Pressure grows for US to copy EU’s CVA exemption

Corporate hedgers are pressing US regulators to exempt their trades from Basel III’s credit valuation adjustment (CVA) charge – as European policy-makers have done – so US companies and banks are not put at a competitive disadvantage to their transatlantic peers.

Dealers estimate the CVA charge would result in as much as a fourfold increase in capital requirements for uncollateralised trades.

“European policy-makers seem to be enacting capital charges on derivatives positions that are significantly more favourable to end-users than the capital proposal of the US prudential banking regulators. Their approach is to recognise that end-users’ hedging activities are in fact reducing risks, and so should attract less capital… The absence of a US exemption will put US companies at a meaningful competitive disadvantage,” warned Tom Deas, treasurer of FMC Corporation – a manufacturer of insecticides – on behalf of the Coalition of Derivatives End Users in testimony at a House Financial Services Committee hearing on April 11.

A three-pronged CVA exemption for corporates, sovereigns and pension funds was agreed by Europe’s legislators at the end of February, as part of the text that transposes Basel III into European law. It was endorsed by the European Parliament on April 16 and now needs to be ratified by the Council of the European Union.

The implications for US firms have already caught the attention of US policy-makers. On March 21, Republican congressman Stephen Fincher introduced a bill – the Financial Competitive Act of 2013 – in the House Agriculture Committee, which would require the Financial Stability Oversight Council (FSOC) to analyse the effect on the US of a transatlantic difference in the CVA regime. The bill calls on the FSOC to recommend steps that the US Congress and regulators should take to minimise any expected negative effects on US financial institutions, derivatives markets and end-users, and to encourage greater international consistency in implementation of internationally agreed capital, liquidity and other prudential standards.

“My legislation is simply asking for due diligence in determining if US financial institutions will be competitively disadvantaged. To me, this exemption will provide a significant advantage to European banks, European customers and European end-users,” Fincher said when the bill was introduced.

That is a welcome step for US corporates, says Luke Zubrod, director for risk and regulatory advisory at Chatham Financial. “This is a positive development and means US policy-makers have considered the possibility that not providing a CVA safe harbour for end-users might adversely affect US competitiveness. It has been a dormant discussion so far, but the European exemption has acted as a catalyst. We would have preferred to see an exemption in the US capital rules, but attention to it in legislative form is good news.”

Proponents of an exemption argue the CVA capital charge doesn’t make sense given the clearing exemption for corporates that is contained in the Dodd-Frank Act. That exemption reflects arguments that corporate participants lack the large stocks of liquid assets needed to satisfy clearing house demands for initial and variation margin. But uncleared, uncollateralised trades attract a big CVA capital charge unless the exposure can be hedged with credit default swaps (CDSs), meaning corporates would escape the margin demands associated with clearing only to face a hike in trading costs.

According to Deas, the cost for FMC Corporation to enter into a seven-year cross-currency swap could increase by a factor of three compared to current rules.

In addition, critics are worried the CVA charge would make corporate CDS spreads more volatile. Banks are able to mitigate the capital requirement by hedging with CDSs, but CDS spreads are also an input when calculating the charge, creating a potential feedback loop – widening spreads would result in a higher CVA charge, and the higher charge would spur more banks to buy CDS protection – theoretically driving spreads wider.

 

This article was first published on Risk

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