In April, I appeared as a witness before our industry’s oversight body of the U.S. House of Representatives regarding the impact of capital and margin requirements on end-users and our industry. Members of Congress were interested in how capital requirements and in particular the leverage ratio may increase the cost of clearing and reduce access to hedging by mistreating customer margin as bank leverage.
I testified to the fact that if left unaddressed, this issue has the potential to be devastating to our industry by reducing the number of clearing members, limiting customer access to markets, and hindering a clearinghouse’s ability to move positions during a crisis.
One opposing witness tried to dismiss these concerns by downplaying the impact on the banking system and equating the cost to end-users to a "ham sandwich." To put it mildly, Members were not impressed by this flippant analogy, given the real impact on their constituents and our industry. When the banks allocate these capital costs—estimated as much as $66 billion today and $265 billion when mandatory clearing goes fully into effect—to their clearing divisions, many find the business economics of clearing to be unsustainable. To steal a line from Ghostbusters, this equates to a ham sandwich that is “thirty five feet long and weighing approximately six hundred pounds.” Now that’s a big ham sandwich!
I reminded the Committee that after the financial crisis, the G20 committed to the twin goals of enhancing capital requirements and requiring clearing, and thus margining, of standardized over-the-counter products through regulated clearinghouses. Both bank capital and margin play important roles in protecting the safety and soundness of our markets but in very different ways.
Bank capital is the amount of funds that a banking institution holds in reserve to support its banking activities, and it serves as a stable financial cushion to absorb unexpected losses by banks. On the other hand, margin consists of dedicated funds collected daily that aim to reduce the exposure to losses for clearinghouses and their members.
Put simply, margin is a performance bond that ensures customers make good on their transactions. Regulatory rules ensure that initial customer margin is always there during a crisis by segregating these funds from clearing members in the form of cash or extremely safe and liquid securities.
Unfortunately, the Basel Committee has decided to include initial margin in calculating a bank’s exposure for the purposes of determining capital requirements. This decision is already leading to higher costs for commodity producers, manufacturing companies, investment managers and other customers that use these markets to manage their risks.
Walt Lukken, President and CEO of FIA, testifies before the House Agriculture Subcommittee on Commodity Exchanges, Energy and Credit about the impact of margin and capital requirements on end-users. This video is an excerpt of questions and answers during the hearing that was held on April 28, 2016.
I told the committee that given these new capital constraints, clearing members are beginning to limit the amount and types of clients that they accept to clear. It will also likely cause further consolidation among clearing members, resulting in fewer players supporting the safety of the clearinghouses. In the U.S., the number of clearing members has decreased from 94 ten years ago to 55 today. While there are several factors contributing to this consolidation, capital has been cited by several banks that have exited the clearing business.
I noted to the Committee that the most concerning issue is the leverage ratio’s impact on a clearinghouse’s ability to move or port client positions from a defaulted clearing member to another healthy clearing member during a crisis. If porting cannot be achieved due to capital constraints, clearinghouses will be forced to liquidate in a fire sale client positions during volatile market conditions, adding unnecessary stress to an unstable marketplace. After all, the ability of clearinghouses to move customer positions during the failure of Lehman Brothers in 2008 is one of the fundamental reasons that policy makers and the G-20 determined to expand clearing.
The good news is that the Members of the Agriculture Committee get it: they understand that clearing mitigates systemic risk, that margin reduces exposure in the clearing system, and that imposing capital requirements on margin is not only unnecessary, but also counterproductive to promoting central clearing. They asked insightful questions, such as whether we should be considering capital, margin, and clearing requirements in a more holistic way to ensure there are no conflicts. They were also very concerned about how the agricultural producers and businesses they represent are going to manage risk if clearing becomes more costly. I was glad that there was real concern and a common-sense commitment to addressing this issue from both sides of the aisle.
There is more good news too: the Basel Committee has agreed to seek additional input from the industry on the treatment of initial margin. FIA is leading an effort to gather and present data that quantifies the repercussions of the existing approach. It’s critical that we work together as an industry to educate regulators on the full effects of capital requirements.
We can’t afford to lose sight of the forest for the trees. The leverage ratio should not stand in the way of greater adoption of central clearing for derivatives, one of the core goals of the G-20's post-crisis financial reforms. It is vital that regulatory incentives are aligned in moving towards this goal.