As the FCA reviews investment firms’ prudential rules (IFPR), looking to potentially change the capital constraints to the benefits of nonbank liquidity providers; The “frenemies”, AFME and EPTA representing the parties whose liquidity provision businesses are most at stake have striking opposing arguments.
in a speech on 2 February, the Bank of England executive director Rebecca Jackson described principal trading firms as banks’ frenemies, both competitors and valuable clients reliant on banks for leverage, clearing and market access.
While a lot of the on-risk liquidity provision has moved to nonbank liquidity providers, she warned that “risks have not entirely left the banking sector, they have just been transformed,” with banks increasingly exposed through intraday settlement and counterparty channels as electronic liquidity provision scales.
This dialectic is apparent in AFME and EPTA submissions to the now-closed FCA engagement consultation.
The FCA consultation acknowledges that investment firms now sit under the IFPR, but their market-risk capital is inherited from old bank Basel-based rules and the regulator wants to check whether those rules are fit for purpose in the context of modern non-bank dealers and market makers. Plainly, the consultation asks what the best way is to set a minimum capital buffer for trading risk.
Proprietary traders want to lower their capital requirements
The European Principal Traders Association (EPTA) jumped on this opportunity to voice the need for changes and argues that today’s Basel-derived framework is both pro-cyclical and blunt. It claims that margin-based clearing margin given factors (K-CMG) can overstate exposure by five to nearly one hundred times, and that net position risk factors (K-NPR) penalise hedging and liquidity provision in stressed markets.
The Association for Financial Markets in Europe (AFME), which represents European sell-side and the largest European banks amongst them, disagrees. It argues that deposit-taking is the wrong yardstick for systemic risk. It also warns that a small number of dominant non-bank liquidity providers could amplify market disruptions and may harm execution outcomes. It also points out that its members underwrite 90% of European debt and 85% of listed equity issuance, AFME urges the FCA to split “systemic” firms into bank-like standards while leaving smaller trading firms on simpler, proportionate rules to support a level playing field in liquidity provision/.
In its answer to the consultation, EPTA argues the current risk framework imports a post-GFC bank mindset into non-bank trading and says the calibration can become pro-cyclical when volatility and margins rise.
On the margin-based method, EPTA writes that “K-CMG overstates risk relative to actual loss exposure, by factors ranging from five to nearly one hundred,” adding that the level of conservatism “goes well beyond prudential objectives”. It urges the FCA to remove the 1.3 scalar and replace the K-CMG high-water mark with an averaging approach to reduce cliff effects.
EPTA also pushes for a recalibrated K-NPR.
The association argues that “the absence of meaningful netting mechanisms penalises hedging strategies,” particularly in fixed income, commodities and cross-currency positions. Market sources told Global Trading that most electronic liquidity providers function around a central risk book managing correlated risks across assets to great results, but are impaired by current prudential netting rules. Rather than targeting relief only at certain types of firms, EPTA proposes broad changes to the risk weights, giving one simple example, they propose to reduce the equity general/specific risk charge from 8% to 4%.
AFME says proprietary trading firms should be split between non-systemic and systemic buckets
AFME’s response supports a simpler approach for smaller, non-systemic firms, but also warns that the engagement paper understates the risks posed by a small set of very large non-bank liquidity providers.
It argues regulators should not treat deposit-taking as a proxy for systemic importance and says: “Market risk standards should be calibrated to the activities and systemic footprint of a firm, rather than the legal form or the presence of retail deposits.”
AFME wants the FCA to introduce a new categorisation that separates systemic non-bank liquidity providers from other investment firms.
In its view, those systemic firms should face bank-aligned market-risk standards.
AFME says: “We consider that systemic non-bank liquidity providers should be subject to requirements aligned with those banks already comply with.”
More specifically, AFME thinks systemic should be required to use a sophisticated approach based on the FRTB standardised approach and presumably not given better authorized leveraged terms than their members’.
That would prevent their frenemies’ proprietary trading clients from putting their own systemic operations at risk in case of a triggering feedback look but also presumably keep the playing field level in liquidity provision.
