In a prior blog, Navigating the Nuances of QCCP Default Fund Contributions, we discuss adjustments to capital treatment for default funds in order to account for margin efficiency benefits provided by cross-margining arrangements. This blog serves as a companion piece, outlining revisions to the capital framework that would allow banks to recognize the risk-reducing effects of cross-product netting on their exposures to clients.

Key Points

• U.S. prudential capital rules fail to recognize cross-product netting arrangements, undermining banks’ risk management capabilities and capital efficiency, especially in U.S. Treasury securities clearing.
• The lack of regulatory recognition for cross-product netting results in excessive and unnecessary capital requirements, discouraging banks from pursuing risk-reducing strategies and potentially jeopardizing both market liquidity and overall systemic stability.
• One solution is to extend the Standardized Approach for Counterparty Credit Risk (SA-CCR) to include repos, allowing these transactions to be treated as forward-settling interest rate derivatives and properly reflecting risk-mitigation benefits of cross-product netting.
• Reforming the prudential capital rules to recognize cross-product netting is critical for strengthening market liquidity, advancing capital efficiency, and reducing systemic risk as the volume of cleared U.S. Treasury transactions inevitably rises under new SEC regulations.

Prudent risk management and effective capital frameworks are essential for financial stability and growth. A recent discussion paper by SIFMA, ISDA, and FIA, “Cross-product Netting Under the US Prudential capital rules,” identifies a gap in current U.S. capital rules: the limited recognition of cross-product netting in U.S. Treasury securities clearing.¹ This blog post summarizes the main arguments for why improved recognition of cross-product netting is necessary to advance capital efficiency, boost market liquidity, and facilitate new Treasury clearing mandates.

What is Cross-Product Netting?

When a bank holds multiple financial agreements such as repurchase agreements (repos) and futures contracts, cross-product netting agreement enables these positions to be assessed collectively instead of individually. These agreements allow financial institutions to settle and terminate positions on a net basis across various financial transactions, including derivatives and repurchase (repo) transactions. Netting significantly reduces the counterparty credit risk of the entire portfolio, resulting in a lower total exposure.

How Do Current U.S. Prudential Capital Rules Address Cross-Product Netting?

While banks play a crucial role in providing liquidity and facilitating access to capital markets, the existing U.S. prudential capital rules do not fully acknowledge the risk-reducing benefits of cross-product netting agreements.

Currently, cross-product netting is not recognized under the standardized approach to capital requirements, which is used by most large banks. Furthermore, the proposed 2023 Basel III Endgame revisions would eliminate the Internal Models Methodology (IMM), which previously allowed for some recognition of netting benefits.² This means that the risk-reducing effects of cross-product netting would be entirely disregarded, leading to an ‘overcalibration’ of capital requirements.

This overcalibration creates a perverse incentive: banks might face increased capital requirements even when they employ risk-reducing cross-margining efficiencies. Such punitive capital treatment could limit bank involvement in the transition to increased clearing of U.S. Treasury repo securities, negatively impacting market liquidity and potentially increasing systemic risk. The whitepaper illustrates this with an example where a portfolio of repos and U.S. Treasury futures subject to cross-product margining, without regulatory recognition of netting, could see a significant increase in exposure despite reduced initial margin due to netting.

What Are the Advantages of Extending SA-CCR to Cover Repos?

The whitepaper advocates for a preferred approach to revise the U.S. prudential capital rules: extending the SA-CCR to include repos. This approach involves treating repos on U.S. Treasury securities as forward-settling interest rate derivatives. By doing so, a pre-existing methodology within the U.S. prudential capital rules can be leveraged to recognize the risk-mitigation benefits of cross-product netting.

Under this proposed extension, the exposure amount of a netting set under SA-CCR would continue to be a function of the replacement cost and the potential future exposure of the transactions within that netting set. Specifically, a repo subject to a cross-product netting agreement would be represented as a forward purchase of an interest rate derivative, and a reverse repurchase agreement as a forward sale. The U.S. Treasury securities underlying these repos would be reflected as collateral for calculating the replacement cost and potential future exposure of the netting set.

This method ensures that the volatility of the underlying securities is captured in the potential future exposure calculation through the application of relevant supervisory factors, thereby eliminating the need for separate haircuts on the funding or instrument leg of the repo within the SA-CCR calculation. The whitepaper also suggests that a hedging disallowance parameter could be incorporated to refine the recognition of netting between repos and derivatives, calibrated to ensure that the overall capital requirement is not significantly more prohibitive than calculations under the Internal Models Methodology (IMM).

This approach offers a practical and consistent way to integrate cross-product netting benefits into the prudential capital rules, aligning capital requirements more closely with the actual risk profiles of banking organizations and promoting greater efficiency in the U.S. Treasury markets.

Why This Matters for the Future of U.S. Treasury Markets?

The proposed changes are not merely technical adjustments; they are crucial for the efficient functioning and stability of the U.S. Treasury markets. The SEC’s U.S. Treasury clearing final rule is set to significantly increase the volume of U.S. Treasury repo transactions subject to mandatory clearing. Without appropriate recognition of cross-product netting, banks would face disproportionately high capital requirements, hindering their ability to facilitate this increased clearing activity.

By adopting a more risk-sensitive capital framework that acknowledges the benefits of cross-product netting, regulators can:

• Enhance Market Liquidity: Encourage greater bank participation in cleared markets, ensuring ample liquidity for U.S. Treasury securities.
• Improve Capital Efficiency: Allow banks to optimize their capital allocation, freeing up resources for other productive investments.
• Reduce Systemic Risk: Promote the use of risk-reducing netting arrangements, thereby strengthening the overall financial system.

Conclusion

The successful implementation of the SEC Treasury clearing final rule hinges on a prudential capital framework that accurately reflects risk. Recognizing cross-product netting arrangements under the U.S. prudential capital rules, particularly through an expansion of SA-CCR, is not just about regulatory efficiency; it’s about fostering a safer, more liquid, and more resilient U.S. Treasury market for everyone. The whitepaper provides a compelling case for updating the U.S. prudential capital rules to reflect the economic realities of cross-product netting. Implementing these changes will be instrumental in supporting the smooth transition to increased central clearing of U.S. Treasuries and fostering a more robust and efficient financial market.

Author

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

Footnotes

1. https://www.sifma.org/resources/general/cross-product-netting-under-the-us-regulatory-capital-framework/ [↩]
2. https://www.federalregister.gov/documents/2023/09/18/2023-19200/regulatory-capital-rule-large-banking-organizations-and-banking-organizations-with-significant [↩]

Related Resources

• White Paper

  Cross-product Netting Under the U.S. Regulatory Capital Framework

• Blog

  Navigating the Nuances of QCCP Default Fund Contributions