Monday, January 11, 2010

Basel could force OTC derivatives onto exchanges

Posted on the International Financial Law Review by Elizabeth Fournier:

New Basel proposals apply large haircuts to securitisations exposures used as collateral to hedge counterparty risk. They could ramp up charges and force derivatives trades based on that risk onto exchanges

The haircuts would be applied to the collateral that counterparties give to each other to secure obligations. Under the existing Basel II rules, all similarly rated instruments are given the same haircut. But under new rules a distinction would be made between government, corporate and asset-backed bonds.

“The Basel committee wants banks to have an economic incentive to trade derivatives through regulated exchanges, so is increasing the counterparty risk charges for one-to-one deals,” said Mark Nicolaides, partner at Latham & Watkins in London.

The new rules would double the haircut as the perceived risk involved increased, with AAA-rated government bonds subject to a 0.5% haircut, corporate bonds incurring 1% and securitisation exposures 2%.

“For a one-year instrument that might not seem like much,” said Nicolaides, “but when you consider that for instruments with more than five year residual maturity that goes up to 4%, 8% and 16% respectively, it’s a dramatic difference.”

With a consultation period on the proposals open until April 16, this point will be hotly contested by banks.

But with the additional regulatory benefit of encouraging regulated trades it’s likely to remain, particularly in the light of Wednesday’s move by the Bank of International Settlements to call central bankers and the heads of large financial institutions to a meeting in Basel to express concerns about renewed risk-taking.

The latest set of Basel proposals has also reassessed how interconnected banks are, and added a 25% premium on counterparty risk charges for large financial institutions.

The rules mean that a bank and its special purpose vehicles (SPVs) will be considered 100% interconnected, so if a bank fails its SPVs will also automatically fail.

Due to the level of detail in the proposals, banks are expected to take their time planning responses, with meetings over the next four to six weeks, and draft consultations after that.

“The committee isn’t tinkering around the edges anymore,” said Nicolaides. “This is a comprehensive modification of the rules involving some very complicated calculations.”

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