Jurisdictions may vary but the markets are international and regulation is effectively ‘global’, or is it? Perhaps. Here in Japan, we have a different and significantly more nuanced perspective, which is reflective of other parts of the world.
What has been clear for some time is that the largely uncoordinated and rapid introduction of new laws and rules in the wake of the 2008 financial crisis and subsequent G20 Pittsburgh Summit has led to a range of unintended consequences.
The prevailing ‘one-size-fits-all’ mind-set is a classic example. Take the CFTC guidance for the definition of a ‘US Person’, subsequently amended to meet non-US political and operational imperatives. Even now, the US and EU are still wrangling over mutual recognition of CCPs. But the headlines mask some more subtle, significant challenges in other jurisdictions, where market structure and culture differ from Europe and the US; one of these relates to swaps clearing, trade compression and leverage ratios.
Having been based in Tokyo for several years, I have lived with a domestic market quietly and effectively becoming the first in the world to be subjected to a clearing mandate for OTC interest rate swaps (November 2012). Since then, Japan has certainly not stood still. Nor has it allowed itself to be consumed by prevailing financial forces or dominated by the same concerns – at least not in the same way. While foreign banks are considerably exercised over leverage ratios under Basel III (an arguably artificial measure which has little bearing on the riskiness of a portfolio, based on the gross notional of outstanding swaps positions) Japanese banks simply do not have the same view. For them, leverage ratios figure on a distant horizon, of little immediate importance. Given substantial capital reserves, there is certainly no business incentive to be overly concerned in the short term.
One effect of this removed philosophy is that techniques that are both valuable and urgent to ‘foreign’ market participants here are of far lower priority to home players. Where the regulatory worlds collide over the imperative to reduce leverage ratios this can be particularly apparent, nowhere more so than when it comes to the volume of swaps portfolios (cleared or uncleared) participating in risk-free netting and compressions. Typically risk free netting allows the consolidation of trades with identical economic profiles, previously held as separate outstanding contracts, into a single contract. The process is not mandatory and participants can choose which trades to net. Compression by contrast is a multi-organisational process with all participating members and clients agreeing which trades in their portfolios are eligible, along with their risk and other tolerances. The compression is normally finalised before the beginning of business on the morning of the compression day, with the Members’ and Clients’ positions being communicated back to them for updating in their systems, an operationally intensive process.
This is where international financial markets receive the reality check of national difference. The structure of the market in Japan is very different from those in the US and Europe; it is dominated by a small number of very large domestic swap dealers, trading with the foreign banks and a large number of smaller domestic institutions. The underlying market tends to be highly directional, with the majority of the Japanese banks in one direction and their foreign bank counterparts the other.
Even this tells only a partial story. There are arguments that hedge accounting makes compression ineffective for qualifying trades, particularly in a directional portfolio, but there may still be significant benefits where adjacent tenor buckets can be offset or regular adjustment to hedges creates a large number of offsetting trades. The question of how easily auditors can be convinced that a compressed portfolio with a similar risk and payment profile meets hedge accounting standards still remains.
What is certain is that the current situation which has the potential to increase risk in Japan will manifest in other jurisdictions. From a purely Japanese perspective, the recently demonstrated limited participation in compressions by the Japanese banks is adding risk to JSCC’s default management process. Internationally we should all be taking notice. Inevitably, as time passes there will also be an increasing number of incompressible trades in foreign banks’ portfolios (as the CCP must always stay flat, an economically identical, corresponding trade is needed for that trade to be included). Should a foreign bank default, its portfolio will be auctioned off. But if that portfolio consists of uncompressed trades with a large notional principal, it may be of such a size that no bank with concerns over leverage ratios would be safely able to bid on it. Even those who could bid would discount their bid to account for the impact on their leverage ratio. Worse still, even if the regulators were to allow some short-term rule relaxation to help stabilise the market, it still might not be possible to sufficiently reduce the gross notional of the portfolio at a later date.
In such circumstances, during a time of financial crisis, the consequences could be that foreign banks would have a significantly worse view of the value of another foreign bank’s portfolio in a default auction, making their bids less competitive or even below the “one cent” level, particularly given that they are likely to be simultaneously bidding for a number of other default portfolios across multiple jurisdictions and time zones.
So, what is the solution? Of course all this may be a temporary blip in the Japanese market due to the staggered phasing-in of leverage ratio rules. If however, it is down to the structure of the Japanese banks then both here and in other similar jurisdictions worldwide, we will need additional incentives, beyond the leverage ratio, to change behaviour. As markets wake up to the implications, we may well see a “premium”, impacting all participants in affected markets.
Published on: DerivSource 27 May 2015
Published on: Tabb Forum 01 June 2015