Op risk fears for European asset managers

The US Securities & Exchange Commission (SEC) is changing its rules to encourage domestic securities firms to base their derivatives business on its home turf. And the SEC makes no bones about its willingness to reduce capital requirements in order to see trades currently being booked in London, or other more lenient offshore regulatory regimes, booked in the US instead. 

The SEC’s new rules – which it introduced in December 2000 – are based on the value-at-risk modelling of a securities firm’s derivatives positions. They are designed to take account of the reduced risk of hedged positions. The SEC’s current broker-dealer lite rules do not take account of risk exposure, instead using a “binary” system that treats derivatives as long or short underlying positions. 

Michael Macchiarola, SEC assistant director of market regulation, says: “Here’s an attempt to accommodate US firms that want to do business in the US. Business that is ‘properly’ US business – with a US customer, involving a US security – should be done here. There’s no reason to put it in London other than to get lower capital charges. That’s a distortion of business.”

The SEC has tested the new rules – a revision of its broker-dealer lite regime – with Goldman Sachs’ equity derivatives division. According to Macchiarola: “The VAR approach allows you to net a great deal more than was allowed under the old net capital rules. A lot more correlations are tolerated.”

A second component of the new rules focuses on credit risk. Macchiarola says the SEC adapted to derivatives counterparty risk its earlier rules for bond trading portfolios, which applied a credit risk charge based on credit rating. “The charge is actually less, but we built in concentration provisions that were different from regular securities regulations,” Macchiarola says.

Finally, margins for derivatives – which were treated like outright stock positions under the SEC’s old rules – will be abolished. The net effect of these three changes is substantial. Across its equity derivatives portfolio, Goldman Sachs estimates that its capital charge has been reduced by half. 

While the SEC’s new capital rules have been influenced by the US Federal Reserve’s risk-based approach to financial holding company capital reserves, the SEC has recognised that the nature of securities company regulation has to be different, says Macchiarola. “Until 10 or 12 years ago, everything on a broker-dealer’s balance sheet was collateralised. Then they got into derivatives.”

Some observers say the SEC’s biggest challenge will be to persuade US securities firms to book their interest rate derivatives transactions at home. Equity derivatives are closely related to the underlying securities, and it suits firms to book deals under the same jurisdiction as the cash securities market. However, interest rate swaps and options have no status under US securities law, observers point out. Although the Commodity Futures Modernization Act passed by Congress in December may change this, US broker-dealers currently book trades via unregulated affiliate entities, and see no reason to change this status quo.