Commodities and the Capital Requirements Directive

1
Commodities and the Capital Requirements
Directive

• RWE Workshop
• December 2005
• Slides prepared by ISDA

2
What is set to change ?

• MiFID Article 2.1(i) and (k) exemptions are to be
  reviewed by the Commission in March/April 2008,
  and may then be amended or repealed.
• If so, some commodity firms may become subject to
  CRD for their financial activities.
• Questions
• What will be the perimeter of their business
  subject to capital rules?
• Is the CRD the appropriate regulatory instrument
  ?
• Should the CRD be recalibrated to a different
  solvency target ?
• Should approaches to each one of the risks
  identified in the CRD be amended for commodity
  firms ?

3
Advocacy tactics

• Joint Working Group set up by ISDA, EFET, FOA
• Various sources of information
• FOA-KPMG questionnaire
• EFET hypothetical portfolio testing
• CFRC Compendium ( www.isda.org )
• Breakdown of responsibilities
• ISDA credit risk/credit risk mitigation
• EFET market risk
• FOA operational risk
• Group has established contact with Commission and
  domestic regulators (FSA, BaFIN)
• All relevant documents produced in the WG are
  available at https//www.isdadocs.org/c_and_a/risk
  _manage.htmlCOMMODITY

4
Perimeter of activities subject to capital
requirements

• Starting point will be MiFID. Products included
  are defined at Annex I Section C and include most
  commodity derivatives, with the exception of
  contracts entered into for commercial purposes.
• (7) Options, futures, swaps, forwards and any
  other derivative contracts relating to
  commodities, that can be physically settled not
  otherwise mentioned in C.6 and not being for
  commercial purposes, which have the
  characteristics of other derivative financial
  instruments, having regard to whether, inter
  alia, they are cleared and settled through
  recognised clearing houses or are subject to
  regular margin calls.

5
Perimeter of activities subject to
capitalrequirements

• Key questions for capital purposes
• 1) Should the proposed capital regime apply to
  the whole consolidated balance sheet of firms ?
  Or just to their trading activities?
• 2)   Do participants believe that the scope of
  the proposed capital framework should be the same
  as that of MiFID ? In particular, would it make
  sense to also include SPOT commodity positions in
  the calculation of market risk capital ? Further,
  for credit risk purposes, is it reasonable to
  focus purely on derivatives entered into for non
  commercial purposes, where netting sets might
  also include commercial transactions ?
• 3)   If a firm has trading outlets in several EU
  countries, should it be supervised at a
  consolidated level ? On what basis should the
  consolidating supervisor be determined ?

6
Capital Requirements Directive (CRD)

• Transposes the new Capital Accord into EU law.
  Approved on 28 September 2005
• Implementation staggered
• 1/1/2007 for firms using simple approaches
• 1/1/2008 for firms using sophisticated approaches

7
CRD

• CRD 3 Pillar approach
• Pillar 1 minimum capital requirements
• Pillar 2 supervisory review. May lead to
  additional capital requirements
• Pillar 3 disclosure requirements
• Fundamental question Is CRD adapted to risks
  borne by commodity firms on their derivative
  business ?

8
CRD

• Commodity firms do not pose the same risks as
  financial institutions
• NO depositor/investor exposure
• NO systemic risk (Enron failure)
• Risks on the physical side already monitored by
  physical regulators
• This has motivated light touch capital regulation
  in the EU
• And no regulation in other key countries (US,
  Switzerland)

9
CRD

• Commodity firms special case is acknowledged at
  political level in the EU
• CRD Recital 19 (b) The goal of liberalisation of
  gas and electricity markets is both an
  economically and politically important goal for
  the Community. With this in mind, the capital
  requirements, and other prudential rules, to be
  applied to firms active in those markets need to
  be proportionate and should not unduly interfere
  with achievement of the goal of liberalisation.

10
CRD

• Article 45d of the CAD further institutes a
  carve-out for commodity firms, which will become
  regulated by the earlier of end 2010 and the time
  by which the Commission has proposed an
  appropriate capital regime.
• Calendar is set by the Commission industry
  understands that they are planning to conduct the
  capital review in parallel with the MiFID
  exemptions review, i.e. conclude by spring 2008.

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CRD

• Conclusion the case for applying the CRD to
  commodity firms has not been made
• Further, even if a CRD type approach were
  retained, the target insolvency level should be
  distinct from that applied to financial
  institutions.
• Target pursued for financial institutions based
  on Basel I. No equivalent regime to Basel I
  exists for commodity firms.
• If a lower target is retained, e.g. 99th
  percentile instead of 99.9th, credit risk and
  operational risk capital charges are reduced
  respectively by 50 and 33.
• QUESTION DO MEMBERS OF THE CFRC WISH TO ARGUE
  FOR A RECALIBRATION OF THE CRD ?
• IF SO, WHAT PERCENTILE SHOULD BE USED ?

12
Credit charge re-calibrated at 99.9th perc.
13
Credit risk charge re-calibrated at 99th perc.
14
Operational risk charge re-calibrated at 99th
perc.

• Operational risk charge is intended to represent
  on average 12 of total regulatory capital for
  fis.
• Commodity firms are likely to use the Basic
  Indicator Approach , i.e. calculate op risk
  capital as a fixed percentage, alpha, of average
  income.
• Currently, alpha corresponding to a 99.9th worst
  case op risk scenario, is 15.
• We are seeking to re-calibrate alpha at the 99th
  percentile.
• Assuming a split between the various forms of
  capital (market, credit and operational) in
  firms overall reg cap, it is possible to compute
  the of income which the operational risk charge
  should represent if it were calibrated at the
  99th percentile.

15
Operational risk charge re-calibrated at 99th
perc.

• Assumptions To be verified, based on metal
  traders experience in the UK, and the EFET
  hypothetical testing exercise
• Overall cap charge split as follows
• Market 30
• Credit 58
• Operational 12
• Then, the operational risk charge should be
  computed as 10 of income under the Basic
  Indicator Approach, implying a reduction in alpha
  value of 1/3.

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CRD Main Risks

• Under CRD, 3 main risks must be capitalised
• Credit Risk
• Market Risk
• Operational Risk
• All three risks are relevant to commodity firms
  commodity derivatives activities. Question is
  should CRD be modified with respect to each one
  of these risks for commodity firms ?

17
Counterparty credit risk

• Counterparty Credit Risk arising from commodity
  derivatives activities
• Capital 8 . RW . EAD
• RW is the Risk Weight
• Standardised, function of external rating of
  counterparty, and in the absence of a rating,
  100 (in general).
• Articles 78 to 83 of CID, Annex VI of CID- Basel
  Accord paras 53 to 68
• Internal Ratings Based a function of the credit
  quality of the counterparty, expected recovery
  rate and tenor of the credit risk (Effective
  Maturity M)
• Articles 84 to 89 of CID, Annex VII of CID- Basel
  Accord paras 271 to 324

18
New approach to calculating EAD

• Spectrum approach to calculating EAD

EPE modelling Approach (IMM)
Standardised Method
Current Exposure Method (CEM)
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Counterparty credit risk

• EAD calculation reviewed as part of the Trading
  Book Review launched jointly by the Basel
  Committee/ IOSCO.
• Under current Basel Accord, for OTC commodity
  derivatives (zero charge for exchange traded or
  centrally cleared, daily margined derivatives)
• EAD Current MTM notional

20
Counterparty credit risk

• Current commodity add-ons (Annex III, CID)

21
Counterparty credit risk

• Current MTM can reflect applicable netting
  agreements.
• Future exposure can also be amended to reflect
  netting, although imperfectly
• (CID, Annex III)
• PCEred0.4 x PCE gross 0.6 x NGR x PCE gross,
• PCE is potential future credit exposure
• NGR net to gross ratio.
• The current approach lacks risk sensitivity

22
New approach to calculating EAD

• Standardised approach
• EAD beta x max (CES RPi x CCRMi),
• Where
• Beta 1.4
• CE current exposure
• RPi is the risk position in hedging set I each
  commodity is a separate hedging set.
• CCRMi multiplier for hedging set i
• For commodities 3 different multipliers are
  offered
• -Gold 5
• -Precious metals except gold 8.5
• -Power 4
• -Other commodities 10

23
Counterparty Credit risk

• Expected Positive Exposure Approach
• Risk sensitive diversification effects fully
  recognised within netting set
• Computationally intensive requires simulation
  of exposure profiles per netting set over one
  year
• Backtesting and stress testing requirements apply
• Further optional degree of complexity brought by
  the computation of alpha multiplier

24
Counterparty credit risk

• Questions for commodity firms
• Which approach will they use to calculate the RW.
  Are there specific obstacles which they would
  like to see removed in the CRD ?
• Which EAD computation approach would they like to
  adopt ?
• Which amendments to these approaches would they
  wish to see applied e.g. more commodity buckets
  and different CCFs under the SM, lower add-ons
  under the CEM ?

25
Credit Risk Mitigation (CRM) issues

• Credit Risk Mitigation recognised by regulators
  subject to stringent criteria
• (Articles 90-101 of CID, Annex VIII)
• Two main forms of mitigation
• Funded (collateral)
• Unfunded (credit derivatives, guarantees, letters
  of credit)

26
CRM issues

• Treatment of collateral
• ?Current counterparty risk approach
• EAD (RCadd-on) CA, where CA is the
  volatility adjusted collateral amount. Firms can
  calculate their own haircuts (99tile, 10 days) or
  use regulatory haircuts. Eligible collateral
  includes financial instruments as well as
  physical commodities
• ? EPE modelling approach
• Collateralisation reflected directly into EPE
  modelling

27
CRM issues

• Unfunded credit protection
• Recognised protection providers under Foundation
  IRB
• Sovereigns, PSEs, financial institutions, with
  lower risk weight than the entity being hedged
• Other guarantors, rated at least A-.
• The minimum rating condition is removed under
  advanced IRB. One further benefit of applying for
  AIRB recognition. But does the advantage outweigh
  the cost ?

28
CRM issues

• Treatment of unfunded credit protection
• Substitution approach use the lowest of risk
  weights of the reference entity and the
  protection seller. Implies maximum default
  correlation Very onerous
• New ASRF approach only available for financial
  institution/ insurance company protection sellers
  rated A-. Generates lower capital charge than
  substitution for reference obligors BBB.

29
CRM issues

• Questions for commodity firms
• Are any forms of widely used credit risk
  mitigation not recognised under the CRD ?

30
Market risk

• Excludes gold derivatives/ treated as FX risk.
• 2 approaches standardised, VaR modelling
• Not fundamentally modified by trading book
  review, unless exposures are illiquid (stress
  testing requirements, valuation requirements).

31
Market Risk

• Standardised approach (Reference CAD Annex IV
  Calculating capital requirements for commodities
  risk)
• Positions in identical commodities/ commodity
  futures/ options/ warrants are netted (long minus
  short).
• The net positions are assigned in a maturity
  ladder.
• Maturity bands

32
Market risk

• Standardised capital charge equal to
• Sum of matched long and short positions within
  bands, multiplied by the appropriate spread and
  by the spot price for the commodity,
• Matched positions between maturity bands for each
  band into which a position is carried forward,
  multiplied by 0.6 and by spot price,
• Residual unmatched positions, multiplied by 15
  and by spot price
• Extended maturity ladder approach available for
  firms with diversified exposures

33
Market risk

• VaR modelling approach (Annex V of CAD)
• Potential loss is calculated over 10 day horizon
  at 99th percentile
• Subject to multiplier 34, itself defined by
  application of backtesting
• Effective observation period is at least one
  year.

34
Market risk

• Questions for commodity firms
• Which approach are they likely to adopt ?
• What difficulties will they encounter in
  developing their chosen approach ? Should the
  rules be made more flexible to adjust for these ?
  E.g., under the standardised approach, by relying
  on forward prices rather than spot prices and
  removing the charge for matched positions within
  bands ?
• Is a simple modeling approach useful ?
• German commodity firms have proposed one to
  BaFIN, based on historical simulation and VaR
• Market values of last 51 days of trading are
  generated for the portfolio based on this set of
  data, a mean change in value, as well as the
  standard deviation of value changes are
  calculated
• The capital charge is set equal to
• Normsinv(99) SQUROOT(10) STDEV10Abs(MEAN)
  1.5

35
Operational Risk

• Risk capitalised for the first time by regulators
  in Basel II
• Articles 103 to 105 of CID, Annex X
• Three approaches
• Basic indicator approach
• Charge 15 of average net income over 3 years
• Standardised approach
• Charge 18 (trading and sales) of average net
  income over 3 years (for firms mostly trading
  15 instead of 18)
• Advanced measurement approach loss data
  distributions (99.9, 1 year) external data
  scenario testing.
• Which approach are commodity firms likely to
  choose ? Any particular difficulty in
  implementing it ?

36
Unsettled Transactions

• Scope which transactions will be subject to
  treatment?
• Where covered by scope, what is mechanism -
  delivery vs payment/delivery, or not?
• What is the settlement period - over or under 5
  days?
• Would a carve-out from the long settlement
  treatment be justifiable ?

37
Unsettled Transactions

• Capital treatment for DvP transactions

38
Unsettled Transactions

• Capital Charges for non DVP Transactions

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Recap on key questions

• Should commodity firms be regulated for capital
  purposes ?
• What business should be regulated ?
• If regulation applies, should commodity firms be
  subject to a lighter touch capital regime than
  financial institutions ? For instance calibrated
  on a less onerous solvency standard?
• Where could the capital requirements be made
  lighter ? Operational risk ? Credit risk ? Market
  risk ? Large exposures ?

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Useful contact details

• ISDA
• esebton_at_isda.org (CRD related matters)
• pwerner_at_isda.org (Energy, Commodity and
  Developing Products Committee)