On November 19, 2019, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation (together the “U.S. Prudential Regulators”) adopted a final rule to implement the standardized approach for counterparty credit risk (SA-CCR). SA-CCR is a new approach for calculating the exposure amount of derivative contracts under the U.S. Prudential Regulators’ regulatory capital rules. The final SA-CCR rule includes some changes that are beneficial to derivatives end users, as well as some changes that are less favorable for end users.
Currently, banks use the Current Exposure Method (CEM) to calculate derivatives exposures but, once the SA-CCR rule goes into effect, certain large and international banks will be required to use SA-CCR instead. Other banks will be able to choose whether they want to use SA-CCR. The exposure amount is important to both banks and end users because it gets translated into the credit charge that banks charge clients who are executing derivatives trades.
Removal of “alpha factor” for end users
Compared to the previously proposed version of the SA-CCR rule, the final rule includes some beneficial changes that Chatham advocated for earlier this year on behalf of end users. Those changes include a revision to the way in which the exposure amount is calculated for end users. The proposed version of the rule was expected to greatly increase the exposure amount for end users’ unmargined derivatives trades. But, the final rule removes a multiplier (known in the rule as an “alpha factor”) from the exposure calculation for end users, thereby reducing the exposure amount and lessening the likelihood that end users will face higher credit charges from banks as a direct result of the alpha factor in the exposure calculation.
Recognition of only “financial collateral”
The final rule still includes some less welcome provisions that end users should be aware of. These unfavorable provisions include the limitation of forms of recognized collateral to only “financial collateral” (which includes cash and certain liquid securities) for purposes of calculating the replacement cost of a derivative contract. Although it is somewhat unclear what this will mean in practice, since (i) replacement cost is part of the equation to calculate exposure under SA-CCR, (ii) the final SA-CCR rule does not recognize forms of collateral other than “financial collateral,” and (iii) many end users are typically not in a position to post “financial collateral” and instead typically rely on other types of (unrecognized) collateral such as letters of credit, the result is that SA-CCR could potentially increase the exposure amount of many end users’ derivatives contracts compared to CEM. This, in turn, could result in banks charging end users higher credit charges.
Concerns for commodities end users
Another unfavorable provision included in the final rule involves the calibration of supervisory factors for commodities based on rolling spot prices, which leads to an overstatement of risk in the capital calculation for many types of commodities. This, in turn, leads to increased capital costs which may be passed on to firms hedging commodities or which may cause some banks to cease offering commodity hedges in certain classes, thereby limiting the liquidity available to commodities end users.
The SA-CCR rule goes into effect on April 1, 2020, with a mandatory compliance deadline of January 1, 2022 for those banks required to use SA-CCR.