Following on from my article SA-CCR: Standardised Approach Counterparty Credit Risk, I wanted to look at the related topic of Capital requirements for Cleared Swaps and get a sense of the size of these requirements.
In March 2014, the Basel Committee on Banking Supervision (BCBS) published it’s Standardised Approach (SA-CCR) for measuring exposure at default (EAD) for counterparty credit risk (CCR), (see bcbs279.pdf). SA-CCR replaces the current non-internal model approaches, the Current Exposure Method (CEM) of 1995 and the Standardised Method (SM) of 2005. The majority of banks use CEM as relatively few firms have Internal Model Method (IMM) approval from their regulator.
In April 2014, BCBS published “Capital requirements for bank exposures to central counterparties (see bcbs282.pdf).
Together these two documents provide the details of the credit risk capital requirements for cleared swaps.
The bcbs282 document introduces the concept of a Qualifying Central Counterparty (QCCP) as an entity that is licensed to operate as a CCP (including a license granted by way of confirming an exemption), and is permitted by the appropriate regulator to operate as such with respect to the products offered.
This is subject to the provision that the CCP is based and prudentially supervised in a jurisdiction where the relevant regulator has established, and publicly indicated that it applies to the CCP on an ongoing basis, domestic rules and regulations that are consistent with the CPSS-IOSCO Principles for Financial Market Infrastructures.
In addition, for a CCP to be considered a QCCP, the terms defined in paragraphs 206 and 207 of the Annex for the purposes of calculating the capital requirements for default fund exposures must be made available or calculated in accordance with paragraph 208 of the Annex. (More on this later).
A quick Google search will show that all/majority of CCPs are QCCPs, so we will focus on these.
Scope of application
Exposures to CCPs arising from OTC derivatives, exchange-traded derivatives transactions, securities finance transactions and long settlement transactions will be subject to these rules. Exposures arising from the settlement of cash transactions (equities, fixed income, spot FX and spot commodities) are not subject.
There are two components to the capital requirements; trade exposures and default fund exposures.
Trade exposure calculations may be determined using either an Internal Model Method (IMM) or the Standardised Approach (SA-CCR), the later is detailed in bcbs279 and was covered in my article SA-CCR: Standardised Approach Counterparty Credit Risk. As a reminder SA uses the following formula:
where alpha equal 1.4, RC is Replacement Cost and PFE is Potential Future Exposure.
Replacement Cost captures the loss that would occur if a counterparty were to default and was closed out of it’s transactions immediately.
Potential Future Exposure add-on represents an potential increase in exposure over a 1-year time horizon for unmargined transactions or a MPOR of 5d, 10d or 20d for margined transactions.
From Exposures we use specified risk weights to get to Risk Weighted Assets (RWA) and then a Capital Ratio to determine the minimum capital requirement for the exposure component.
Lets now extract some key text from the bcbs282 document.
Clearing member exposures to CCPs
192. Where a bank acts as a clearing member of a CCP for its own purposes, a risk weight of 2% must be applied to the bank’s trade exposure to the CCP in respect of OTC derivatives, exchange-traded derivative transactions, SFTs and long-settlement transactions. Where the clearing member offers clearing services to clients, the 2% risk weight also applies to the clearing member’s trade exposure to the CCP that arises when the clearing member is obligated to reimburse the client for any losses suffered due to changes in the value of its transactions in the event that the CCP defaults.
In all cases, a minimum MPOR of 10 days must be used for the calculation of trade exposures to CCPs for OTC derivatives.
Clearing member exposures to Clients
195. The clearing member will always capitalise its exposure (including potential CVA risk exposure) to clients as bilateral trades, irrespective of whether the clearing member guarantees the trade or acts as an intermediary between the client and the CCP. However, to recognise the shorter close-out period for cleared client transactions, clearing members can capitalise the exposure to their clients applying a margin period of risk of at least five days in IMM or SA-CCR.
196. If a clearing member collects collateral from a client for client cleared trades and this collateral is passed on to the CCP, the clearing member may recognise this collateral for both the CCP-clearing member leg and the clearing member-client leg of the client cleared trade. Therefore, initial margin posted by clients to their clearing member mitigates the exposure the clearing member has against these clients. The same treatment applies, in an analogous fashion, to multi-level client structures (between a higher level client and a lower level client).
Here paragraphs 197 to 199 are quite verbose, the short summary is that if client does not suffer losses from the default of a clearing member then the risk weight is 2%, otherwise it is 4%, unless the client transactions would not be ported at market value to another (non-defaulting clearing member, in which case the bank (client) will capitalise its exposure (including potential CVA risk exposure) to the clearing member as a bilateral trade (so higher capital).
Paragraphs 200 to 203 are quite involved.
The gist as far I can understand seems to be that collateral posted to the CCP needs to be held by a custodian in a bankruptcy remote fashion from the CCP or for clients from the Clearing Member for the risk weight to be 0%, otherwise either 2% or 4% must be used.
Enough on the first component of the capital requirement.
Onward to the second, more interesting (trust me).
Default Fund Exposures
Banks are also required to capitalise for exposures arising from default fund contributions to a qualifying CCP.
206. Clearing member banks will apply a risk weight to their default fund contributions determined according to a risk sensitive formula that considers (i) the size and quality of a qualifying CCP’s financial resources, (ii) the counterparty credit risk exposures of such CCP, and (iii) the application of such financial resources via the CCP’s loss bearing waterfall, in the case of one or more clearing member defaults. The clearing member bank’s risk sensitive capital requirement for its default fund contribution (KCMi) must be calculated using the formulae and methodology set forth below. This calculation may be performed by a CCP, bank, supervisor or other body with access to the required data.
The steps for calculation are:
(1) First, calculate the hypothetical capital requirement of the CCP due to its counterparty credit risk exposures to all of its clearing members and their clients. This is calculated using the formula for KCCP:
where RW is a risk weight of 20% and Capital ratio means 8%.
𝐸𝐴𝐷𝑖 is the exposure amount of the CCP to CM ‘i’, including both the CM’s own transactions and client transactions guaranteed by the CM, and all values of collateral held by the CCP (including the CM’s prefunded default fund contribution) against these transactions, relating to the valuation at the end of the regulatory reporting date before the margin called on the final margin call of that day is exchanged.
The sum is over all clearing member accounts.
There is a lot more detail, but I will spare you that, mainly as should be obvious from the above KCCP can only be calculated with details of every clearing members exposure, meaning only the CCP itself or it’s regulator could do the calculation.
Consequently CCPs publish KCCP calculations to members as well as in their quarterly CPMI-IOSCO Quarterly disclosures. (Note: Clarus CCPView has KCCP data from all major CCPs).
So lets move onto the next step, which clearing members can perform themselves.
(2) Second, calculate the capital requirement for each clearing member:
• KCMi – is the capital requirement on the default fund contribution of member i;
• DFCMpref – the total prefunded default fund contributions from clearing members;
• DFCCP – the CCP’s prefunded own resources (e.g. contributed capital, retained earnings, etc), which are contributed to the default waterfall, where these are junior or pari passu to prefunded member contributions;
• DFipref – the prefunded default fund contributions provided by clearing member i.
This approach puts a floor on the default fund exposure risk weight of 2%.
208. The CCP, bank, supervisor or other body with access to the required data, must make a calculation of KCCP, DFCMpref, and DFCCP in such a way to permit the supervisor of the CCP to oversee those calculations, and it must share sufficient information of the calculation results to permit each clearing member to calculate their capital requirement for the default fund and for the bank supervisor of such clearing member to review and confirm such calculations.
KCCP must be calculated on a quarterly basis.
So there you have it.
I think we need an example to understand this capitalisation of default fund exposure.
A Clearing Member of LCH SwapClear with a £100 million pre-funded default fund contribution (DFipref).
Using CCPView, we obtain the following for LCH SwapClear as of 30-Sep-2016:
KCCP = £1,034,710,000 DFCMpref = £4,747,000,000 DFCCP = £49,260,000
Using the formula for KCMi, we get £21,573,268 for the capital requirement.
(Note the second term in the KCMi formula is only £160,000).
So £100 million of default fund exposure at LCH SwapClear requires a bank to have £21.6 million of capital.
Interesting, higher than I would have guessed, but these are the numbers.
Mind you the rule for Non-Qualifying CCPs is to use a risk weight of 1,250% for default fund contributions, so using an 8% capital ratio, this means the full £100 million is required as capital. (Note for the trade exposure part, SA-CCR must be used, so IMM is not allowed).
These capital requirements lead to some interesting questions.
How do the LCH figures compare to other CCPs such as CME and Eurex?
What is the relative size of Capital from Trade exposures to Default Fund Exposures?
How does this Credit Risk Capital compare to Market Risk Capital under FRTB SA or IMA?
How different (lower) are capital requirements for Futures compared to Swaps.
All topics for another day.
I plan to cover some of these in future blogs.