The unintended consequences of financial regulation have been seeping into the markets since the first rule was made in the wake of the financial crisis.
One prime example is the leverage ratio, which determines the required capital of general clearing members. The actual calculation of the capital requirement within the Basel III leverage ratio framework is a particular sticking point for the OCC. Right now, the Current Exposure Method (CEM) is used in the calculation, whereas the OCC and a wide swath of industry participants believe that the Standardised Approach for Counterparty Credit Risk (SA-CCR) would better encapsulate the nature of listed options markets.
From the OCC’s perspective, maintaining CEM as the methodology in the calculation will lead to the weakening of liquidity in the options market.
“With listed options, CEM is extraordinarily punitive because it looks at each option as an individual kind of risk component and does not give offset for long options,” said John Fennell, executive vice president and chief risk officer with the OCC.
Basically, CEM doesn’t recognize a position in the aggregate, only the sum of its legs. For example, say a clearing firm is short calls in some company that equate to 2,400 in exposure but is also long calls in the same company that equate to 2,600. Under CEM, that means the firm’s exposure is 5,000. On the other hand, SA-CCR takes into account risk offsetting positions and directional trades, which means in the above example the firm’s exposure would be 200 (the difference between the long and short position). Those are exponential differences.
The oddity is that an institution with an unhedged position (just being short calls) would have to pay less than the firm in the above example, which essentially discourages hedging.
“By supporting something that requires the banks to hold less capital, [regulators] think that introduces risks into the system,” said Fennell. “From our perspective, by supporting a capital framework that doesn’t promote hedging or incentivize hedging, you’re asking liquidity providers or market participants to put raw exposures on because it’s cheaper than putting on a more prudent risk based position.”
Part of that issue is the fundamental disagreement between the industry and regulators as to what constitutes a risk. In the banking world, the FDIC has been vocal that more capital is better.
“The CEM calculation is a bank regulation, not a capital markets or securities market regulation. So the way the bank regulators look at it is they say if you have liabilities, whatever they’re valuing that liability at, that’s how much capital a bank should reserve,” said Fennell. “It didn’t take into account how capital markets work and how trading works.”
The current conundrum is the result of Basel III, but OCC now is dealing with multiple US agencies on the matter including the FDIC and Federal Reserve Bank.
The options industry’s concern is this: If big bank clearers find these capital requirements burdensome, they will decrease their activities in the space or even bow out completely. In other sectors of the financial markets, the departure of established players has created new opportunities. But in this case there are not enough new or existing non-bank clearers capable of plugging the gap created by a bank exodus from options. They just do not have the balance sheets of big banks. Meanwhile, if the banks are affected, then their clients such as market makers are impacted as well.
The CEM simply does not take into account that when it comes to the options market, participants can have books with huge notional values that are essentially risk neutral.
There is no easy way around CEM. The best case timeframe to implement SA-CCR in lieu of CEM is 2018. Realizing the time horizon is so far out, OCC and its industry partners are pushing for some sort of interim solution. But trying to find a way to alter the calculation without a rule filing is not an easy task. If SA-CCR isn’t adopted, a jury-rigged interim solution could become the long-term, lesser-of-evils solution.
In the end, if CEM stays in practice, the industry could see a shift back to OTC products given the burdens of centrally cleared activity. It’s an ironic twist in a post-Dodd-Frank world.