About the topic:•IMF Working Paper•Dep’t: Monetary and Capital Markets Department•Title: Counterparty Risk in the Over-The-Counter DerivativesMarket•Prepared by Miguel A. Segoviano and Dr.Manmohan Singh• November 2008 In this paper the area of interest in counterparty risk that may stem fromthe OTC derivatives markets
AbstractThe financial market turmoil of recent months(in 2008) has highlightedthe importance of counterparty risk.The paper discusses counterparty risk that may stem from the OTCderivatives markets and attempt to assess the scope of potential cascadeeffects.This risk is measured by losses to the financial system that may result viathe OTC derivative contracts from the default of one or more banks orprimary broker-dealers. We then stress the importance of “netting”within the OTC derivative contracts.We summarize our results in the context of the stability of the bankingsystem and provide some policy measures that could be usefullyconsidered by the regulators in their discussions of current issues.
Few definitions for the clear understanding:Over-the-counter : OTC or off-exchange trading is to trade financialinstruments such as stocks, bonds, commodities or derivatives, directlybetween two parties. It is contrasted with exchange trading, which occursvia facilities constructed for the purpose of trading (i.e. exchanges), suchas stock market.Forwards and Swaps are prime examples of OTC contracts. It is mostly donevia the computer or the telephone. For Derivatives, these agreements areusually governed by an International Swaps and DerivativeAssociation agreement. This segment of the OTC market is occasionallyreferred to as the “Fourth Market“.What makes OTC derivative market risky?•Non-standard products are traded here.•OTC derivatives have less standard structure and are traded bilaterally.•OTC derivatives are significant in the asset classes such as interest rate,foreign exchange, equities and commodities• Counter-party risk and Credit risk
The International Swaps and Derivative Association suggested five main waysto address the credit risk arising from a derivatives transaction, as follows:• avoiding the risk by not entering into transactions in the first place;• being financially strong enough and having enough capital set aside to acceptthe risk of non-payment;• making the risk as small as possible through the use of close-out netting• having another entity reimburse losses, similar to the insurance, financialguarantee and credit derivatives markets.Obtaining the right of recourse to some asset of value that can be sold orthe value of which can be applied in the event of default on the transaction.
Importance of OTC derivatives in modern banking•The OTC derivatives markets are large and have grown exponentially overthe last two decades•The expansion has been driven by interest rate products, foreign exchangeinstruments and credit default swaps.•The notional outstanding of OTC derivatives markets rose throughout theperiod and totalled approximately US$601 trillion at December 31, 2011.•These institutions manage portfolios of derivatives involving tens ofthousand of positions and aggregate global turnover over $1trillion.•International financial institutions have increasingly nurtured the ability toprofit from OTC derivatives activities and financial markets participantsbenefit from them. As a result, OTC derivatives activities play a central andpredominantly a beneficial role in modern finance.•The advantages of OTC derivatives over Exchange traded ones are mainly thelower costs (in terms of government taxes and fees payable) and the ability forsellers and buyers of these products to bilaterally negotiate and customize thetransactions themselves.
Equity Linked Derivative: Derivatives whose value derives from equity prices.equity derivative is a class of derivatives whose value is at least partly derivedfrom one or more underlying equity securities.Options and futures are by far the most common equity derivatives, howeverthere are many other types of equity derivatives that are actively traded. Theseinclude:•Equity future—traded on an organized exchange, in which counterpartiescommit to buy or sell a specified amount of an individual equity or a basket ofequities or an equity index at an agreed contract price on a specified date.•Equity option—gives the purchaser the right but not the obligation to purchase(call) or sell (put) a specified amount of an individual equity or a basket ofequities or an equity index at an agreed contract price on or before a specifieddate.•Equity swap—in which one party exchanges a rate of return linked to an equityinvestment for the rate of return on another equity investment.
Credit Default Swap - CDS:A swap designed to transfer the credit exposure of fixed income products betweenparties. A credit default swap is also referred to as a credit derivative contract,where the purchaser of the swap makes payments up until the maturity date of acontract. Payments are made to the seller of the swap. In return, the seller agreesto pay off a third party debt if this party defaults on the loan. A CDS is consideredinsurance against non-payment. A buyer of a CDS might be speculating on thepossibility that the third party will indeed default .The buyer of a credit default swap receives credit protection, whereas the seller ofthe swap guarantees the credit worthiness of the debt security. In doing so, therisk of default is transferred from the holder of the fixed income security to theseller of the swap. For example, the buyer of a credit default swap will be entitled to the par value ofthe contract by the seller of the swap, if the third party default on payments. Bypurchasing a swap, the buyer is transferring the risk that a debt security willdefault.
Notional Value:The total value of a leveraged positions assets. This term is commonly used inthe options, futures and currency markets because a very small amount ofinvested money can control a large position.For example:one S&P 500 Index futures contract obligates the buyer to 250 units of the S&P500 Index. If the index is trading at $1,000, then the single futures contractis similar to investing $250,000 (250 x $1,000). Therefore, $250,000 is thenotional value underlying the futures contract.To the audience’S&P index stands for………?
Hedge Ratio1. A ratio comparing the value of a position protected via a hedge with the size of the entire position itself.2. A ratio comparing the value of futures contracts purchased or sold to the value of the cash commodity being hedged.Eg:• Say you are holding $10,000 in foreign equity, which exposes you to currency risk. If you hedge $5,000 worth of the equity with a currency position, your hedge ratio is 0.5 (50 / 100). This means that 50% of your equity position is sheltered from exchange rate risk.• The hedge ratio is important for investors in futures contracts, as it will help to identify and minimize basis risk.
Credit derivative:It is an OTC derivative designed to transfer credit risk from one party toanother. By synthetically creating or eliminating credit exposures, they allowinstitutions to more effectively manage credit risks. Credit derivatives takemany forms.For example:A bank concerned that one of its customers may not be able to repay a loan canprotect itself against loss by transferring the credit risk to another party whilekeeping the loan on its books.
Cascading effects of financial market turmoil in 2008Loss of confidence in the market both currency andinstruments.International investors withdrawing funds.Banks related panics and recession coinciding.Crash of stock markets.Currency crises.Sovereign defaults.Transformation of investors to, being risk averse.Problem of managing risks and allocating capital.Effect of the crises on dependent currencies and world market.Affect on International investors.,etc……………………………
IntroductionNotional amounts of all categories of the OTC contracts reached almost $600 trillionat the end of December 2007. These include foreign exchange contracts, interest ratecontracts, equity linked contracts, commodity contracts, and credit default swaps(CDS) contracts.Interest rate contracts continue to be the largest segment of this market comprising66 percent of all OTC derivative market or about $400 trillion.Growth in the credit derivatives segment has been the fastest and the volume hasmore than doubled in the 2007 to about $60 trillion.
In order to quantify counterparty risk, we calculate (expected) losses absorbedby the system under two different scenarios. For the estimation of (expected)losses, they define(i) The exposure of the financial system to specific financial institutions (FIs); and(ii) Propose a novel methodology to estimate the probability that given that a particular institution (counterparty) fails to deliver, other institutions in the system would also fail to deliver.Counterparty risk largely stems from the creditworthiness of an institution.In the context of the financial system that includes banks, broker dealers,and other non-banking institutions (e.g., insurers and pension funds),counterparty risk will be the cumulative loss to the financial system from acounterparty that fails to deliver on its OTC derivative obligation.
Thus, in order to estimate the potential cumulative loss in the system,we need to quantify two variables(i) The exposure of the financial system (EFS) to a particular institution or institutions that would fail to deliver; and(ii) The probability that given that a particular institution (counterparty) fails to deliver, other institutions in the system would also fail to deliver.Eg…………………………..
Risk in derivatives stems from various other variables :Price changes, volatility, leverage and hedge ratios, duration, liquidity,and counterparty risk.Gross market values do provide some measure of the financial riskfrom OTC derivatives. These are all the open contracts that are eitherin a current gain (or loss) position at current market prices and thus, ifsettled immediately, would represent claims (or liabilities) oncounterparties.Gross market values are correlated to the notional amounts of thederivative contracts: the larger the notional amount, the larger thegross market value from price changes, all other things being equal.Although gross market values capture the economic significance,these values are not netted.
Netting:1. Settling mutual obligations at the net value of a contract as opposedto its gross dollar value.2. Reducing the transfer of funds between subsidiaries to a net amount.Netting often occurs in situations in which one of the participants isexperiencing extreme financial difficulty, such as bankruptcy. Nettingwill be specific to the master agreement of the institution; thus itis possible that OTC derivatives may not be offset against repo positions.Thus counterparty risk will be discussed only in the context of “un-netted” and “unassigned” liabilities of an institution.
WHAT WAS ENVISAGED BY MOVING OTC DERIVATIVES TO CCPSSince Lehman’s demise and AIG’s bailout, regulators have been searching for away to unwind SIFIs, but as yet, with limited success. Some new institutions,or CCPs, are being proposed that will inherit the bulk of derivative portfoliosof existing SIFIs. It is envisaged that a critical mass of SIFI’s derivative-relatedrisks will be moved to CCPs so that this regulatory effort can bear fruit.A key incentive for moving OTC derivatives to CCPs is highermultilateral netting, i.e., offsetting exposures across all OTC productson SIFIs’ books. Intuitively, the margin required to cover the exposureof the portfolio would be smaller in a CCP world.However, if there are multiple CCPs that are not linked, the benefits ofnetting are reduced, because cross-product netting will not take place(since CCPs presently only offer multilateral netting in the same assetclass and not across products).
Just to readOf all the financial institutions that got government aid during the financial panic of 2008, none was less morallydeserving than AIG. The insurance group imploded due to reckless bets it had made through what was essentially anin-house hedge fund. Nor were many bailouts bigger than the $182 billion combined commitment that the FederalReserve and the Treasury Department made to AIG during the Bush and Obama’s administrations. Yet no bailout wasmore necessary, given the cascading disaster that AIG’s failure could have let off in the U.S. and European financialsystems.You hardly hear anything about the AIG bailout these days, in contrast to the debate that still rages over GeneralMotors, Chrysler, Fannie Mae and Freddie Mac. Could it be that, all things considered, the AIG bailout is workingpretty well? Actually, yes. The firm used $140 billion of the $182 billion available from the government, dividedbetween Fed loans and Treasury equity purchases. The bulk of that has returned to the government, with interest.This has occurred because, having spent the past two years selling excess assets and modernizing its core insurancebusinesses, AIG is profitable again. The firm’s only remaining debt to the Fed is a $9.3 billion loan, against which thecentral bank holds collateral valued at almost twice that. So it’s highly unlikely taxpayers will take a loss — and quitelikely they’ll turn a profit.The remaining federal commitment consists of the Treasury Department’s majority share of AIG stock. There’s goodnews on that front, too: On Wednesday, Treasury announced that it plans to sell $6 billion of its stake. Cleverly,Treasury sold about half of that amount back to AIG; this gave Treasury an alternative to merely dumping shares onthe market and so boosted the price it could command on behalf of taxpayers. Wednesday’s sale reduced the taxpayers’stake in AIG to $35.8 billion, at the current price of roughly $29 per share.Treasury still has to shed more than a billion shares, or 70 percent of the company. The current bull market facilitatedthe latest sale; it can’t last forever. Still, Bernstein Research, a Wall Street firm, recently described AIG as ―arecapitalized and de-risked firm, on a stable footing and pursuing a thoughtful renewal.‖ Since the government paid$28.50 each for its shares, all it needs to break even is for AIG’s stock price to stay about where it is now. Given thefirm’s restructuring, that seems feasible.. As with other bailouts, the true cost-benefit analysis can never be known, since we’ll never know exactly how big acatastrophe it averted.On balance, though, the risk of disaster was sufficiently high, compared to the – so far — modest costs, that the AIGrescue deserves to be labeled, if not a success, then certainly a gamble worth taking.
WHAT IS ACTUALLY HAPPENING AND WHY DOES THIS GIVE RISE TOSUBSTANTIAL RISKS?Recent developments have diverged substantially from this “first-best” solution. ACFTC draft proposal has lowered the capital threshold for a CCP(central counterparty) to $50 million, which will encourage new entrants in this business.Furthermore, end-user exemptions along with not moving certain products like theforeign exchange OTC derivatives to CCPs may not only dilute the intendedobjectives, but actual outcomes may be sub-optimal relative to the status-quo.CCPs will require collateral to be posted from all members. In essence, both partiesshould post collateral to CCPs; no exceptions or exemptions. This is also called two-way CSAs (Credit Support Annexes). Thus moving transactions to CCPs would make the under-collateralization obviousand require large increases in collateral. The amount of capital needed to be raisedwill depend on how the collateral requirements are assessed by CCPs and theregulators (e.g., entity type, rating, or riskiness of the portfolio that is offloaded toCCPs) and how firms choose to raise the required collateral.
Systemically important financial institutions (SIFI) are Financial institutions that aredeemed systemically important to the global economy in the sense that the failure ofone of them could trigger a global financial crisis. The prevention of their collapseand the limitation of the consequences of a collapse are important as a means ofprotecting the financial system.This section highlights key issues that need to be understood when moving a sizablepart of the OTC derivatives positions at SIFIs to CCPs. These issues include(i) interoperability of CCPs which would allow multilateral netting of positionsacross SIFIs residual positions;(ii) sizable collateral needs;(iii) unbundling netted positions;(iv) duplicating risk management;(v) likely regulatory arbitrage;(vi) concentration of systemic risk;(vii) decrease in rehypothecation of collateral(viii) backstopping by central banks; and(ix) more SIFIs to supervise.
Interoperability of CCPsInteroperability, or linking of CCPs, allows a SIFI to concentrate itsportfolio at a CCP of its choice, regardless of what CCP its tradingcounterparty chooses to use. Thus, at the level of each CCP, CCPi may holdor have access to collateral from another CCPj that may go bankrupt in thefuture, so that losses involved in closing out CCPj’s obligations to CCPi canbe covered.However, legal and regulatory sources indicate that cross-border marginaccess is subordinate to national bankruptcy laws. Thus it is unlikely thatCCPi in a country would be allowed access to collateral posted by CCPjregistered in another country.
Sizable collateral requirementsWithout interoperability, the 10 largest SIFIs will continue to keep systemic riskfrom OTC derivatives on their book and regulatory efforts will introduce more newentities (CCPs) that will hold systemic risk from OTC derivatives.Thus, collateral needs will be higher in the proposed world. Most of the majorSIFIs’ derivatives books are largely concentrated in one ―business‖ (a legal entity)to run the derivatives clearing business so as to maximize global netting.A Tabb Group study (November, 2010) also estimates under-collateralization in theOTC derivatives market at around $2 trillion and suggests that due to end-userexemptions a significant part of this market will not reach CCPs.ISDA(int’l swaps and derivatives association) has also acknowledged the sizablecollateral needs resulting from moving derivative positions to CCPs, despite their(earlier) margin surveys indicating that most of this market is collateralized.The sizable collateral needs imply that CCPs may not inherit all thederivative positions from SIFIs.
Unbundling of netted positionsThe SIFIs are reticent to unbundle ―netted‖ positions, as this results in deadweightloss and increases collateral needs. Since there is no universally accepted formaldefinition of a ―standard‖ contract (or contracts that are ―clearable‖ at CCPs), thereis room for SIFIs to skirt this definition despite the higher capital charge associatedwith keeping non-standard contracts on their books, since the netting benefits maybe sizable relative to the regulatory capital charge wedge. This can be expected ofSIFIs where risk management teams build high correlations across OTC derivativeproducts for hedging purposes.Adverse impact on risk managementIn an environment where CCPs compete, unlimited loss sharing may not be a viablebusiness model because market participants are likely to choose CCPs with thelowest loss sharing obligations in their rules, everything else being equal.Yet, pushing CCPs to clear riskier and less-liquid financial instruments, as theregulators are now demanding, may increase systemic risk and the probability of abailout. Banks may also provide loans as collateral and not lose clients/business.
Regulatory arbitrage likelyGaps in coordinating an international agenda will result in regulatory arbitrage bySIFIs.Following Senator Lincoln’s ―push out‖ clause under Dodd-Frank Act, SIFIs’ bankinggroups can keep interest rate, foreign exchange, and investment grade CDS on thebanking book. Other OTC derivatives like equities, commodities, and belowinvestment grade CDS have to be outside the SIFI’s banking book. This will also leadto ―unbundling‖ of positions (or a move to another jurisdiction like the U.K. that skirtsthe Lincoln ―push out‖).Concentration of systemic risk via “risk nodes”Regulators are ―forcing‖ en-masse sizable OTC derivatives to CCPs. This is a hugetransition, primarily to move this risk outside the banking system. If the intendedobjective(s) are achieved, these new entities should be viewed as ―derivativewarehouses,‖ or ―risk nodes‖ in financial markets, and not under thepayment/settlement rubric.
CB backstop (or taxpayer bailout)A CCP may face a pure liquidity crisis if it is suffering from a massive outflow ofotherwise solvent clearing members, in which case the risk is that it will have torealize its investment portfolio at low prices. Assume an external shock whereeveryone is trying to liquidate collateral simultaneously. This will lead to aproblem if the CCP has repo’d out the collateral it has, cannot get it back, and forwhatever reason does not want to pay cash to the members (i.e., effectivelypurchasing the securities at that price). In these circumstances, a central bank (CB) would be repo-ing whatevercollateral the CCP would ultimately get back. In such instances, it would be moresensible to require the bank members (e.g., JPMorgan, Credit Suisse) of the CCPto access the CB and then provide the CCP with liquidity.
Decrease in re-hypothecationThe decrease in the ―churning‖ of collateral may be significant since there is demand fromsome SIFIs and/or their clients (asset managers, hedge funds etc.), for ―legally segregatedaccounts‖ for the margin that they will post to CCPs. Also, the recent demand forbankruptcy remote structures—another form of siloing collateral—that stems from thedesire not to legally post collateral with CCPs in jurisdictions that may not have the centralbank’s lender-of-last-resort backstop (i.e., liquidity and solvency support)will reduce re-hypothecation (see Box 2).Supervision of more SIFIsRegulators will have to supervise more SIFIs, as CCPs will effectively be SIFIs.Furthermore, existing SIFIs (i.e., large banks/dealers) will retain OTC derivative positionssince nonstandard contracts will stay with them. End-user exemptions and (likely exempt)foreign exchange contracts will not migrate to CCPs. SIFIs may keep somenonstandard/standard Combination on their books due to netting benefits across productsand not move them to CCPs despite higher regulatory capital charge. Post-Lehman there hasnot been much progress on crisis resolution frameworks for unwinding SIFIs; thus creatingmore SIFIs need to be justified. However, policies and regulations in these areas areevolving
HOW TO GET BACK ON TRACK: TWO ALTERNATIVESIn view of the remaining risks described above, there is a need for alternativepolicies. We offer two such options below. These options are only two of many, andshould not be seen as precluding other suggestions to address the systemic risk atSIFIs.Taxing Derivative Liability Positions of SIFIsIn order to summarize the derivatives risk to the financial system, we measure theexposure of the financial system to the failure of a SIFI that is dominant in the OTCderivatives market, according to the SIFI’s total ―derivative payables‖ (and not―derivative receivables‖).Derivative payables represent the sum of the counterparty’s contracts that areliabilities of the SIFI. Similarly, derivative receivables represent the sum of thecounterparty’s contracts that are the assets of the SIFI.At present, a SIFI’s derivative payables do not carry a regulatory capital charge andare not reflected in risk assessments.
On the other hand, derivative receivables are imbedded in credit risk and there isalready a capital charge/provision for potential non-receivables. By usingderivative payables as a yardstick, we thus provide a readily available metric tomeasure systemic risk from derivatives, compared to other sources that focus onderivative receivables.The five largest European banks had about $700 billion in under-collateralized riskin the form of derivative payables as of December 2008. The U.S. banks hadaround $650 billion in derivative payables as of end-2008, as dislocations werehigher then. The key SIFIs active in OTC derivatives in the United States areGoldman Sachs, Citi, JP Morgan, Bank of America, and Morgan Stanley. InEurope, Deutsche Bank, Barclays, UBS, RBS and Credit Suisse are sizableplayers.It is useful to note that the International Swap and Derivatives Association’s(ISDA) master agreements allow SIFIs to net (or offset) their derivativereceivables and payables exposure on an entity. Thus, if Goldman has a positiveposition with Citi on an interest rate swap and a negative position with Citi on acredit derivative, ISDA allows for netting of the two positions.
CCPs as a Public Utility InfrastructureAs noted above, regulatory efforts to move the OTC derivatives market to CCPswith appropriate collateralization are meeting with limited success due to thecomplexity of the market, excessive opacity, and other vested interests of thefinancial industry.Given the systemic importance of CCPs, it would appear appropriate for regulatorsto at least consider approaching them as a public utility infrastructure.For example, moving most OTC derivatives to closely regulated exchanges wouldreduce systemic risk and enhance transparency, while also reducing spreads onmany products.However, the large banks have fought hard to keep their most profitable businessline opaque, and have been supported in this by some large end users. SIFIs whooriginate the OTC derivative transactions are passing on the risks, but not theprofits, to CCPs. Regulators have allowed this to happen―recently they agreed that―third‖ party marks/quotes will not be required to price derivatives moving to CCPs.
Thus the bid/ask spread of SIFI transactions will remain opaque and will not beavailable real time. Altogether, the bespoke nature of much of the OTC derivativesmarket and the ―compromise‖ between regulators and SIFIs provides the argumentfor the current policy of transferring only certain parts of this market to afragmented set of CCPs. Quantity restrictions are also not being implemented, asthese would limit the growth of OTC derivatives, which are often seen as beneficialin that they ―complete‖ markets.However, the welfare benefits of derivatives markets are somewhat speculative. Inparticular, the costs of financial, sector ―pollution‖ (Haldane, 2010) may be largesince systemic tail risk is created by the markets and does not arise fromfundamentals. The social costs of future financial crises will continue to becorrelated with the high rents in the market.The importance of CCPs is apparent since key regulators are willing to provideliquidity support in certain situations (e.g., ECB and the Fed). Such a backstop maylead to moral hazard that may manifest itself, for example, in CCPs not requiringfull collateral from their clearing members/clients, quite possibly with theacquiescence of regulators.
By contrast, organizing CCPs as utilities encompasses both(i) a government backstop and(ii) a carefully engineered and regulated infrastructure that emphasizes safety andtransparency. By ensuring that users of OTC derivatives (both the large dealers and endusers) bear the full social costs of those products, the utility model could reducethe extent of financial ―pollution‖ and also limit the excess rents currently earnedby major participants in the market at the expense of the broader economy.However, given that CCPs are not being treated as utilities, the size of the publicbackstop provided is very high, compared with a suboptimal amount of systemicrisk reduction. This raises the question whether the public at large is being wellserved by the present non-utility regulatory models.
SOME POLITICAL ECONOMY CONSIDERATIONSCB backstopping of CCPs is shifting the potential taxpayer bailout from Wall Streettoentities. This transition is increasingly opaque to the ordinary taxpayer, especiallysince moving derivatives from SIFIs’ books to those of CCPs is mired in convolutedarguments and impenetrable technical jargon. However noneconomic considerationshave been instrumental in pushing the regulatory efforts forward, some of which arehighlighted below. The ECB favours a CB liquidity backstop but not the United Kingdom. The ECB’s view is that in order to have an account with a Euro-zone CB, a CCPshould be incorporated and regulated in the Euro-zone (and not, for instance, in theU.K.).Some have suggested offering CCPs access to a ―standing credit facility‖ at CBs.But even if a CCP does not have a CB account, the relevant authorities could stilldecide to bail out the CCP if it is deemed too systemically important to fail. Putdifferently, using public money to bail out a CCP is a policy decision, independent ofwhether the CCP has routine access to central bank liquidity.
In distressed market conditions, access of CCPs’ members to CB overnightcredit may not be sufficient to ensure that the CCP remains liquid, as the liquiditytransfer from the CB to the CCP (via CCP members) may not materialize as CCPmembers may hoard liquidity for precautionary reasons, perhaps reflectinguncertainty over CB actions. Thus CB backstopping and associated funding, ifprovided, might be based on the condition that funds are passed through the CCPmember banks (i.e., increasing their liability to CB) to CCPs.
Managing counterparty risk with OTC derivatives collateral managementManaging credit risk remains a top priority of financial institutions andcorporations, thrown into sharp focus by recent market events. As participants inOTC derivative transactions come under increasing pressure to mitigatecounterparty risk, many have returned to the original risk management tool:collateralization.The use of collateral in OTC derivatives has grown dramatically over the pasteight years. While it is unclear how potential regulatory changes will impact thistrend, the number of collateralized derivative trades is expected to showconsistent growth.Demands for more frequent reconciliation and access to pricing utilities areadding new levels of complexity to the additional volume. These trends create aclear need for more advanced collateral management platforms to replace theincreasingly stressed and outmoded spreadsheet-based systems.
Impact of Regulatory Changes on Use of CollateralThe widely anticipated regulatory changes are likely to have some impact on theuse of collateral in OTC derivatives trading. A move toward central clearing forstandardized OTC instruments, for example, would eliminate the need for sometrades to be collateralized bilaterally. As the vast majority of OTC positions are not standardized, however, suchmeasures would be unlikely to seriously reduce collateral use.Ahead of such regulatory change, the financial industry has taken a proactivestance towards mitigating counterparty risk. In its June letter to the FederalReserve, International Swaps and Derivatives Association (ISDA) defined threekey pillars for collateral management:
•To rapidly put in place robust Portfolio Reconciliation practices to detectsignificant trade population and valuation differences that could give rise todisputed collateral calls. The Fed 16 dealers have already made strides towardsreconciling portfolios on a daily basis.•To set out a Roadmap for Collateral Management focusing on independentamount risk issues; electronic communications that will standardize margin calls;portfolio reconciliation; CSA review; and the development of best practices forcollateral management. Many of these recommendations are on track forimplementation by year-end.•To develop a new Collateral Dispute Resolution process for the industry.Collateral Management Is Growing in Complexity as Well as ScaleWhile mitigating counterparty risk, several of the ISDA recommendations placegreater demands on collateral management systems.Daily portfolio reconciliations alone necessitate more robust collateralmanagement capabilities.Over time, the ability to sustain continued growth and understand counterpartyrisk on a global basis will require greater interoperability—significantly reducingthe ability of collateral systems to remain in silos. Ultimately, theseinterconnections will promote enterprise wide collateral management
Understanding OTC derivatives collateralCollateral for OTC derivatives is most commonly provided under an ISDA CreditSupport Annex (CSA) or similar arrangement. Where collateral has been posted bya counterparty under a collateral arrangement, the company will generally have theright if the counterparty defaults to liquidate such collateral and apply the proceedsto amounts payable by the failed counterparty under the derivative contract.Where the company has posted collateral and the failed counterparty is holding thecollateral, under the terms of the standard CSA, the counterparty must return theposted collateral if it defaults. If the collateral is not returned immediately, thecompany can set-off and withhold payment of any amounts payable by thecompany to the failed counterparty up to the amount of the collateral.Rights to liquidate or set-off against the collateral for derivative contracts areprotected by certain safe harbours under the US Bankruptcy Code and, forexample, will generally not be subject to automatic stay (such set-off rights will beespecially valuable if the company has a bilateral master netting agreement with thecounterparty as it would be able to set-off payments across all derivativesagreements with the counterparty).
Complications can arise, however, where a bankrupt counterparty holds collateralin excess of the companys obligations to it. In that case, a key question is whethersuch excess collateral remains property of the company or is part of the bankruptcyestate of the defaulting counterparty, in which case the company may only have anunsecured claim for the return of its collateral.One consideration is whether the company has granted re-hypothecation rights tothe counterparty (that is, the contractually negotiated right of a secured party undera CSA to sell, pledge, assign, invest, use, commingle or otherwise dispose of theposted collateral). If so, and if the counterparty has commingled the collateral withits own assets or transferred such collateral to a third party, the companys right toreturn will be subordinated to the third partys rights in the collateral and may betreated as an unsecured claim.Similar concerns can arise even if the company has not granted re-hypothecationrights, but the collateral has not been segregated and identified on the books of thecounterparty as collateral of the company posted for the benefit of the counterpartyas a secured party under the CSA.These issues may be addressed by changes to the structure of the collateralarrangement and improvements to the underlying collateral documentation.
CONCLUSIONSPresent efforts to move OTC derivatives to CCPs involve the following:i. A significant increase in overall collateral needs.ii. Some netted positions will need to be unbundled.iii. Duplicating risk management teams (at CCPs) which already exist at largebanks.iv. Public authorities will have to supervise more SIFIs, as CCPs will effectively beSIFIs. Furthermore, existing SIFIs (i.e., the large banks/dealer) will retain OTCderivative positions (nonstandard contracts, end-user exempted positions, foreignexchange contracts, ―netted‖ positions, etc).v. Regulatory arbitrage will increase—stemming from commodity caps in the U.S.,and from the ―push out‖ clause in the Dodd-Frank act.
vi. Re-hypothecation, or churning of collateral will decrease, as much of thecollateral at CCPs will be segregated at the client’s request or, in bankruptcyremote structures.vii. Derivative warehouses will be created that are more akin to ―concentrated risknodes‖ in global finance.viii. CCPs will be viewed under the payment/settlement rubric. They will thuslikely garner CB support and taxpayers could well be on the hook again to bail-outCCPs.These regulatory steps seem unlikely to adequately reduce systemic risks or excessrents from OTC derivatives, and the likelihood of future taxpayer bailouts appearsto remain significant. Taxing derivative payables would be a good alternative (or acomplementary solution while regulations are finalized). Explicitly recasting theOTC market infrastructure as a public utility might be another option, although thiswould need to be accompanied by stronger steps to eliminate cross-borderregulatory arbitrage.