Margin and Capital Optimization for Banks and Non-Banks Facing Dual Regulatory Requirements

Historically, the concept of adequate balance sheet capitalization has only been a regulatory concern of the world’s largest global investment banks and financial institutions, which was never more apparent than with the collapse of Bear Stearns and Lehman Brothers.

However, the systemic risk implications that came with the financial crisis that began in 2007 allowed regulators to create global mandates that set minimum capital requirements on banks and similar annual capital stress testing such as the Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act stress test (DFAST) in the United States and the European Banking Authority’s E.U.-wide stress tests.

Following a narrow 3-2 vote in July 2020, for the first time, the Commodity Futures Trading Commission (CFTC) in the U.S. approved a final rule imposing new capital requirements on Swap Dealers and Major Swap Participants that are not subject to supervision by a banking regulator. The final rule, which went into effect in October 2021, allows Swap Dealers to have the option to choose one of three alternative methods to establish and meet minimum capital requirements, depending on the characteristics of their business.

The CFTC’s new rule overlaps with Uncleared Margin Rules (UMR), being phased in annually between 2016 and 2022, in which financial entities will be required to post and collect regulatory initial margin on derivatives activity for the very first time. Though there are some differences, capital and non-cleared margin rules share many similar properties and cross-reference one another in setting minimum requirements and thresholds across each. Both capital rules and UMR aims to ensure that market players reserve enough protection to adequately create themselves a buffer against unforeseen loss. Mostly, either advertently or inadvertently, more margin will increase your capital requirements and more risk will increase your margin requirements.

Currently, the industry-standard initial margin model is set by ISDA SIMM TM, based on the Basel Committee's original prescription for a sensitivity-based Value-at-Risk (VaR) for market risk capital requirements. This particular program is designed to propagate a “one-size-fits-all” VaR model that is straightforward enough for all market participants to utilize. The majority of capital regulations apply a “higher of” threshold test to determine minimum capital requirements, particularly for non-banks, where an effective capital floor can be set as a percentage of total “uncleared swap margin,” usually between two and eight percent.

Raising large amounts of new capital and funding segregated initial margin can prove to be quite expensive. Therefore, it is imperative that buy-side firms are strategic in how they choose capital calculation approach, initial margin calculation method, and most importantly, their own legal entity registration status and counterparty-specific trading activity; all with the goal of reducing the cost of heightened regulatory compliance. 

Given the importance of these calculations, many buy-side firms are finding that using a vendor like Acadia to automate this process is aiding in cost optimization. Additionally, buy-side firms are utilizing new tools like advisory services and community-led optimization initiatives such as trade compression to further reduce costs.

Ultimately, these calculations are helping make progress on the long-term effort to create industry-wide standards, making reporting programs transparent and safe for financial institutions of all sizes. As the final phase of UMR looms in 2022, the effort for standardization in capital and initial margin calculation is a welcomed narrative for both businesses and their regulators.