Key Points:

• Central counterparties use default funds, contributed by clearing members, to cover losses from member defaults, supporting market stability.
• Current U.S. regulatory capital rules require banking organizations to hold capital based on the central counterparty’s “hypothetical capital requirement” (Kccp), calculated from exposures at default (EAD). These rules fail to properly recognize the substantial risk-reducing impact of cross-margining arrangements, resulting in capital requirements for banks that are unnecessarily stringent.
• As cross-margining becomes more prevalent—particularly with forthcoming mandates like the SEC’s U.S. Treasury clearing requirement—this inadequacy will only become more pronounced and problematic.
• SIFMA, alongside ISDA and FIA, propose two approaches to revise capital rules for default fund contributions to better reflect actual risk.

Background

Central counterparties (CCPs) are critical for managing counterparty risk in financial markets, relying on default funds to cover losses if a clearing member defaults. The regulatory capital treatment of banks’ contributions to these funds, especially in light of cross-margining, has sparked debate. SIFMA, ISDA, and FIA have released a whitepaper analyzing U.S. capital rules and recommending changes to better reflect current risk management practices in CCPs.¹ This post summarizes the main insights and policy suggestions from that whitepaper.

Understanding the Core Concepts

Before diving into the specifics of the whitepaper, it’s essential to grasp a few fundamental terms:

• Qualifying Central Counterparty (QCCP): A QCCP is an entity that is licensed to operate as a CCP by the relevant regulator and is prudentially supervised. QCCPs play a crucial role in financial markets by mitigating counterparty risk in derivatives and other financial transactions.
• Default Fund: A Default Fund is a pool of financial resources contributed by clearing members to a CCP. Its purpose is to cover any losses that may arise from the default of a clearing member, ensuring the stability and integrity of the clearing system.
• Standardized Approach for Counterparty Credit Risk (SA-CCR): SA-CCR is a regulatory framework under Basel III for calculating the exposure amount of counterparty credit risk for derivative contracts. It aims to provide a more risk-sensitive and consistent approach to measuring counterparty credit risk compared to previous methods.

Why Does the Current Rules Inadequately Reflect the Risk?

The whitepaper critically examines the existing U.S. regulatory capital rules governing banking organizations’ contributions to QCCP default funds. Under these rules, a clearing member banking organization’s capital requirement for its default fund contribution is largely determined by the QCCP’s hypothetical capital requirement (Kccp). This Kccp is intended to reflect the QCCP’s exposure to each of its clearing members, calculated using the Exposure at Default (EAD) for derivative contracts and repo-style transactions.

The core issue identified by the whitepaper is that the current Kccp calculation fails to adequately recognize the risk-reducing benefits of QCCP cross-margining arrangements. While these arrangements allow QCCPs to collect less initial margin from clearing members due to netting across different products, the regulatory capital framework does not fully account for the corresponding economic risk offsets. This disconnect leads to an ‘overcalibration’ of capital requirements, meaning banks are required to hold more capital than is economically justified by the actual risk. This problem is expected to become more pronounced as cross-margining arrangements expand, particularly in light of the SEC’s mandate for U.S. Treasury clearing.

What are the Proposed Solutions?

To address this overcalibration, the whitepaper proposes two distinct approaches—a preferred approach and an alternative approach—both of which aim to revise the U.S. regulatory capital treatment for default fund contributions to better reflect the economics of QCCP cross-margining arrangements. A common thread in both proposals is the utilization of an expanded SA-CCR methodology.

Central to both proposed approaches is the concept of a ‘qualifying cross-margining arrangement.’ For an arrangement to be considered as such, it must meet specific criteria:

• Combined Portfolio Aggregation: The arrangement must enable clearing members or their clients to post aggregate initial margin or prefunded contributions based on a combined portfolio that includes different products, such as derivatives and repos.
• QCCP Involvement: All CCPs involved in the cross-margining arrangement must be recognized as QCCPs under the U.S. regulatory capital rules.
• Regulatory Approval: The cross-margining arrangement must have received approval from the applicable regulator for each participating CCP.

1. The Preferred Approach: Simplicity and Risk Sensitivity

The preferred approach outlined in the whitepaper aims for a more straightforward implementation while maintaining risk sensitivity. Under this method, a QCCP would determine its Kccp for each clearing member by combining two components:

• Non-Cross-Margined (Non-XM) Positions: The EAD for positions not subject to cross-margining, including any related initial margin or prefunded contributions.
• Cross-Margined (XM) Positions: The EAD for positions that are part of a cross-margining arrangement involving that QCCP and another QCCP. This EAD would be multiplied by an ‘allocation factor,’ jointly determined by the participating QCCPs based on their loss-sharing agreement. This factor ensures that the total EAD for XM positions is appropriately distributed between the QCCPs, with the sum of allocation factors across QCCPs always equaling one.

This approach is favored for its relative simplicity, requiring only one EAD calculation per clearing member, and its ability to accurately reflect the risk profile by considering both non-cross-margined and allocated cross-margined positions.

2. The Alternative Approach: A More Conservative Stance

The alternative approach, while also leveraging the expanded SA-CCR methodology, takes a more conservative stance. It requires a QCCP to perform two separate EAD calculations for each clearing member:

• Non-XM Positions: An EAD calculation based on the QCCP’s non-cross-margined positions and associated initial margin or prefunded contributions.
• XM Positions: A second EAD calculation that includes both the QCCP’s own cross-margined positions and the cross-margined positions of the clearing member that are held by another QCCP participating in the same arrangement, along with their respective initial margins.

The sum of these two EAD calculations would then determine the QCCP’s hypothetical capital requirement. A crucial element of this approach is a ‘cap’ mechanism: the calculated hypothetical capital requirement cannot exceed the figure that would be derived using the current U.S. regulatory capital rules (i.e., based on all positions cleared by that QCCP). This effectively means that if the combined portfolio does not yield sufficient risk offsets, the QCCP’s hypothetical capital requirement would revert to the existing, more conservative calculation method.

This alternative approach is inherently more conservative because it effectively counts cross-margined positions twice across the two QCCPs involved. However, the cap ensures that this conservatism does not lead to an excessively high capital requirement if risk offsets are not significant.

Why Do these Changes Matter?

The proposed revisions in the whitepaper are not merely technical adjustments; they represent a crucial step towards a more accurate and economically sound regulatory framework for financial markets. By better aligning capital requirements with the actual risks and risk offsets present in QCCP cross-margining arrangements, these changes can:

• Improve Capital Efficiency: Reduce the burden of overcalibrated capital requirements on banking organizations, freeing up capital for more productive uses.
• Enhance Market Efficiency: Encourage the wider adoption of cross-margining arrangements, which are vital for reducing systemic risk and improving liquidity in cleared markets.
• Promote Financial Stability: Ensure that regulatory capital adequately reflects the true risk profile of financial institutions, contributing to a more resilient financial system.

Conclusion

As the financial landscape continues to evolve, particularly with initiatives like the SEC’s U.S. Treasury clearing mandate, the need for regulatory frameworks that are both robust and responsive to market realities becomes increasingly apparent. The whitepaper provides a thoughtful and detailed roadmap for achieving this balance, fostering a more efficient and stable global financial system.

Author

Guowei Zhang, Managing Director and Head of Capital Policy of SIFMA.

Footnotes

1. CCP Cross-Margining Arrangements Default Fund Contributions Under the U.S. Regulatory Capital Rules [↩]

Related Resource

• White Paper

  CCP Cross-Margining Arrangements Default Fund Contributions Under the U.S. Regulatory Capital Rules