Basel III and futures clearing - costs are going up

Basel III, the new set of regulatory standards for banks, is focused on macro prudential policies to reduce the systemic risk in the global banking system. Who doesn't want a reduction of systemic risk, but this new regulatory environment will have a real cost on all traders especially for those who trade futures. Futures have always been a  clearing area that was less capital intensive. This is going to change radically. 

There is always the law of unintended consequences or second order effects when there is a change in the regulatory environment. Here, the unintended consequence will forcing smaller managers out of the market. The new regulatory environment will hit hard those who are less active traders and those who focus on commodities. 

There are three key capital rule changes with Basel II which will effect futures trading:

1. Strengthening of bank capital requirements

2. Enhancements on risk coverage 

3. New leverage ratios 

The increase in bank capital requirements from 4% to 6% means that the cost of capital will increase. Fewer types of capital will qualify as Tier 1, additional capital buffers have been introduced, and the risk weighted assets definitions have changed. Banks will have to make more with less to keep ROE at target levels.

There will be a large increase in capital required for risk weighted assets. Banks will have to be more sensitive to counterparties even for those who trade on exchanges. Client facing risk and CCP risk will both be accounted for using OTC capital rules. Exchange trading does not get any special treatment. Close-out risk is now going to be accounted with recovery assumptions. There will be real costs with knowing your counterparty.  

The leverage ratios will cause an increased focus on what is on the balance sheet of the bank including the type of collateral held at clearinghouses. There is some confusion on definitions of segregated funds such that clearing firms do not want excess funds, do not want cash, and want as much trading as possible for a given dollar held for clearing. Next year there will be add-ons to leverage risk measures  which will make clearing commodities much more capital intensive. 

The cost of clearing will differ from client to client based collateral used, netting eligibility, the length of time positions are held, and internal credit rating. If you are a small, less active, long-term trader, with limited credit history, then you will see significant increases in clearing and brokerage if you can find a firm at all to clear your trades. 

There will be more consolidation in the clearing firms and there will be a greater variance in pricing across firms. Clients will have a hard time finding clearing firms to take their business especially if they are at firms that are exiting clearing.  Futures traders are waking up to this new world, but the fully impact has yet to hit home.