Key Points:

The proposed reforms would apply to all exposures to CCPs arising as a result of financial derivatives (both OTC and exchange traded derivatives), repos/reverse repos and securities lending and borrowing transactions

On 2 November 2011 the Basel Committee on Banking Supervision issued its second consultative paper on the Capitalisation of Bank Exposures to Central Counterparties (CCPs).

The stated aim of the proposals is to require banks to more appropriately capitalise their exposures to over-the-counter (OTC) derivatives and to create incentives for banks to increase their use of CCPs.

These two aims go hand-in-hand. In the aftermath of the global financial crisis, regulators in jurisdictions around the world have been championing the virtues of the use of CCPs to clear transactions in the OTC derivatives market. The rationale is that a CCP is able to net counterparty exposures on a multi-lateral basis, thereby reducing the magnitude of potential losses sustained by market participants should any one participant fail.

Other than where the use of a CCP may be mandated by regulation, regulators are seeking to incentivise banks to use CCPs by giving preferential capital treatment (ie. in the form of lower capital charges) to exposures to CCPs that comply with certain regulatory requirements. In other words, by imposing higher capital charges on banks that do not transact via a CCP, the new regime should result in banks holding a level of capital that more appropriately reflects the higher risks that they take on in these situations.

It should be noted that the proposed reforms have a broad scope, applying to all exposures to CCPs arising as a result of financial derivatives (both OTC and exchange traded derivatives), repos/reverse repos and securities lending and borrowing transactions.

Qualifying and non-qualifying CCPs

Central to the proposed reforms is the categorisation of a CCP as qualifying or non-qualifying. A qualifying CCP (QCCP) will be one which complies with the CPSS-IOSCO international Principles for Financial Market Infrastructures (these principles are designed to enhance the robustness of the essential infrastructure supporting). Any other CCP will be a "non-qualifying CCP" (non-qualifying CCP).

Exposures to QCCPs will receive preferential capital treatment, as opposed to exposures to non-qualifying CCPs which will not.

If a QCCP loses its "qualifying" status, it will have a grace period of three months before the non-qualifying CCP capitalisation rules apply.

Preferential treatment of exposures to qualifying CCPs

A bank that acts as a clearing member (CM) of a QCCP will have two types of exposures for regulatory capital purposes:

  • Trade related exposure – this is the mark-to-market of current and potential future OTC derivatives exposures.

  • Where the exposure is to a QCCP, it will receive a low risk-weight of 2%, reflecting the low risk of default by the QCCP. If collateral is posted for the OTC derivative in a way which is bankruptcy remote from the QCCP, the risk weight applied to the collateral will be 0%.

  • Default fund related exposure – this is the risk that a non-defaulting CM will be required to contribute to a default fund in the event of default of another clearing member.

The process for determining the capital exposure under this limb is complex but, essentially, the capital to be allocated to an individual CM will be lower if there is less concentration risk in the CCP. However, the requirement for banks to hold capital to cover their exposure to default fund contributions is a controversial one and represents a significant shift from the position put forward previously by the Basel Committee. One of the key concerns that banks may have with this proposal is that it may put them at a disadvantage when compared to non-bank CMs that are not subject to the same capital requirements.

Treatment of exposures to non-qualifying CCPs

A CM trading with a non-qualifying CCP will be required to capitalise its trade-related exposures in accordance with the bilateral framework for calculating capital. This will result in an applicable risk weight of at least 20% (if the CCP is a bank) or 100% (if the CCP is a corporate financial institution under the Basel III framework).

As with exposures to QCCPs, the capital requirement will also need to be adjusted to account for contributions by the CM to the non-qualifying CCP's default fund.

Capital treatment of exposure of a client to a CM

If a CM client enters into an OTC derivative that is cleared on a CCP, the capital charge relating to the client's exposure under the OTC derivative will be treated as a CCP exposure provided certain requirements relating to segregation and continuity are satisfied. Otherwise, the capital requirements will be determined on the basis of the bilateral exposure to the CM.

Next steps

The Basel Committee intends to publish the final rules by the end of 2011 with a view to issuing the new rules by January 2013.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states and territories.