Trade exposures with CCPs - CRR Provision

Regulatory Capital Anatomy™ The JC’s untutored thoughts on how bank capital works. →Go uptown 306(1). An institution shall apply the following treatment to its trade exposures with CCPs: 306(1)(a) it shall apply a risk weight of 2 % to the exposure values of all its trade exposures with QCCPs; 306(1)(b) it shall apply the risk weight used for the Standardised Approach to credit risk as set out in Article 107(2)(b) to all its trade exposures with non-qualifying CCPs; 306(1)(c) where an institution is acting as a financial intermediary between a client and a CCP and the terms of the CCP-related transaction stipulate that the institution is not obligated to reimburse the client for any losses suffered due to changes in the value of that transaction in the event that the CCP defaults, the exposure value of the transaction with the CCP that corresponds to that CCP-related transaction is equal to zero. — Section 306(1), CRR View Template Capital Requirements Regulation: 575/2013/ (EUR Lex) | BIS publications: BIS capital requirements for bank exposures to central counterparties | leverage ratio | RWA | portfolio risk | systemic riskIndex: Click ᐅ to expand: Regulatory Capital Tell me more Sign up for our newsletter — or just get in touch: for ½ a weekly 🍺 you get to consult JC. Ask about it here.

In which the Capital Requirements Regulation 575/2013 (EUR Lex)) requires that, for a clearing member to achieve a zero weighting on its exchange traded derivatives clearing business, it must first be able to pass losses occasioned by the default of a CCP on to its client.

Where this came from

In the same way that that irritating guy with the Tele in the Redondo Guitar Center lists his influences as Hendrix, Sonic Youth and Mahler, this part of CRR lists as its influences the BIS paper from April 2014, capital requirements for bank exposures to central counterparties. That assumes your brokers are all agents the way US futures commission merchants are.

Twist: European clearers generally act as riskless principals. Cue tons of fun trying to work out what this all agency chat means for a principal.

This talks about CCPs. What about intermediate brokers?

Well, you would like to think so. It doesn’t make a lot of sense otherwise. But CRR itself is silent on the point. But here's the read across:

• The BIS paper on which CRR provision was modeled is framed in the positive: “Where the clearing member offers clearing services to clients, the 2% risk weight also applies to the clearing member’s trade exposure to the CCP that arises when the clearing member is obligated to reimburse the client for any losses suffered due to changes in the value of its transactions in the event that the CCP defaults.”
  • The theory being that unless the clearing member has agreed otherwise, it wouldn’t be liable for those provisions in the first place: ie, it assumes an agency model (Common in the US) for client clearing.
  • The European model is a back-to-back principal model, however, so unless you’ve somehow carved it out, you would be liable for it, all other things being equal.
• The BIS does talk about this a little: “The treatment in paragraph 192 to 194 may also apply to exposures of lower level clients to higher level clients in a multi-level client structure, provided that for all client levels in-between the conditions in (a) and (b) below are met.” The conditions (see here for their text) are predicated on all the structures being of an agency kind.
• One is therefore obliged to extrapolate from an agency model to the economic equivalent under a principal model.

The clearing member’s own negligence, fraud or wilful default

But it will be a generous client indeed who does not insist on a carve-out from that right for defaults caused by the clearing member’s own negligence, wilful default or fraud. Would such a carve-out invalidate an application of 306(1)(c)?

Respectfully, it is submitted, it would not:

It is clear in 306(1)(c) that whether or not the CCP is generally “in default” in the abstract, in the sense of being “insolvent” it must have specifically defaulted under the transaction (that is, it must have failed to pay something that it owed to the clearing member).

Of course, a CCP’s insolvency would be likely to lead to a transaction default.

Any negligence, wilful default or fraud on the clearing member’s part under the CCP transaction would, QED, be a default by the clearing member. The CCP then would be entitled to withhold payment under the transaction; ie, it would not be in default in doing so.

What, then, if a clearing member default were so egregious that it caused the total failure of the CCP, meaning the CCP failed to pay even amounts that it was obliged to pay on default by the clearing member?

So a loss to the clearing member which arose out of the CCP’s inability to perform under a transaction which, in turn, came about as a result of the clearing member defaulting to that CCP would not be “loss suffered in the event that CCP defaults”: if the clearing member sued the CCP for that loss, it would fail.

Looking at it another way, if such a carve-out did invalidate 306(1)(c) then the provision would have no application at all, because it would be commercially impossible to remove it.

See also

• The Basel / BIS paper on which this turbulent regulation was based: Capital requirements for bank exposures to central counterparties
• Agency versus [[prini