SA-CCR and its Impact on Cleared and Uncleared Markets
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[00:00:00] Ali Curi: Markets conversation is a new ION podcast where we discuss topics of importance to capital markets participants with product owners, subject matter experts, and industry leaders. 

[00:00:15] Chris Barnes: Number one best piece of advice I've had is don't be an asshole. Remember you're dealing with human beings. Particularly finance, we forget that people are humans really, you know, it's very, very tempting to treat them as, in a trading environment, as an adversary or from a kind of market's perspective as just a statistic. 

[00:00:36] Amir Khwaja: So I think for people starting, I would say, identify within FinTech, a space that interests you a space that's, that's gonna grow, understand tech, understand the finance part, try and learn both because really you are applying tech to solve financial problems.

[00:00:51] Ali Curi: Hi everyone, and welcome to Markets Conversation. I'm Ali Curi. On today's episode, we'll discuss how the standardized approach for counterparty credit risk, [00:01:00] more commonly known SACCR, applies to over the counter derivatives, exchange traded derivatives, and FX.

[00:01:07] SACCR is rapidly becoming the standard across the globe for bank regulatory capital, replacing CEM, or current exposure method. What this means for market participants and global markets and products is that, well, it's all very complex and varied. But to help us break it all down, our guests today are Chris Barnes and Amir Khwaja from ION Markets. Let's get started. 

[00:01:29] Chris Barnes and Amir Khwaja. Welcome to the podcast.

[00:01:34] Chris Barnes: Thank you, Ali. 

[00:01:34] Amir Khwaja: Great!

[00:01:35] Ali Curi: Amir, before we get to what SACCR will and will not do for cleared and uncleared markets, let's back up a little bit and work through some of the foundational topics. So let's start with defining what regulatory capital is and why it's i mportant to the banking industry. 

[00:01:52] Amir Khwaja: So if you step back, you know, banks have a special role in the economy, right. They essentially extend credit. Because they have this special [00:02:00] role they're highly regulated. Yeah. By central banks, essentially in those economies. And that regulation also contains, uh, requires, you know, a few things, but from a capital point of view, it requires banks, because they have these special role in the economy, to have a minimum amount of capital to conduct their businesses. That capital is there because banks need to keep functioning and be able to cover expected and unexpected losses in their businesses, right. So, what happens, you know, I have a depositor, deposit some money in a bank that bank lends that to a borrower that, or someone needs a mortgage or a corporates lend, a borrow, and then money from banks, right. 

[00:02:34] So they always engage in this credit extension business where they're transforming deposits into loans, maturities extending credit, and they're faced with credit risk where borrowers can default. Right? So banks need to have enough capital to cover those defaults and keep running a smooth business extending credit, but that's the main kind of reason. 

[00:02:53] Chris Barnes: Amir, in terms of that, right. I think it's important to recognize that this is not one for one, right. A bank [00:03:00] doesn't take out a deposit and then lend that out. There is a multiplier, applied to it. We're not talking about a blockchain bank, right. Which is, zero leverage, a hundred percent deposits, a hundred percent loans. There is a grade leverage here.

[00:03:13] Amir Khwaja: Yes. Yeah. So I think so again, so because you have that, uh, leverage in a bank, it's very important to maintain a minimum amount of capital that is set by regulators. And I think the other important point is that it also creates a level playing field between banks in different countries, right? So the last thing you want is, you know, institutions that have lower capital requirements as a shareholder, you're looking at return on capital right firm with very little capital, uh, Would earn more return on capital for the same profit.

[00:03:40] This minimum capital is a global standard that is required for all banks to maintain, because they all play the same sort of role in the financial system, to extend credit, to transform maturities. So I think that's very important to, so they need capital to cover, expected losses in their businesses going forward and they need to have similar levels of [00:04:00] capital.

[00:04:00] Now, royalty is most banks hold far more capital than a minimum required by regulators because shareholders demand that, right? So shareholders have their own view on how much capital banks should hold. So I think it's important. And I think the main risk that banks take from a capital point of view is counterparty credit risk.

[00:04:14] The fact that one of their borrowers can default. By far, the largest amount of reg capital is for credit risk, which is where SACCR comes in for most businesses in banking, right? There are businesses that take on more market risk, right? They're trading they're more flat or take on more operational risk with not spending credit so much, but by and large, you know, you have credit risk market risk, operational risk, and most banking businesses, and most bank groups of that all bank groups, the largest risk is counterparty credit risk, for which they required to maintain a large amount of capital, well above the minimum, from regulators. And that's really why we're talking about, um, SACCR on this call. Right? Cause it's the main, the main metric. 

[00:04:53] Ali Curi: Let's talk about that for a minute. Although it's been around for a number of years, SACCR, there's been some iterations [00:05:00] and there's a new one.

[00:05:01] Let's, uh, break that down a little bit. What is new about what just happened with SACCR and, um, how does it affect the markets? 

[00:05:09] Chris Barnes: So I think from , from my perspective, the biggest impact we're seeing from SACCR is that it's gone live across pretty much all jurisdictions now for leverage ratio. Leverage ratio is, or historically was, a regulatory reaction to the global financial crisis of 2008.

[00:05:29] The regulatory community recognized that banks were under capitalized, and so they introduced a very crude methodology, uh, which looked at the gross notional of derivatives to apply a leverage ratio over and above standard, uh, capital calculations for banks. That was intentionally crude. And that was based on something called the current exposure methodology or CEM.

[00:05:56] Broadly speaking, what leverage ratio did was [00:06:00] led, particularly the, uh, derivatives markets, down a path of intense concentration on something called compression, whereby uh, banks are highly motivated to get rid of as much gross notional as possible. And so if you have, for example, a trade, which is a buyer of five years versus a sell of, uh, five years versus another counterparty under CEM, under old leverage ratio rules, it's massively beneficial to compress those two trades into a risk neutral package, effectively step out of both of those trades and lose all of that gross notional. Now, what SACCR does, is when it's introduced for leverage ratio, it changes that balance. So SACCR is what we consider to be a risk sensitive model.

[00:06:48] So instead of being driven by gross notional, it's now driven by net risk. Uh, there's some intricacies around the model in terms of how you calculate that net risk, uh, [00:07:00] whether you are calculating it on an asset class level, whether you are calculating it on a counterparty level and what the risk factors are exactly.

[00:07:08] That's why we as market participants involved in software, you know, are interested in it because that's modelable, and we have input data that we can put through a model, and we can give you an output that gives you SACCR metrics. What it means from a market participant perspective, is that it can impact market behavior.

[00:07:29] So, as I said, compression was a massive focus under CEM for leverage ratio reasons.

[00:07:35] Move to SACCR. What SACCR does is focus you on net risk. So you don't really care if with the same counterparty, you have a buyer of five years and a sell of five years. If we just talk about pure SACCR metrics, uh, that is a risk neutral package. And so it will not impact your, uh, SACCR results. Now what it does do, and we'll get onto [00:08:00] this a little bit more later, is that it really changes the behavior for large directional market participants. So, SACCR is risk neutral. So the more risk you have in your book, the larger the SACCR metrics will be.

[00:08:16] Amir Khwaja: Chris, and just stepping back. So a bit of history. So again, you know, when the Basel Accords in 1998 were introduced, 88, right? So really, you know, you need a simple standard method that are used by all banks, right? So, for counter party credit, CEM, or current exposure, is a simple method used by any bank, no big or how small. It just uses the gross notional for trade times some factor. Right.

[00:08:38] Now that meant it's very simple. So it's attractive. Anyone can use it, but it's not at all risk sensitive, right. So as Chris said, if I pay or receive a hundred million in that model, I've got 200 million times some factor. Whereas in reality, if you're looking at risk, those things net have no risk, right? So it was a crude model, but it worked well for its function, but it also [00:09:00] meant that banks that were global and very sophisticated, went to internal models, which can get approval for that are essentially much more quantitative and sophisticated, but not transparent and not comparable between institutions, right. So I think now with SACCR, we have a chance of having a model that is risk sensitive. So it recognizes pay receives buy sell. So it's, a much more appropriate risk model that can be used by all firms in a sensible way. And it removes, you know, some of this behavior about around compressing gross notional for the sake of improving a reg metric, right? Not for any of the benefit, right. So I think, you know, we often talk about regulations drive behavior. It's fine if it makes sense. But often that behavior is just trying to improve a metric, right.

[00:09:42] In this case, reduce the CEM capital credit number, right. By having a much better method like SACCR replacing CEM, we now have a credit metric that is risk sensitive. So things offset, right? We don't need to worry about compression so much. It's all needed, but nowhere they on the same sort of [00:10:00] scale. Right? So hence it leads to a much better allocation of capital for counter party credit risk, than the CEM method, which could overstate.

[00:10:07] And I think to pick up to Chris's point, about leverage ratio. So I think, uh, despite counterparty credit capital in the crisis, it transpired that with hindsight, it did not stop banks from taking immense leverage, more leverage than was imagined, right? Because the capital ratios defined the amount of capital you have, even though most banks had more capital than the minimum reg required, it still proved to be not enough. And you saw some bailouts or lots of bailouts in the subprime crisis in G6. So that work through with regulators to reduce a new metric for amount of the amount of leverage, right. And partly because I think, you know, much of this exposure is off, is off balance sheets, right.

[00:10:45] When we're talking about derivatives and we're talking about balance sheets and asset liabilities, derivative exposure, doesn't show up in the classic accounting way on, on a balance sheet, as asset liabilities. right? So, so that's why having leverage ratio, you know, I think really solves [00:11:00] some of the constraints that Chris can touch upon that we're missing in the capital models, right?

[00:11:04] Chris Barnes: In terms of these bank capital models, I think what we have to accept as market participants is that there isn't a right answer, but SACCR is undoubtedly a better answer than CEM. And so whilst it's, you know, it's really, really tempting when you, uh, go through the blogs on the calculations of SACCR or, the model and you step through it and ahead, and you go through the calculations to have a critical hat on, you know, and go, well, really, we, I should have some correlation between FX pairs, et cetera.

[00:11:36] You know, that is just a step too far from, from a going from where we were, which was gross notional based with no real tie in with actual risk, to SACCR now, which is a risk sensitive model. That is a great step forward. 

[00:11:52] Amir Khwaja: Yeah. Agreed and agreed. And I think from Chris's point, you know, we don't want banks who have too much capital, the same way as we don't have too little capital, right. With gross measures [00:12:00] like CEM, there's a danger that many businesses have way too much capital that is required for that risk type, counterparty credit risk, because it doesn't allow for netting, right. And netting has been a huge part of the growth and derivatives in the last 20 years.

[00:12:12] If you look at is the and netting, you it's been a huge function of why swap markets have grown, right? The fact that's ignored in CEM you know, is just travesty. I think having SACCR correct that having clearing, you know, it's kind of very important which Chris touched upon, why SACCR is much better for cleared portfolios, right.

[00:12:28] And I think the key point is we don't want too much capital within a bank. We want the proper amount of capital. But there's no right answer, right? It needs to be appropriate for the risks they're facing against their counterparts, and in the market. 

[00:12:39] Advert: This episode is brought to you by ION. At ION, our cleared derivatives solutions automate your complete trade life cycle and deliver actionable insights whenever and wherever you need them.

[00:12:51] We offer execution in order management, post trade processing, and a complete front to back business solution. To learn more, visit us at [00:13:00] iongroup.com/markets. Or email us@marketsiongroup.com. 

[00:13:05] Ali Curi: Chris, this update to SACCR, it's been referred to as the supermodel, I'm guessing because some of those changes have improved on what was previously being used, such as CEM.

[00:13:17] What does this new SACCR supermodel mean for say cleared derivatives or uncleared derivatives and FX in particular? 

[00:13:24] Chris Barnes: I'm going to start this answer with a name check, actually, because the first person I, ever heard refer to SACCR as a supermodel was, uh, Tobias Becker who's now at Quantile. He's really a guy that gets into the weeds of SACCR, right.

[00:13:39] And he was explaining out of a presentation, how SACCR is appearing in more and more elements of Basel. Now that Basel have a risk sensitive model, the temptation is to introduce it into more and more areas of reg cap.

[00:13:56] So as I said, SACCR has been around for a while. [00:14:00] Probably, uh, the first time it was published was 2013, 14. It's just been implemented across a number of jurisdictions for leverage ratio. So now you have a risk sensitive measure of leverage ratio. SACCR has been available to use for counterparty credit risks. So to calculate your credit risk weighted assets since 2015, 16, 17, depending on the jurisdiction. So again, that replaces CEM for the credit side of your balance sheet so you can now use SACCR. 

[00:14:32] Now staying in the credit world. Now, even if you are one of the big, big, big global banks who invest a hell of a lot of resources into developing their own internal models, so called IMM banks. So they have an internal model for measuring credit risk across their very, very complex bilateral portfolios.

[00:14:54] Even if you're one of those banks with any approval from your local regulator, SACCR now [00:15:00] comes in as an overlay to that. And regulators say, well hold on, we believe in SACCR. And so if your internal model spits out an RWA number that is too low, we're actually gonna floor your credit, uh, capital at a percentage of the SACCR output. Whether that's 70%, 80% depends with time and implementation timelines. 

[00:15:25] We're seeing SACCR a implemented across a number of different areas of reg cap. And so the temptation is to think of it as this kind of overarching supermodel, which is gonna have different impacts at different banks, but everybody is very likely to be impacted by SACCR.

[00:15:44] Amir Khwaja: I think we're saying there, the word super to us means many use cases in multiple regulations, not it's a brilliant model, right? It's a model right. Clearly is far, far better than I think, one thing which kinda interest me is in Chris, you know, view this question in terms of the change from CEM to [00:16:00] SACCR for counterparty credit, yeah, that is now live in some jurisdictions, not in most jurisdictions. What does it mean? Which product types that trade, you know, in a market business like foreign exchange, cleared derivatives, bilateral derivatives will become less or more attractive. Is there gonna be change on, on what businesses that banks, for example, you know, there's always been a talk that, uh, client clearing, again, you know, as ION Markets, we have many customers that are clearing brokers, FCMS.

[00:16:25] There's always been a view that client clearing is very balance sheet intensive, right? Consume too much capital or a lot of capital for the profit required based on some of these rules. Right? So I guess the question is, you know, I guess in twofold, right? Which businesses in banks are gonna benefit from the move CEM to SACCR, which are gonna suffer high level? And which products that trade in the marketplace, right, are gonna be more tracked? Any thoughts on that? 

[00:16:49] Chris Barnes: So I think you really need to break that down in into three. One is if you just talk about cleared derivatives. Followers of the blog know we're very focused on rates [00:17:00] in, in FX. So when I talk about cleared derivatives, I'm thinking mainly of rates, okay. 

[00:17:05] I was a swap trader at HSBC 2002 to 2010 /11. That was when markets were beginning to transition to the cleared model that was before clearing mandates. Fast forward now to clearing mandates with a SACCR hat on. Most of your swaps will be facing a single CCP. In the case of the major currencies, a dollars Euro Sterling, that major CCP is very likely to be LCH swap clear. From a SACCR perspective, what that means is you are always measuring net risk versus the same counterparty for rates. If I trade a five year, dollar swap, and that might have Deutche on one side of it, and when I get out of that trade, it's got Citi on the other, I have a buy and sell over five years versus two different counterparties at LCH. But I've notated it to LCH for all intents and purposes from a SACCR perspective, LCH acts as [00:18:00] that netting node. And so from a SACCR perspective, I have zero risk. And so I have zero risk weighted assets there. That's great!

[00:18:07] SACCR definitely benefits a business, if you think of a typical broker dealer, who's doing most of their business in/ out and runs a relatively flat book, SACCR really benefits that type of model, as long as it's cleared.

[00:18:22] Why do I say as long as it's cleared? Because if you look at uncleared derivatives, what SACCR does, is it grosses up all of your risk exposures across counterparties. So it divides your portfolio into different netting buckets. The, uh, overarching decider of what a netting bucket is, is what counterparty you're facing.

[00:18:45] So if I have a bilateral trade facing Deutche and a bilateral trade facing Citi, even if I'm risk neutral, my SACCR exposure to that gets doubled up. 

[00:18:54] Amir Khwaja: So I think one of the reg outcomes or goals from the crisis in [00:19:00] 2008 was a move to clearing, yeah, to reduce systemic risk in the industry. So by having a reg measures that also reinforce, so as well as clearing mandates by having capital measures that also count for clearing and netting appropriately also gives a incentive. Right. Yeah. And, just kind of makes sense. Right. As opposed to some that largely ignored most of those netting clearing benefit. 

[00:19:21] Chris Barnes: Yeah. No. Now Amir, if I just take the counter of that.

[00:19:25] If you look at FX markets, one of the kind of findings of the GFC and subsequent stressors in market since is that FX, even though it's a bilateral market, continues to cope with stressors in the market very, very well. It continues to trade. It continues to, uh, operate and people can move risk through FX.

[00:19:47] However, what SACCR does is from a structural perspective, it really penalizes FX businesses. It's increased the risk weights from CEM, broadly speaking. But [00:20:00] what it really does is because FX exposures tend to be directional, it's all a bilateral market still. And because those exposures are across hundreds of counterparties, they gross up. So you, uh, end up with really the worst case possible, uh, under SACCR, whereby it's a bilateral market, you have loads of counterparties, and you have loads of directional risk.

[00:20:26] Ali Curi: You bring up a really important point because, uh, from what I read, it was widely anticipated that optimization would become more important for the dealer community under SACCR. So what does optimization mean for clearing?

[00:20:40] Chris Barnes: From a cleared perspective, um, the focus on optimization is probably going to reduce the reliance on compression. Compression is still very valid and useful. Um, it's a sensible thing to do. It reduces your line items. And if you're one of the biggest [00:21:00] 30 banks, so captured as a G-SIB gross notional still does feed into G-SIB metric.

[00:21:05] It's still there. It's still a thing. Compression is not about to disappear. But what it means from a, from a risk perspective, if all that risk is cleared, you are at a single netting node already because most CCPs have a dominant market share in any given risk metric. You know, the need to, to move risk around within that CCP is lessened by SACCR. Um, but I think from an uncleared perspective, you really wanna sweep as much of your uncleared risk into clearing as possible. 

[00:21:40] Swaptions, for example, swaptions create a huge amount of linear Delta in uncleared markets, but those Delta hedges are done in clearing. SACCR really penalizes that, uh, behavior. What you want is the swaption generating the [00:22:00] Delta.

[00:22:00] Or the Delta itself to be in clearing, which is then netting against your cleared hedges. Um, so that your SACCR risk netting is as effective as possible. You know, so netting is as old as the sun. It's, it's very simple. Um, it's not a very sexy subject, but the whole point of SACCR is to just increase the amount of netting that you've got in your book.

[00:22:27] Amir Khwaja: So could we talk a bit about netting very briefly, so clearly, you know, so, what we mean here is that if we have a trade that's in our favor and one against us, should a counterparty default, we can net those two trades end up with a small net number rather than have to pay them and not get our money, right.

[00:22:41] So, you know, so it's, it's fundamental to the growth of, of the top market, but in terms of volume, et cetera, et cetera, and, and efficiency. Right. So I think we should talk a little about, so, so, but optimization, what we really mean is going forward. To run an efficient business that, that it consumes its resources, which are really capital its constraints, [00:23:00] like leverage ratio, it's important to look at the exposures you have in your book and how they can be, I don't know, Chris, rejigged, right? To have that most efficient portfolio that still has the same economic outcome. 

[00:23:11] Chris Barnes: And so from a software perspective, you need access to these metrics and you don't need access to these metrics quarterly. You don't need access to these metrics monthly. You need these daily. You know, so that when you call up your, your, uh, counterparty, you know, what your SACCR metric facing them is, or you're going to submit a number of these SACCR metrics to a third party optimization provider. It needs to be timely. It needs to be accessible.

[00:23:38] Ali Curi: Gentlemen. I think that there's a lot more to cover. I think it would warrant, uh, both of you to come back and give us an update. Um, I think that there's going to also be some, um, some other issues that probably pop up, you know, pro SACCR and, and against it, and just as, as people in the market start to use it. So I think it, uh, opens it up for an opportunity to come back and [00:24:00] give us an update. 

[00:24:00] I think this is the, the perfect opportunity for you to plug your, your blog. Uh, what's your blog address? Where can we find you? 

[00:24:06] Chris Barnes: Clarisft.com/vlog. You will lose days of your life there. I warn you.

[00:24:14] Ali Curi: And with that, we'll close it out.

[00:24:16] Chris Barnes and Amir Khwaja. Thank you for joining us today. It's been such a pleasure having both of you on the podcast. 

[00:24:22] Amir Khwaja: Thank you, Ali. 

[00:24:23] Chris Barnes: Thanks Ali. 

[00:24:24] Ali Curi: And that's our episode for today. You can follow ION Markets on Twitter and LinkedIn. Thank you for joining us. I'm Ali Curi until next time.