And Another Thing About Derivatives…

Investors have largely been preoccupied with the Fed the last few weeks.

But concern about QE has led many people to miss another potentially critical event. The unveiling of new “Basel” rules on how banks should handle derivatives.

The Basel Committee on Banking Supervision has for years now been working to harmonize global banking rules. Most major banking nations are agreed to do what the Committee says.

This week, the Committee released a somewhat wordy document called the “Revised Basel III Leverage Ratio Framework and Disclosure Requirements”.

There are a lot of eye-raising points within. But the biggest one deals with how banks carry derivatives on their books.

Currently, banks are allowed to “net” their derivatives positions. Take Goldman Sachs USA as an example. Last quarter, the company held $1.35 trillion in derivatives contracts. Of these, $691 billion had positive value while $662 billion had negative value (depending which side of the trade the company is on).

Under current rules, Goldman is allowed to offset its positive and negative positions. So, the company reports a “net fair value” of just $64 billion. Just 5% of the total amount of derivatives it holds.

This net number is important. Because it’s used to calculate the firm’s leverage ratio. The lower the derivatives value, the less cash the bank needs to keep on hand as “rainy day” savings against its obligations.

Enter the new Basel rules. The Committee is proposing that rules about netting be changed. So that banks can only net contracts that cover the same underlying instrument, with the same delivery date.

This is a sea change. Currently, banks like Goldman can net, say, a contract on Euro futures against a contract on Japanese equities. It doesn’t matter what the underlying contract is. Only whether the value is positive or negative.

Under the proposed new rules, this will stop. Now banks will only be able to net Euro contracts against Euro contracts. Japanese equities against the same equities.

The result will be a lot less netting. Meaning higher carrying values for derivatives. And ultimately, banks needing to retain a lot more cash to meet leverage ratios.

The rules are by no means final. The Basel Committee is soliciting comments until September 20. You can bet the banking community is going to push back hard.

But if this does get passed, it’s a major “line in the sand”. Keep an eye on this one.

Here’s to the net result,

Dave Forest / @piercepoints / Facebook

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