Efficiency is Vital to Delivering Resilience

With less than three months to go until implementation of US Treasury clearing begins at the end of this year, it's critical that the mandate is safely implemented without compromising market efficiency. This represents a huge change in market structure, and capital and margin requirements must be properly aligned with economic risk to avoid constraining banks from providing liquidity. The objective of Treasury clearing is to improve the resilience of the world's most systemically important market, but this will only be achieved if firms are able to recognize important exposure offsets without being hit by excess capital requirements.

To enable the efficient implementation of Treasury clearing, market participants are looking to use cross-margining programs like the one offered by CME Group and the Fixed Income Clearing Corporation to recognize offsets and reduce margin requirements across portfolios of Treasury cash, repo and futures transactions. But those efficiencies must also be recognized in the capital framework. Otherwise, reduced margin that reflects risk would paradoxically trigger sharp increases in capital requirements under the standardized approach for counterparty credit risk (SA-CCR), restricting balance sheet capacity and the ability of banks to provide the client clearing services that are crucial to the success of the reforms.

The latest US Basel III proposal permits cross-product netting under SA-CCR for certain repo and derivatives trades, including those between clearing members and their clients, but the proposed methodology is excessively conservative and would result in capital requirements that don't reflect the underlying risk of well-hedged portfolios. In ISDA's response to the US consultation in June, we recommended a change to the methodology that would more closely align capital with risk. As the clock ticks towards the start of Treasury clearing, it's becoming increasingly urgent that this adjustment is made and we've been engaging closely with US regulators to explain why it is needed.

The need to consider derivatives and repos holistically is not confined to the US, however. It reflects a broader shift in the market structure that spans other jurisdictions. With the expansion of central clearing and margin requirements for non-cleared derivatives, market participants increasingly rely on access to repo and other securities financing transactions (SFTs) to quickly generate the cash and high-quality liquid assets needed to meet derivatives margin calls. SFT markets play a vital role in fostering liquidity, mobilizing collateral and supporting the smooth functioning of derivatives markets. Earlier this year, ISDA published a whitepaper identifying the key regulatory and structural issues that affect the availability of secured funding and setting out a series of targeted adjustments that would support resilient, efficient and well-supervised SFT markets.

Policymakers have also been looking at ways to improve the resilience of SFTs. In keynote remarks at the ISDA Derivatives Trading and Treasury Forum in London last month, the Bank of England's Nat Benjamin highlighted the repo market's essential role in keeping cash and collateral flowing through the financial system. ISDA has been working with the central bank on its plans for the haircutting of gilt repo transactions to ensure these are appropriately calibrated. The European Securities and Markets Authority is also reviewing margining practices in the repo market and suggested in a recent working paper that future research should combine trade-level haircut data with net exposure information to obtain a holistic view of margining practices.

As Nat Benjamin noted, poorly calibrated policy measures could reduce market-making capacity and genuine risk offsets should be recognized to avoid unnecessary liquidity demands and funding pressures, particularly during periods of stress. This is exactly why any new measures to improve gilt repo market resilience must be carefully considered and appropriately designed.

Ultimately, the industry's focus on efficiency can support the public sector's objective of greater resilience. Risk-appropriate rules can help to deliver both objectives, which is why ISDA is pushing for that outcome across derivatives and SFTs. With a consistent, appropriate framework that reflects economic risk, market participants will be able to realize vital efficiencies that will deliver the resilience sought by regulators.