Worth Reading: Cboe’s Chief Policy Officer On the Dangers of the Current Exposure Method (via IFLR)

Cboe Blog
August 12, 2019

In a recent article for International Financial Law Review, Cboe’s Chief Policy Officer, Angelo Evangelou, detailed why the Current Exposure Method (CEM) – a methodology created to determine capital requirements for counterparty credit risk to derivatives in the U.S. – is harming liquidity provision in the options market. Angelo explains that because of CEM, banks in the options clearing business are unnecessarily incurring capital charges and makes the case for change.

In the piece, Angelo makes three key points:

“The U.S. options market is a critically important component of our financial system.”

Why? Because options help manage risk. Angelo explains how options are used by institutional and retail investors to manage risk, hedge portfolios and augment returns. He also describes how the ability of market makers to continuously make markets benefits all investors.

“Virtually all options market maker trading in the U.S. is cleared through a small handful of bank-owned clearing firms.”

These banks are subject to capital requirements imposed by regulatory agencies, which in most cases, makes complete sense, however, the CEM “is insufficiently calibrated to account for the varied risk profiles of listed options,” Angelo argues. What does that result in? Banks in the options clearing business incur capital charges despite having no relationship to the actual risk posed by clearing those options trades.  

“Fewer liquidity providers reduces competition and can negatively impact liquidity available to investors.”

Angelo cites industry opinion that the capital charges are causing market makers to make fewer trades, leading to options market maker concentration and a decay in liquidity. He notes the gradual pace but states, “there is concern it could accelerate rapidly under the right or wrong conditions.”

Never fear, Angelo offers up a solution to these problems. It’s called SA-CCR.

SA-CCR, or the Standardized Approach for Counterparty Credit Risk, is a methodology designed to calculate the capital required to assess counterparty risk. In the article, Angelo explains that he – along with Cboe – supports SA-CCR because it is more risk-sensitive and goes beyond what is necessary to address the shortcomings of CEM.

In short, to ensure the health of the options market, Angelo supports a swift adoption of SA-CCR, urging our bank regulatory agencies to “stay the course” or formulate interpretive relief under the current regime.

Read the whole article, Running Out of Options, on the International Financial Law Review website.

To learn more about this topic, visit our Market Policy and Government Affairs webpage.