I have been reading through the Basel Committee of Banking Supervisors’ (BCBS) Consultative Document of 5 November 2015 on *Haircut Floors for Non-Centrally Cleared Securities Financing Transactions*. This sets out the proposed incorporation into Basel III of the recommendations of Workstream 5 of the Financial Stability Board (FSB) on securities financing transactions. In particular, the paper sets out the framework for minimum haircuts to be imposed on non-centrally cleared SFT between banks and non-banks. If transactions do not meet these minimum haircuts, they will be considered uncollateralised for the purposes of capital adequacy calculations. The methodology of the proposals is problematic.

The first problem is that the measure of haircut used by the BCBS is not a haircut at all. A haircut is a discount of the cash value of an SFT to the value of collateral, ie the ratio of (1) the difference between the value of the collateral and cash to (2) the value of the collateral. The BCBS “haircut” is, in fact, a bastardised version of an initial margin. An initial margin is a premium in the value of collateral over the value of cash, ie the ratio of the value of collateral to the value of cash. For example, the BCBS/FSB “haircut” of 6% is actually an initial margin of 106%. The true equivalent haircut would be 5.66% (= (106-100)/106).

While the BCBS are being consistent with the way haircuts are expressed in Basel III for adjustments to collateral and exposure values for capital adequacy calculations, it is confusing to use the word “haircut” in regulations that are supposed to be applied at market level. This criticism may seem semantic but it is worth recalling the problems that the confusion between haircut and initial margin caused with term repo just before GMRA 2011. It would also be a good idea to ensure the BCBS terminology was consistent with the reporting requirements of the EU SFT Regulation (SFTR).

The second problem with the BCBS haircut framework is the method calculation of haircuts for individual SFT within a “netting set” (ie a portfolio of SFT under the same master agreement), at least as set out in the example on p6 of the BCBS paper. Each SFT with cash in the same cash currency or the same type of security against the same type of collateral (where the typology is that of Basel III supervisory haircuts) is given a representative “artificial traded haircut” according to the formula:

To simplify:

where C_{i} is the sum of the collateral S_{j} (which can be cash in the same currency or the same type of security) and E_{i} is the sum of the exposures created by lending the same currency or same type of security S_{k}. The artificial traded haircut is represented by H_{j,k}. This means it is a haircut to be applied to S_{j} when it is collateralising an exposure to a loan of S_{k}. The artificial traded haircut has to be compared with the floor as shown in the table below or as implied by the following formula:

The artificial traded haircut only has to be calculated for security type S_{j} if it is a non-government issue and has been received net within the same netting set. On p6 of the BCBS paper, the following portfolio example is given:

In the example, only security A is liable to minimum haircuts and has been net received. Security A is deemed the collateral in all the trades, which means these should be the following types of transaction:

Trade A = reverse repo of security A

Trade B = securities lending of security B v collateral security A

Trade C = securities lending of sovereign security v collateral security A

Trade D = repo of collateral security A

This view of security A as always being the collateral is confirmed by the calculation of the implied floor f as (1 + collateral floor)/(1 + exposure floor), in which A’s floor is in the numerator.

The problem with the BCBS proposal is the formula for the artificial traded haircut. It is complicated and therefore not good regulation. But the complexity is unnecessary. The idea of an artificial traded haircut is to prevent banks using a combination of several SFTs, which individually may not be subject to minimum haircuts, to synthesize a position which would have been subject to haircuts had it been transacted as a single SFT. For example, a repo of cash against corporate bonds would be subject to minimum haircuts (assuming it was also with a non-bank and was not centrally cleared). But a bank could try to replicate this transaction and avoid minimum haircuts with a repo against government bonds and a securities borrowing transaction between the same government bonds and the corporate bond, neither of which might be subject to minimum haircuts. To prevent such regulatory arbitrage, the BCBS applies minimum haircuts to securities lending and borrowing transactions even where there is no cash. It does so by implying an artificial traded haircut to each collateral type at a portfolio level using the formula above, as set out in the example above. If the artificial traded haircut falls below the floor for that type of collateral, all trades in the portfolio against that type of collateral are deemed uncollateralised.

But is the BCBS formula needed? Why not split each securities lending/borrowing (SLB) transaction into a repo and reverse repo, and imply the haircut from these notional transactions. For example, trade B in the BCBS example, 200 of A borrowed against 210 of B, could be seen as a reverse repo of 200 of A against cash, and a repo of 210 of B against cash. Using the regulatory haircut of 6% for A, the cash value of the implied reverse repo should be 200/1.06 = 188.7. If the cash value of the implied repo is assumed to be the same, then the value of B needed to fully collateralise the cash would, using the regulatory haircut for B of 10%, be 207.5 (188.7*1.10). As 210 of B is actually being given, this transaction falls short of the minimum haircut by 2.5.

In the case of the example portfolio, the difference with the BCBS is that trade D falls below the floor, as too much collateral is being given. Consider how this simpler approach would work in the case of the example portfolio:

Trade A | reverse repo of 100 v 105 of A | given A’s supervisory haircut is 6%, A should be 100 x 106% = 106 | so trade A is short of haircut of 1 of A |

Trade B | securities borrowing of 200 of A v 210 of B | this trade is equivalent to reverse repo of 200 A and a repo of 210 B: given A’s supervisory haircut is 6% and B’s is 10%, the reverse repo of A should be against 200/106% = 188.7 of cash, so the repo of B should be 188.7 of cash v 188.7 x 110% = 207.5 of B | so because trade B is giving 210 of B, it represents a deficit of haircut of 2.5 of B |

Trade C | securities lending of 85 of sovereign bond v 90 of A | given A’s supervisory haircut is 6%, A should be 85 x 106% = 90.1 | so trade C is short of haircut of 0.1 of A |

Trade D | repo of 20 of cash v 25 of A | given A’s supervisory haircut is 6%, A should be 20 x 106% = 21.2 | so trade D is giving 25 of A, it represents a deficit of haircut of 3.8 of A |

In total, the portfolio has haircut deficits of 4.9 of A and 2.5 of B, which is equivalent to 7.6 of B.

Does this approach lose the protection intended by the BCBS approach against regulatory arbitrage? Consider applying haircuts to the net notional trades in the example portfolio (where sovereigns have been deemed to be equivalent to cash):

Trade 1 | reverse repo of 165 v 170 of A | given A’s supervisory haircut is 6%, A should be 165 x 106% = 174.9 | so trade A is short of haircut of 4.9 of A |

Trade 2 | securities borrowing of 200 of A v 210 of B | this trade is equivalent to reverse repo of 200 A and a repo of 210 B: given A’s supervisory haircut is 6% and B’s is 10%, the reverse repo of A should be against 200/106% = 188.7 of cash, so the repo of B should be 188.7 of cash v 188.7 x 110% = 207.5 of B | so trade B has a deficit of haircut of 2.5 of B |

In total, the portfolio has haircut deficits of 4.9 of A and 2.5 of B, which is equivalent to 7.6 of B, the same as when haircuts are applied individually. And now consider applying haircuts to the gross positions of each type of collateral in the example portfolio:

Position 1 | outflow of cash & sovereigns of 165 | there should be collateral of 165 x 106% = 174.9 of A |

Position 2 | inflow of A of 370 | if 174.9 of A is required to collateralise the cash & sovereigns, there is a surplus of 195.1 of A — this is equivalent to 195.1/106% = 184.1 of cash, which is equivalent to 184.1 x 110% = 202.4 of B |

Position 3 | outflow of B of 210 |

In total, the portfolio has a haircut deficit of 7.6 of B, the same as in the previous approaches.

Why is the BCBS using such a complex approach?