Swaps compression to combat leverage ratios

Fri Aug 16, 2013 12:02pm EDT

LONDON, Aug 16 (IFR) - Banks are aiming to tear up billions of dollars worth of derivatives exposures in order to radically shrink balance sheets to comply with Basel III rules ahead of time.

Analysis from RBS suggests European banks will have to cut 843bn euros of assets to meet the leverage ratio, after supervisors recently made clear they were not prepared to water down the regulations.

Derivatives exposures impose significant pain under the new rules, which look at gross, rather than net, notional positions. Deutsche Bank's balance sheet, for instance, balloons 60% to 1.9trn euros if benefits associated with netting of derivatives and related collateral are removed.

Trade compression looks set to become a vital tool for banks managing down exposures. Barclays earmarked 35bn pounds of savings on derivatives in its latest financial results, while Deutsche specifically cited compression along with increased netting from central clearing to achieve asset reductions of up to 170bn euros.

"It's fair to say the industry was blindsided by the leverage ratio," said Zar Amrolia, co-head of fixed income and currencies at Deutsche Bank. "Compression will be a key tool for us to manage down our exposures, and we need as an industry to get on and do this."

Banks do not have to comply with a 3% leverage ratio until the start of 2018 under Basel III. Some national supervisors are pushing for a swifter adoption, however, and in the same way that banks raced to boost capital ratios well ahead of regulatory deadlines, analysts believe a similar stampede to shrink balance sheets to hit leverage targets will ensue over the coming months.

"We went through a period when everyone was worried about RWA, but now the gross leverage ratio is the major talking point," said the head of rates trading at a major European bank. "We can probably shrink our balance sheet by a further 5% to 10% through compression alone."

Amrolia said the FX industry set up trade compression in CLS more than five years ago to deal with settlement risk. The rates business has historically been relatively high-margin, which meant it could afford to be less efficient. "There is large scope for further compression," he said.

UNEVEN PLAYING FIELD

There is, however, concern that inconsistent application of the rules from regulators on either side of the Atlantic could disadvantage European derivatives dealers. In particular, European lenders must apply an add-on for collateralised derivatives that is scaled to gross notional.

"The different accounting treatment for derivatives between the US and Europe means there is an 'unlevel' playing field globally. In the near term, larger European banks will be under further pressure to shrink balance sheets," said the European bank's head of rates trading.

Services to slash derivatives notionals are already well established. TriOptima began running compression cycles in 2003, and had eliminated US$322trn of gross notional through its triReduce service as of the end of 2012, including US$84trn in the last year alone.

The firm plans to roll out compression cycles for other products that banks now view as crucial for shrinking balance sheets such as cross currency swaps, which are currently being tested in a pilot scheme.

"We've always made the case it's healthy to reduce balance sheet, but now with the leverage ratio more banks see it as a necessity," said Peter Weibel, chief executive of triReduce.

Weibel reckons there is still substantial room for improvement on compression cycles, particularly if banks are willing to send in transactions that are housed outside of their main trading books, which most have previously declined to do.

"We should get better submissions from banks, which will lead to much better outcomes," said Weibel, who reckons the firm could boost hit rates by over 30%.

"The impact of derivatives on the balance sheet is now attracting interest from senior management sitting above the trading desk level, who view things in a more holistic way. We think there should be more internal support for these cycles," said Weibel.

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