Collateralized banking
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- Prudence Mitchell
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1 Collateralized banking Change of financial networks through central clearing and collateralized banking Stanford University, September 2014 d-fine All rights reserved 0
2 d-fine GmbH» Independent European consulting firm quantification and modeling risk management finance and reporting IT integration» Over 500 professional consultants 85% physicists or mathematicians 65% PhD degrees» Offices Frankfurt London Hong Kong Zurich Vienna Munich» Extensive financial industry and implementation know-how d-fine All rights reserved 1
3 Content A. Clearing obligation for derivatives 3 B. Central clearing C. Criticism on central clearing 9 D. Variety of open problems for research and analyses 11 d-fine All rights reserved 2
4 A. Clearing obligation for derivatives d-fine All rights reserved 3
5 A. Clearing obligation for derivatives Comprehensive regulation of financial markets as a response to the financial crisis 2007»Dodd Frank Wall Street Reform and Consumer Protection Act (dodd-frank)»european Market Infrastructure Regulation (EMIR) Clearing obligation for standard and OTC derivatives»through Central Counterparties (CCP)»Bilateral»Credit Value Adjustment (CVA) charge Securitization of derivative trades by eligible assets (collateral)»haircuts are applied based on the credit worthiness of the issuer assets liabilities Transparency of derivative transactions»trade Repositories derivatives Categories of a financial portfolio d-fine All rights reserved 4
6 A. Clearing obligation for derivatives Comprehensive regulation of financial markets as a response to the financial crisis 2007»Dodd Frank Wall Street Reform and Consumer Protection Act (dodd-frank)»european Market Infrastructure Regulation (EMIR) Clearing obligation for standard and OTC derivatives»through Central Counterparties (CCP)»Bilateral»Credit Value Adjustment (CVA) charge assets liabilities Securitization of derivative trades by eligible assets (collateral)»haircuts are applied based on the credit worthiness of the issuer Transparency of derivative transactions»trade Repositories OTC derivatives Standardized Categories of a financial portfolio d-fine All rights reserved 5
7 A. Clearing obligation for derivatives Comprehensive regulation of financial markets as a response to the financial crisis 2007»Dodd Frank Wall Street Reform and Consumer Protection Act (dodd-frank)»european Market Infrastructure Regulation (EMIR) Clearing obligation for standard and OTC derivatives»through Central Counterparties (CCP)»Bilateral»Credit Value Adjustment (CVA) charge assets Collateral eligible liabilities Securitization of derivative trades by eligible assets (collateral)»haircuts are applied based on the credit worthiness of the issuer Noneligible Transparency of derivative transactions»trade Repositories OTC derivatives Standardized Categories of a financial portfolio d-fine All rights reserved 6
8 B. Central clearing Network structure Netting Collateralization d-fine All rights reserved 7
9 B. Central clearing changes the network structure Central clearing changes the network structure for derivative trading»from bilaterally-connected to centrally-cleared»introduction of new financial institutions central counterparties (CCP) A 0 CCP B A DCM 0 C GCM B Client d-fine All rights reserved 8
10 B. Central clearing changes the network structure Central clearing changes the network structure for derivative trading»from bilaterally-connected to centrally-cleared»introduction of new financial institutions central counterparties (CCP) Adjacency matrix d-fine All rights reserved 9
11 B. Central clearing changes the network structure Central clearing changes the network structure for derivative trading»from bilaterally-connected to centrally-cleared»introduction of new financial institutions central counterparties (CCP) Adjacency matrix Arguments: -Reduction of interconnectedness -Centralization of information d-fine All rights reserved 10
12 B. Central clearing allows netting Central clearing allows CCPs to net opposing positions»offset of opposing positions A 0 C $100 B $100 Arguments: Reduction of credit exposure d-fine All rights reserved 11
13 PV B. Central clearing requires collateralization Variation Margin»Compensations of value changes»intraday mark-to-market valuation»margin calls are due within few hours»payable in cash only Underlying price Derivative price A sell 0 buy C Initial Margin»Coverage of CCP s risk exposure»market sensitive risk measure»e.g. VaR at 99% confidence»margin calls are due daily»payable with eligible collateral»no proprietary capital trade day t 0 Liquidation Period t 0 + n t A sell 0 buy C d-fine All rights reserved 12
14 B. Central clearing requires collateralization Default / Social Fund contribution»mutual coverage of largest single risk exposure in extreme market situations»estimated by stress scenario simulation»contribution are due quarterly»payable with eligible collateral»proprietary capital A 0 Default Fund C Risk sensitivity 3 2 Predictability 1 Frequency VM 0 IM DF Amount Coll. quality Arguments: Reduction of credit losses d-fine All rights reserved 13
15 B. Central clearing enforces immediate liquidation In case a clearing member defaults, the open positions of the CCP must be closed in a few days.»closing usually means hedging and auctioning»liquidation periods are 2-4 days»losses are covered by the Default Waterfall IM Collateral of Member DF Contribution of Member Default Fund Assessments of Members Remaining Capital of CCP Default Waterfall Arguments: CCP is extremely stable because it has no open positions d-fine All rights reserved 14
16 C. Criticism on central clearing d-fine All rights reserved 15
17 C. Criticism on central clearing Most critic are based on the fact that all arguments hold true on a micro-prudential perspective but may fail on a system wide (macro-prudential) analysis. Interconnectedness in centralized networks:»members are still connected trough»non-derivative market»collateral and Security lending»default fund contribution assets Collateral eligible liabilities Transparency/Complexity:»Multiple CCPs»Multiple clearing entities within one CCP»CCPs default management method»separation of asset classes»client protection rule Noneligible OTC Standardized derivatives Financial portfolio of a bank or company More complex, indirect structures d-fine All rights reserved 16
18 C. Criticism on central clearing Most critic are based on the fact that all arguments hold true on a micro-prudential perspective but may fail on a system wide (macro-prudential) analysis. Credit exposure after netting:»ccps only redistributes credit exposure from cleared to non-cleared/non-collateralized markets»at default, the priority is set on cleared derivatives (prioritization)»wrong-way risks A C A $500 0 $1000 C $500 B $1000 B $ assets 750 liabilities B defaults => 1500 / 1750 = 85% 1000 assets 750 liabilities B defaults => 1000 / 1250 = 80% Redistribution/prioritization of credit risk d-fine All rights reserved 17
19 C. Criticism on central clearing Most critic are based on the fact that all arguments hold true on a micro-prudential perspective but may fail on a system wide (macro-prudential) analysis. Credit losses with collateralization:»trend amplification due to VM»Immediate realization of mark-to-market losses»procyclicality of IM»Add. margin calls in stressed market situations»feedback in case of a default»immediate liquidation of derivatives and collateral by CCP Transformation of credit risk into liquidity risk -Procyclicality -Feedback effects d-fine All rights reserved 18
20 C. Criticism on central clearing Most critic are based on the fact that all arguments hold true on a micro-prudential perspective but may fail on a system wide (macro-prudential) analysis. Incentives of a CCP Unsufficient information Costs Unclear whether systemic risk is reduced or increased by clearing obligation d-fine All rights reserved 19
21 C. Variety of open problems for research and analyses d-fine All rights reserved 20
22 risk factor value C. Variety of open problems for research and analyses Optimal use of collateral in financial institutions.»collateral management, Fund Transfer Pricing (FTP)»New pricing of derivatives Risk measurement at CCPs»Margin methods that balance risk sensitivity and procyclicality»method selection, Parameter estimation»design of stress scenarios»risk identification of member portfolios»approximation of feedback effects and liquidation risk Systemic risk»network models that include the centrally-cleared derivative market and the non-derivative market»effect of clearing topology σ multiplier relative shift absolute shift»splitting of portfolios»effect of immediate loss realization d-fine All rights reserved 21
23 References»G20/Pittsburgh 2009, CPSS/IOSCO, Committee on the Global Financial System»Pirrong C, A bill of goods: central counterparties and systemic risk, Journal of Financial Market Infrastructures 2(4), 55 85, 2014»Duffie D, and Zhu H, Does a central clearing counterparty reduce counterparty risk? Working Paper, Stanford University Graduate School of Business, 2011»Galbiati M and Soramäki K, Central Counterparties and the topology of clearing networks, Working Paper No. 480, Bank of England, 2013»Eurex Clearing, Risk Management, »Murphy D, Vasios M and Vause N, An investigation into the procyclicality of risk-based initial margin models, Financial Stability Paper No. 29, Bank of England, 2014 d-fine All rights reserved 22
24 Contact Dr. Stephan Ludwig Manager Mobile d-fine Frankfurt München Zürich Wien London Hong Kong Head Office d-fine GmbH Opernplatz Frankfurt am Main Germany T: +49 (0) F: +49 (0) d-fine All rights reserved 23
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26 C. Variety of open problems for research and analyses d-fine All rights reserved 25
27 Competence Centers Strategy & Governance Market Risk Credit Risk Liquidity Risk Operational Risk Energy & Commodity Risk Economic Capital Asset Liability Management & Treasury Financial Engineering Market Data Accounting Compliance Corporate Finance Corporate Treasury Repo & Securities Lending Asset Management Solutions Market Infrastructure, Clearing & Settlement Trading Systems Risk Management Systems Advanced IT Solutions d-fine All rights reserved 26
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