CRD IV could cost prop firms millions

In the first blog post from The Flipper our new anonymous non de plume open to all across the industry to write under the cloak of anonymity, we look at the impact of CRD IV's capital requirements rules on the prop trading market. 

Much is known about the challenges that banks are facing in complying with the capital requirements set out under CRD IV. However, less well understood is the potentially devastating impact on market markers and proprietary trading firms. 

CRD IV and the associated regulation CRR are aimed at: 

(a) minimising the negative effectsof firms failing by ensuring that firms hold enough financial resources tocover the risk associated with their business 

and 

(b) increasing the likelihoodthat a firms' personnel take an interest in the longer-term success of the businessrather than short-term gains (for which read ‘increased risks’). 

Mostproprietary trading firms, which are Part 4 FSMA authorised by the FCA, areaffected.

There are a number of ‘simple’ rules which apply toremuneration of certain employees, however, much more contentious are the ruleswhich deal with firms’ capital adequacy.

The rules provide standard models for firms to calculatetheir capital adequacy requirements, the upshot of which is that for futures(where the capital requirements can be spectacular) firms must set aside Pillar1 position risk capital of an order of magnitude related to the notional valueof the derivative’s underlying instrument.  

To be clear, for short-end sterling interest rate futures the notionalvalue is £1m. 

Inserting thismultiplier into the standard position risk calculations (CRR 326 onwards andparticularly CRR 339) is tantamount to basing regulatory capital requirementsoff the risk of a total loss; ie. that the future goes to zero.  

Admittedly the spectacular position riskfigures generated are subject to various haircuts as firms determine their ownfunds requirements (e.g. CRR 92).  

Butstill, a simple exchange traded and highly liquid fixed income or interest ratefuture requires regulatory capital orders of magnitude larger than any firm orexchange risk model would predict or clearer would require as margin.  

In short, firms may potentially face a catastrophic capital adequacy hit,especially when trading futures at the short end of the curve. 

Options aretreated similarly to futures although the amount of the capital required tocover an option will depend on its delta. 

Equities receive a morefavourable treatment - the concept ofnotional value is of course not pertinent to equities so the regulators havetaken a different approach that produces significantly lower capital adequacyrequirements.

Modelling risks

In contrast to the standardised approach, firms might try tofollow the banks by running their own risk models to determine Pillar 1position risk requirements.  

However,agreeing a bespoke risk model with the FCA could take months, if not a year,and in the meantime firms would need to apply the standard model.

The good news is that even if a firm uses the standardmodel, there are a number of ways in the model pursuant to which firms canapply haircuts and netting to reduce their capital adequacy requirements. The bad news is it does not reduce the amounts substantially.

The other good news is that the FCA does seem currently opento considering applying different methodologies and calculations, although thetimetable for (and results of) that are uncertain.

Dutch exemption? 

What the FCA has been spending more time doing of late iscomplaining that the Dutch have permitted firms which the AFM regulates toapply different models which lead to those firms having substantially lowercapital adequacy requirements (and therefore a significant commercialadvantage). 

According to various people, the AFM has decided that: 

(a) it willnot permit any firms not currently authorised and regulated by it to come tothe Netherlands 

and 

(b) it will move to the standard model some time in thenext couple of years (probably on the same timetable as MiFID2 implementation).

So all EU firms will be in the same boat eventually,although this isn’t really a ‘win’.

Some argue (and with good reason) that proprietary tradingfirms (which generally have good pre- and post-trade systems and controls andinternal risk management and substantial margin and net liq requirements) donot present a systemic risk of anything like the magnitude that should require themto hold capital of such enormous amounts. 

This could (and will) drive someplayers out of the market, leading to lower liquidity, wider spreads etc.

Those firms which have been around (or have been subject toPillar 1 CRR position risk requirements) for some time may well havelong-standing internal risk models which have been agreed with the FCA. 

Thosefirms which became Part 4 FSMA authorised because of the German HFT law orwhich are planning to become authorised and regulated under MiFID2 do not havethat luxury.  

Counter-intuitively, also,since banks most likely have long-established internal risk models, even thoughthey are much more likely to be the target of CRD IV and CRR, they will findthemselves less affected than smaller proprietary trading firms.

"Bad things will happen"

So let’s assume that a firm needs to calculate its capitaladequacy requirements; how does it do so? 

Well, it can build its own calculator(some firms have) or it can ‘buy’ one from a vendor. Beware, however, that onevendor’s application of the model to a calculator might differ from another’s,giving (perhaps wildly) different answers. 

If the FCA does not agree with afirm’s calculations, bad things will happen. 

Is it any defence for a firm tosay that it used a trusted and well-known vendor’s calculator? Maybe but probablynot - it’s a lack of control over the quality of external providers. 

So shoulda firm build its own calculator? That would depend on costs, I suppose -because if a firm’s own calculator ‘gets it wrong’ it’s the firm which is firmlyon the hook for that.

So where next? Let’s hope that the FCA looks at thedifferent models out there and the ways in which the industry reduces theprobability of a firm blowing up and/or a firm blowing up and taking the marketwith it. 

There may be some advantages in firms that will need to becomeauthorised and regulated under MiFID2 waiting-and-seeing. However, the smart(maybe not ‘smart’ - the ‘cynical’) money is on the FCA not agreeing to a firmapplying an internal risk model without it having run standard models for sometime first or having a track-record of applying successfully an internal riskmodel. 

So for firms that are contemplating becoming authorised and regulatedunder MiFID2, perhaps the best thing to do is to set up asap and run anunregulated business for a period of time to gather data to show the FCA (whenan application is presented to it) that show the firm’s own risk model ‘works’.