time.

Whether the U.S. banking regulators and the BCBS intended to make life more complicated for banks or not, they have certainly done so. So perhaps the best advice for banks in the new world is to look both ways before stepping on the gas.