US banks hit out at collateral rules on derivatives trade

Banks are reeling after rules finalised by US regulators, aimed at reducing the risk of trading esoteric derivatives, are set to increase trading costs and further hit deteriorating fixed income business.

The Federal Deposit Insurance Corporation will require banks to post and receive collateral to protect against losses on derivatives that are traded bilaterally, as opposed to being centrally cleared.

Banks will also have to collect collateral on trades done with their own affiliates, but here the burden has been eased a little as the FDIC’s proposed rules required inter-affiliate trades to both collect and post collateral.

However, this requirement does not go far enough, the industry has said. One large US dealer claimed its cost of funding transactions would double, pushing banks to trade fewer uncleared derivatives, reducing liquidity and increasing costs for clients.

“The inter affiliate issue is not solved by this,” said a risk manager at the bank. “I am certainly not happy having read this.”

The new rules come at a time when banks’ fixed income units are under pressure, squeezed by tougher rules on capital and a shift among clients to simpler, less profitable products. Last year’s global FICC revenue pool of $118bn was 46 per cent lower than in 2009, according to data from Coalition, a research group, and is set to dip again this year.

At Goldman Sachs, a one-third drop in FICC revenues in the third quarter — knocking return on equity down to 7 per cent, the lowest in two years — was the talk of the US banks’ earnings season.

Large, sprawling banks often trade derivatives between different legal entities to centralise risk, or offset risks within different parts of the bank. The requirement to collect collateral when they trade with affiliates would tie up assets that could otherwise be put to work in the market.

The FDIC rule applies to banking entities. Eyes will now turn to rules being written by the Commodity Futures Trading Commission that will apply to non-bank affiliates. If the CFTC requires non-bank affiliates to also collect collateral then the combined rules will effectively still require two-way posting.

“While the requirement to only post one-way rather than two-way with certain affiliates is clearly better than requiring two-way with all affiliates, this rule increases the cost of serving clients and hedging risk while doing nothing to enhance the safety and soundness of the organisation,” said Greg Baer, president of The Clearing House Association, an industry organisation.

The rules also affect the securitisation industry, where assets such as mortgages or loans are packaged up and sold to investors. Often, derivatives are used in the packages to smooth out the different interest rates of the underlying assets, or to convert fixed rate assets into a variable rate that is more suitable to investors.

Ellen Pesch, partner at law firm Sidley Austin, warned of the increased cost of securitising assets, making some deals uneconomic. She added that it could also encourage investors to move deals to Europe where the rules are less stringent.

“I think there are deals getting done on skinny budgets and if you have increased cost because you are posting collateral, then it will inhibit those deals,” she said.

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