US Financials, Dodd-Frank, and Basel III Leverage Requirements

Basel III added new rules to systemically important financial institutions last year but has particular importance for US based firms.

Basel III has another implication for US banks. Under the Dodd-Frank rules (still to be finalized) all OTC derivatives trading must shift to exchanges by a certain date. The U.S. Commodity Futures Trading Commission (CFTC) deadline for comment was this past Sunday (June 5) w/a final date of (early) July 2011 finalized.

Among lawyers, “Swap execution facility” (SEF) and “major market participants,” terms used in the Dodd-Frank Act, require further clarity from regulators. While financial firms continue to lobby about the definition of major market participants , their CFOs have quietly continued to accrue cash. For all those who follow the US financial sector and wonder why banks have been hoarding cash and underperforming look no further. The answer is margin.

Under the proposed rules, trading will thus become even more expensive for key players in the CDS market - particularly for banks and funds that work in the custom ("bespoke") finance world. While margin has always existed to some extent among financial institutions involved in OTC trading the rules were not transparent and often varied significantly across the board (e.g. AIG, Lehman Bros, Bear Sterns being notable examples of weakly applied internal rules).

The CME (Chicago Mercantile Exchange), one of the largest exchanges in the world, and the OCC (Options Clearing Corporation) have very clear rules on margin. It is after all, how they have managed to survive multiple financial crises for decades.

Earlier this year, market participants won an exception for Dodd Frank compliance rules but those were mostly w/respect to currency and agricultural derivatives hedging by multinational corps ("MNCs"). While they won exceptions in reporting requirements margin still needs to be posted because under the rules of an exchange, the exchange will make whole any counter-party losses. The CDS trade in sovereign, corporate, and junk (high yield or just HY for short) would be similarly affected.

And as readers here know margin is just another word for leverage. There are also major implications among the rules for the Treasury market. The short dollar trade is now popular among conventional wisdom but a sharp change in legal rulemaking could add to a countertrend rally.

The Bottom Line: Banks continue to accrue cash but have been underperforming this year because of regulatory uncertainty about new trading and reporting rules. In the absence of clear channels of communication they have bolstered their balance sheets to look more healthy than ever.