D2LT’s Rachel Scanlon recently interviewed John Feeney, former ISDA board director and currently head of Martialis Consulting, on the hot topic of capital treatment for collateral, and “settled to market”.
Rachel: Hi John and thank you for joining us today. We have been hearing a lot about STM in the market. Can you explain to us what this is all about?
John: STM in the derivatives world stands for “settled to market”, and it is a capital treatment concept associated with the Fundamental Review of the Trading Book (FRTB) which is a comprehensive suite of capital rules intended to be applied to banks’ wholesale trading activities (further information at this link: https://www.bis.org/publ/bcbs279.pdf). When counterparties use STM methodology, variation margin payments under a Credit Support Annex are treated as final settlements of the derivatives’ mark-to-market (MTM) exposure, instead of merely collateral transfers. The party with a positive MTM value receives a cash payment from the other party to settle the exposure. After this payment, the MTM value of the derivative is reset to zero each day, with no collateral being posted. This is different from “collateralised-to-market” (CTM), where variation margin is treated as collateral that can potentially be returned later. In the STM approach, variation margin does not constitute collateral for capital purposes. Therefore, there is no “financial asset” for the transferor’s right to reclaim collateral, nor is there a “financial liability” for the transferee’s obligation to return collateral.
Fundamentally, the advantage of STM is that it avoids the build-up of large exposures between counterparties, allowing banks to reduce capital.
Rachel: So what is the regulatory backdrop to all of this?
John: This all comes from the Basel Committee on Banking Supervision, which is the primary global standard setter for prudential regulation of banks. In 2014, the Basel Committee introduced a new capital treatment, the Standardised Approach (SA-CCR) for measuring exposure at default for counterparty credit risk (CCR). SA-CCR started in the US on 1 Jan 2022 and in Australia in 2019 through APS 180.
Rachel: Tell me more about what has been going on in Australia?
John: The important thing is that this has been impacting the Australian market for a long time. Within Australian regulation, there is a separate section for qualifying central counterparties (QCCPs). QCCPs have used STM forever because it reduces counterparty risk associated with variation margin collateral. If this can be done for bilateral transactions, theoretically banks could employ the same capital calculation as QCCPs do. Banks like to pursue this because they can give the same capital treatment to bilateral transactions as they would do when facing QCCPs. Essentially this treatment results in lower capital charges, and better profitability for the banks.
Rachel: Why it is now, in 2024, that are we starting to hear more noise about STM in the market?
John: Australian banks have historically used US capital markets for funding: raising money in the US and switching it back to AUD. Because the US banks allocate capital at the desk level, the individual traders are incentivised to care about how the collateral on their trades works. This means the US traders want to use STM which frees up capital and directly reduces the charge to their desk and therefore improves their P&L. In Australia however, the capital charges are mutualised and not charged at the desk or individual level. Given the significant capital impact that STM can have, the US banks are now pushing this down to Australia.
What we are seeing now is that US banks are starting to contact their counterparties, particularly for cross currency swaps.
It is of course important that the STM methodology and related documents are enforceable, which is where the lawyers come in.
Rachel: What challenges do you expect market players to have around STM?
John: There will be implications in the documentation world when STM is deployed. For STM to work, the currency of the collateral (which is being settled) should match the currency of the exposure on the trade. This is often not the case, particularly around cross-currency swaps. QCCPs do not clear cross-currency swaps so those products have to be traded bilaterally. You can see that the non-standard currencies are going to be a problem, where the only allowed collateral is AUD or USD. Some people are therefore waking up to the fact that they will need to repaper their CSAs to allow for more types of collateral and matching it to the exposure. The vast majority of banks are still on dated ISDA Master Agreements and CSA forms, that do not contain the necessary provisions for STM to be utilised.
Rachel: What do you think the future looks like for all of this?
John: Credibility should be established around this issue in the market. In the meantime, STM discussions will start to develop, and these requirements will ultimately become a regulatory and legal obligation. What we need is more senior regulators speaking about this topic, which would allow the agenda to be expanded, for both markets and the legal function.