A key leverage requirement is a real “slaughterhouse” to the clearing industry, a Commodities Futures Trading Commission (CFTC) commissioner said.
Brian Quintenz is a CFTC commissioner and he was speaking at the Federal Reserve Bank of Chicago Fourth Annual Conference on CCP Risk Management when he noted this about the supplementary leverage ratio.
“Speaking of horror shows,” Quintenz stated,“the Supplementary Leverage Ratio (SLR) is a becoming a real-time slaughter house for the clearing industry and palpable threat to the cleared financial system.
“As a global capital requirement for banks, the SLR is intended to consider size rather than risk. The SLR requires that large banks set aside roughly five percent of assets for loss absorption to supplement risk-based capital requirements and reduce the risks posed by on-balance-sheet lending activities. However, the SLR is also being applied to customer swaps clearing, a different activity altogether. Bank-owned FCMs that hold cash margin for their clearing clients must also set aside the requisite five percent in capital under the SLR.”
A Futures Commission Merchant (FCM) is “involved in the solicitation or acceptance of commodity orders for future delivery of commodities related to the futures contract market,” according to Investopedia.
A clearinghouse steps in between the buyer and seller and guarantees the trade when a security is traded on an exchange.
“The supplementary leverage ratio is the ratio of a banking organization’s tier 1 capital to its totalleverage exposure, which includes all on-balance-sheet assets and many off-balance-sheet exposures,” according to the Office of Comptroller of Currency.
The SLR was part of the larger Basel II agreements; by setting a minimum amount assets required for leverage, the theory was that this would protect banks from unexpected market runs.
But Quintenz argued that when applied to a bank’s clearing operations, rather than properly reflecting risk, the regulation forces banks to hold excess capital needlessly for no logical reason: “First, the application of the SLR to clearing customer margin reflects a fundamental misunderstanding of central clearing. The G-20 adopted central clearing for swaps in 2009 in part to move customer margin off the balance sheets of bank FCMs and into DCOs (Derivatives Clearing Organization). But the SLR treats FCMs as if their risk exposure never changed.
“Second, the SLR ignores the fundamental nature of customer margin. Margin’s purpose is to reduce the risk exposure of derivative contracts. The SLR not only disregards that risk reduction, it transposes it, viewing margin as risk-enhancing. It also disregards the broader exposure reduction through netting of offsetting transactions.”
Quintenz noted that players like State Street, Bank of New York-Mellon, Nomura, RBS, and Deutsche Bank have all left the clearing business as a result of this new rule.
Rather than protecting banks in the next crisis, this SLR may be leading to one, Quintenz argued: “So here we are, subjecting a hedging service industry to an irrelevant test which increases systemic risk, dis-incentivizes investment and innovation, raises costs for customers, and may prevent an orderly resolution of the next crisis. Well done Washington, D.C., well done. Despite some people’s apparent best intentions, the clearing industry isn’t dead yet. But remedying the misapplication of the SLR is critical to ensuring the patient lives.”