Basel III requirements hurt end-user

Walter Lukken, President and CEO at Futures Industry Association (FIA), a global trade organization for the futures, options and centrally cleared derivatives markets, testified about Basel rules before the US House Agriculture Subcommittee on Commodity Exchanges, Energy, and Credit.

Given that FIA’s membership includes clearing firms, exchanges, clearinghouses, trading firms and commodities specialists from more than 48 countries, as well as the surrounding professionals serving the industry such lawyers and technology vendors, Walter Lukken’s official comment on the subject are taken seriously by government and independent regulators.

Following the Basel Committee’s recent consultation on proposed revisions to the leverage ratio, FIA’s Lukken has been gathering and analyzing data on the impact of capital requirements. While supporting most efforts to enhance capital requirements, his view is that the way rules are set up right now, they will harm end-users:

“New capital requirements are lessening clearing options for end-user customers who use futures and cleared swaps to manage their business risks. This harms farmers seeking to manage commodity price fluctuations, commercial companies wishing to lock in prices as they distribute their goods, and pension funds using derivatives to enhance workers’ retirement benefits. The negative impacts to the real economy are significant.”

The Basel leverage ratio and its failure to properly consider the exposure-reducing effect of customer margin was also a target during the hearing. Clearinghouses collect a default margin from members and segregate it away from their own funds as required by the Commodity Exchange Act. However, the Dodd-Frank Act and EMIR are extending clearing requirements to certain OTC swaps. Lukken argues that Basel III capital requirements are lessening clearing options for end-user customers as clearing member banks find difficult to offer clearing services to clients, against G20’s ironic efforts to increase the use of clearing as a counterparty risk mitigation tool.

The problem can be summed up to failure to understand that client margin posted to a bank-affiliated clearing member belongs to the customer and not the bank. “The assumption that this customer margin can be used by the bank without restriction runs counter to the Commodity Exchange Act and Commodity Futures Trading Commission (CFTC) regulations.”, Lukken said, adding that the amount of capital required to be held for clearing under Basel III is estimated at $32-$66 billion, and will rise to $126-$265 billion once more products are subject to clearing.

“An end-user that utilizes the futures market to hedge its business risks is required to clear transactions through a clearinghouse, and to do so it must offset its exposure by posting margin through a clearing member. These are customer funds, provided specifically to offset the bank-affiliated clearing member’s exposure in their obligation to pay the clearinghouse on behalf of the customer. Such customer margin should therefore be considered an offset in determining the bank’s exposure”, Lukken concluded.