Recently, as part of the Basel III reforms, the Basel Committee on Banking Supervision (the “BCBS”) proposed some significant changes to the regulatory capital requirements for banks exposed to central counterparties (“CCPs”) and their default funds that will provide strong incentives for banks to use only CCPs that meet rigorous new standards. On December 20, 2010, the BCBS released a consultative paper entitled Capitalisation of Bank Exposures to Central Counterparties (“Consultative Paper”).

There is little doubt that Basel III will soon come to Canada, along with whatever form the capital adequacy rules for exposures to CCPs finally take. On February 1, 2011, the Office of the Superintendent of Financial Institutions Canada (“OSFI”) published a statement alerting banks, bank holding companies, and federally regulated trust and loan companies to the BCBS’ substantial completion of the international agreement on capital rules, to be implemented starting January 1, 2013, indicating that the reforms in the Consultative Paper will also be implemented by January 2013.

The Consultative Paper reflects the parts of the proposed Basel III1 reforms that set out regulatory capital adequacy rules intended to require banks to more appropriately capitalize their exposures to CCPs (“CCP reforms”). The CCP reforms are aimed at giving banks incentives to increase the use of CCPs in respect of over-the-counter (“OTC”) derivatives transactions while ensuring that the risks arising from banks’ exposures to CCPs are adequately capitalized. The CCP reforms are consistent with Canada’s G20 commitments to increase the use of CCPs and the conclusions of the recently published Canadian OTC Derivatives Working Group2 discussion paper entitled Reform of Over-the-Counter (OTC) Derivatives Markets in Canada.

The BCBS will conduct an impact study to help finalize and calibrate these reforms. Canada is a member of the BCBS and has participated in the development of the reforms.

The CCP reforms will be finalized by September 2011 when the Committee on Payment and Settlement Systems and the Technical Committee of the International Organization of Securities Commissions (collectively, “CPSS-IOSCO”) publishes standards for the supervision and oversight of financial market infrastructures, including CCPs.

the CCP reforms

The CCP reforms require banks to more appropriately capitalize their exposures to CCPs, including both trade and default fund exposures to CCPs, depending in part on whether the CCP is a “qualifying CCP” for the purposes of the new rules:

Generally speaking, the Committee proposes that trade exposures to a qualifying CCP will receive a 2% risk weight. In addition, default fund exposures to a CCP will, in accordance with a risk sensitive waterfall approach (based on a CCP’s actual financial resources and hypothetical capital requirements), be capitalised according to a method that consistently and simply estimates risk arising from such default fund.

The CCP reforms are a significant departure from Basel II3, which assigned a zero percent risk weight for banks’ CCP exposures. They also differ from the BCBS’ December 2009 consultation paper, Strengthening the Resilience of the Banking Sector, which proposed a zero percent risk weight for banks’ exposures to CCPs that are compliant with the CPSS-IOSCO standards.  

  1. maintaining sufficient capital for exposure to CCPs

The BCBS recognizes the fact that important efforts are being made to increase the use of CCPs and that banks and financial systems will increasingly rely on CCPs. Accordingly, the BCBS believes that banks must maintain sufficient capital for their exposures to CCPs and wants to ensure that the incentives to structure financial resources, resulting from regulatory provisions requiring banks to capitalize their exposures to CCPs in a risk-sensitive way, do not have inadvertent consequences.

The BCBS is working with CPSS-IOSCO to better understand such incentives and their relation to the banking system as a whole.

  1. qualifying CCPs

The CCP reforms define “qualifying CCPs.” Where a CCP is compliant with CPSS-IOSCO standards and is able to assist clearing member banks in properly capitalizing for CCP exposures (by either undertaking the calculations or making available sufficient information to its clearing members, or others, to enable the completion of capital calculations), such CCP is considered a “qualifying CCP.” The proposed rules set out the formulae that must be used to calculate a CCP’s hypothetical capital requirements, prefunded financial resources and prefunded default fund contributions from clearing members if it is to be considered qualifying. Exposures to “qualifying CCPs” should benefit from lower capital charges.

Exposures to any CCP that is not a qualifying CCP are to be capitalized at 100% (as opposed to the 2% rate for qualifying CCPs), which is an effective risk weight of 1250%. This encourages banks to deal with CCPs subject to the CPSS-IOSCO standards.

The BCBS invites comments as to whether CCPs, CCP overseers, clearing members, transaction repositories or other sources of information and expertise are best equipped to assemble and manage the necessary information and to complete the calculation of risk and implementation. It also invites comments on how verification of the calculations and related quality control can be assured.

  1. trade exposures

The CCP reforms propose that the low capital charges for exposures to CCPs should be limited to posted collateral (other than collateral which is bankruptcy remote from the CCP, which should have a zero percent risk weight), mark-to-market exposures and potential future exposures to qualifying CCPs. Rather than a zero capital charge, a small but positive capital charge (based on a 2% risk weight) should be associated with such trade exposures.

It is not clear whether a 2% risk weight is appropriate. Obviously the risk weight should be lower than the risk weight applied to non-cleared transactions and higher than zero (since there is a greater than zero risk of either CCP default or having to make contributions to the CCP for the default of a CCP member), but there needs to be more study to determine if 2% is indeed the correct risk weight.

  1. qualifying default fund exposures

Members of a CCP, including banks, agree to provide financial assistance to the CCP where required to cover any shortfalls arising from the default of a CCP member. These agreements by CCP members to contribute to avoid losses from the default of any CCP member are collectively referred to as the default fund. The CCP reforms propose that a bank should capitalize its default fund exposure to a qualifying CCP according to a risk-sensitive approach that is based on the calculation of the CCP’s “hypothetical capital.”

Although the actual model for determining required capital is complex, it is based on the simple principle that where a CCP adequately collateralizes all exposures with appropriate margin, the default fund exposure will be reduced and where the opposite is true, the default fund exposure of CCP member banks will be increased. Thus the CCP reforms encourage CCPs to adopt suitably stringent margin requirements. It remains to be seen what the specific risk weights for each type of instrument cleared by a CCP will be and what value will be given to each type of margin. The determination of these inputs by the regulators will be crucial to ensuring that CCP member banks properly capitalize the risks they assume by agreeing to cover the losses of a defaulting CCP member.

The BCBS is inviting comments on practicable, simple and supervisable methods for calculating such exposure or hypothetical capital other than the current exposure method (“CEM”)4 as well as adjustments to CEM that could improve its utility.

Where a CCP is not a qualifying CCP, a bank’s funded and unfunded, but contractually committed, default fund contributions to such CCP should also be capitalized at a 100% rate (i.e., a risk weight of 1250%).

  1. indirect access

A non-CCP member bank can enjoy the capital benefits of indirectly transacting with a CCP where (1) collateral posted by the non-member bank in connection with such trade has been segregated and is bankruptcy remote from the clearing member; and (2) the non-member bank is legally ensured that another CCP member will take over such trade if the original clearing member counterparty cannot perform.

Canadian banks have not traditionally used collateral arrangements which allow counterparties to segregate collateral in bilateral OTC derivatives transactions, but they will have to adopt such arrangements if they wish to provide clearing services to regulated financial institutions that are not themselves CCP members.

next steps

After the consultation process is completed, the proposed CCP reforms will be further refined between March and June 2011. They will be finalized once the final CPSS-IOSCO standards are published in 2011. National implementation should be complete by January 2013.

potential risks and impact

Timing the implementation of the proposed CCP reforms appropriately will be important. Implementing the BCBS’ recommended counterparty credit risk reforms5 before implementing the CCP-related ones could create a risk to banks and financial systems. Such risk would arise because the increase in capital requirements for bilateral OTC derivatives trades imposed through the counterparty credit risk reforms would create strong incentives to use CCPs, but the increased capitalization of bank exposures required to mitigate the systemic risk arising from such increased use of CCPs would not yet be in place.

Since the vast majority of OTC derivatives transactions in Canada involve regulated financial institutions6, the CCP reforms as implemented by OSFI will play a large role in determining the member rules adopted by any Canadian CCP and the terms of any centrally cleared OTC derivatives contract between a CCP member Canadian bank and its counterparties.

Financial institutions are encouraged to familiarize themselves with the proposed reforms, including OTC derivatives regulation reforms, and prepare for their implementation within the next two years.