Thousands of European financial institutions risk being blocked from using derivatives as they struggle to comply with new rules intended to strengthen markets after the financial crisis.
Many financial institutions far removed from the centre of the 2008 crisis have had to adjust to a new world mandated by the G20 countries in which their derivatives — used to hedge against interest rate moves — are processed through central clearing houses.
A clearing house is a counterparty that sits in the middle of a transaction between buyer and seller with the aim of reducing risk.
This new order requires that, for the first time, many types of derivatives users — ranging from insurance companies and pension funds seeking protection from movements in interest rates to small banks offering fixed-rate mortgages — have to provide margin, or collateral, to protect against losses on their trades.
But Europe — which is more than three years behind the US in introducing the same rules — is now facing a significant added problem. Some of the global investment banks that these institutions are expected to rely on for access to clearing now say they have little capacity on their balance sheets to do it.
“There are some regulatory forces pushing firms to clear; however, there are other pressures causing clearing members to think about capacity,” says Daniel Maguire, global head of rates and foreign exchange derivatives at LCH, a clearing house. “We didn’t have this dynamic when clearing was introduced in the US . . . In the States it was a gold rush to get into clearing.”
Capacity constraints threaten to undermine requirements for clearing, which became a key tenet of the global regulatory response to the crash after policymakers blamed the opaque and often poorly monitored over-the-counter derivatives market for accelerating the crisis.
In the US, more than 70 per cent of cleared trades are administered by five big banks: Morgan Stanley, Credit Suisse, Citibank, JPMorgan and Wells Fargo. Two of these banks told the Financial Times that because their resources are so stretched they have set aside just 20 per cent of the capacity they devote to clearing in the US for European clearing.
The big banks have blamed capital rules that have come from the Basel banking committee, a group of international supervisory authorities. One of the main deterrents is the so-called leverage ratio, a blunt tool that requires banks to hold capital against the notional size of derivatives trades, rather than the amount of risk in a client’s trades.
As a result, it is particularly capital intensive for banks to clear for pension funds and insurers. European pension funds, though, have an exemption from clearing until next year, which could be extended further.
This problem has been exacerbated by the nature of the European rules. The US provides exemptions from clearing for small banks with less than $10bn in assets. This means only 85 of the 5,260 commercial banks in the US have to comply with the clearing requirement, according to data from the US Federal Reserve and Federal Financial Institutions Examination Council. But there is no such provision for Europe’s 5,269 credit institutions.
Banks are less inclined to set up and manage a relationship with smaller derivatives users due to the operational burden of doing so.
European regulators are assessing the problem of smaller investors being blocked from the clearing market. They are currently reviewing rules and plan to publish their findings early next year.
Number of LCH members in Europe able to clear interest rate swaps
But there are some factors that could mitigate the impact in Europe. Banks such as ABN Amro and Commerzbank, along with smaller lenders such as Banco Sabadell in Spain and Banca IMI in Italy, will offer European clearing services. Only 14 members of LCH clear interest rate swaps for clients in the US. Yet in Europe, there are already 34 LCH members able to offer the same services.
There are also more central counterparties in Europe. LCH and CME dominate in the US, while in Europe they are joined by Eurex as well as some smaller clearing houses such as BME in Spain.
“We would have an issue with the same level of concentration risk in the US if that were to also exist in Europe,” says Philip Simons, head of fixed income derivatives sales at Eurex. “We would like to see greater diversity in Europe.”