Central Counterparties. Mandatory Clearing and Bilateral. Margin Requirements for OTC Derivatives. Jon Gregory

Transcription

1 Central Counterparties Mandatory Clearing and Bilateral Margin Requirements for OTC Derivatives Jon Gregory WlLEY

2 Contents Acknowledgements PART I: BACKGROUND 1 Introduction 1.1 The crisis 1.2 The move towards central Clearing 1.3 WhatisaCCP? 1.4 Initial margins 1.5 Possible drawbacks 1.6 Clearing in context 2 Exchanges, OTC Derivatives, DPCs and SPVs 2.1 Exchanges What is an exchange? The need for Clearing Direct Clearing Clearing rings Complete Clearing 2.2 OTC derivatives OTC vs. exchange-traded Market development OTC derivatives and Clearing 2.3 Counterparty risk mitigation in OTC markets Systemic risk Special purpose vehicles Derivatives product companies Monolines and CDPCs Lessons for central Clearing Clearing in OTC derivatives markets 2.4 Summary

3 viii Contents 3 Basic Principles of Central Clearing What is Clearing? Functions of a CCP Financial markets topology Novation Multilateral offset Margining Auctions Loss mutualisation Basic questions What can be cleared? Who can clear? How many OTC CCPs will there be? Utilities or profit-making organisations? Can CCPs fail? The impact of central Clearing General points Comparing OTC and centrally cleared markets Advantages of CCPs Disadvantages of CCPs Impact of central Clearing 38 4 The Global Financial Crisis and the Clearing of OTC Derivatives The global financial crisis Build-up Impact of the GFC CCPs in the GFC LCH.Clearnet and SwapClear Lehman and other CCPs Responses Objections Regulatory changes Basel III Dodd-Frank EMIR Differences between the US and Europe Bilateral margin requirements Exemptions Regulation of CCPS Problems with mandates Oversight CCPs and liquidity support 55 PART II: COUNTERPARTY RISK, NETTING AND MARGIN 57 5 Netting Bilateral netting Origins of netting 59

4 Contents ix Payment netting and CLS Close out netting The ISD A Master Agreement The impact of netting Netting impact outside OTC derivatives markets Multilateral netting The classic bilateral problem Aim of multilateral netting Trade compression Trade compression and standardisation Central Clearing Multilateral netting increasing exposure 71 6 Margining Basics of margin Rationale Title transfer and security interest Simple example The margin period of risk Haircuts Margin and funding Fundingeosts Reuse and rehypothecation Segregation Margin transformation Margin in bilateral OTC derivatives markets The credit support annex (CSA) Types of CSA Thresholds and initial margins Disputes Standard CSA Margin practices in bilateral OTC markets The risks of margining Margin impact outside OTC derivatives markets Operational risk Liquidity risk Funding liquidity risk Segregation risk Regulatory margin requirements Background General requirements Threshold Segregation and rehypothecation Initial margin methodologies Non-netting across asset class Haircuts Criticisms 102

5 x Contents 7 Counterparty Risk in OTC Derivatives Introduction Background Origins Settlement and pre-settlement risk Exposure Definition Mark-to-market and replacement cost Non-margined exposure Margined exposure Valuation adjustments CVA Impact of margin on CVA DVAandFVA Wrong-way risk The balance between counterparty risk and funding 118 Appendix 7A: Simple formula for the benefit of a margin agreement 119 PART III: STRUCTURE AND MECHANICS OF CLEARING The Basics of CCP Operation CCP setup CCPownership Pees What needs to be cleared? Important OTC derivative CCPs CCP operation CCP members and non-members Process of Clearing Compression Requirements for products to be cleared CCP risk management Overview Membership requirements Margining Margin interest rates Default management Declaring a default Close out process Auction Client positions Loss allocation Wrong-way risk CCP linkage Interoperability Participant and peer-to-peer models Mutual offset Cross-margining 146

6 Contents xi 9 Margin and Default Fund Methodologies Variation margin Valuation Frequency of margin calls Convexity and price alignment interest Variation margin and liquidity risk Initial margin Close out period Coverage Linkage to credit quality Haircuts and non-cash margins The SPAN methodology VAR and historical Simulation Value-at-risk and expected shortfall Historical Simulation Look-back periods Relative and absolute scenarios Procyclicality Initial margins for OTC derivatives Requirements for initial margin approach OTC CCP initial margin approaches Competition Computation considerations Standard initial margin model (SIMM) Cross-margining Rationale Cross-margining within a CCP Exchange-traded and OTC products Cross-margining between CCPs Methodologies for cross-margining Default fands Coverage of initial margin Role of the default fund Default fund vs. initial margin Size of the default fand Splitting default funds The Loss Waterfall and Loss Allocation Methods Potential CCP loss events Review of the loss waterfall Clearing member default losses Non-default related losses Analysis of CCP loss structure Second loss exposure The prisoner's dilemma Unlimited default fand contributions Default fand tranches 186

7 xii Contents 10.3 Other loss allocation methods Variation margin gains haircutting Partial tear-up and forced allocation Complete tear-up Other methods Impact on dient trades Methods used in practice Capital charges for CCP exposures Qualifying CCPs Trade and default fund related exposures Capital requirements for trade exposures Capital requirements for default fund exposures Method 1 (interim rules) Method 2 (interim rules) Final rules Example and discussion Client Clearing and bilateral aspects 201 Appendix 10A: Technical details on the interim and final rules Client Clearing, Segregation and Portability Operational aspects General setup Principal-to-principal model Agency model Margin requirements between dient and CCP Client point of view Clearing member point of view Portability Segregation, rehypothecation and margin offset The need for segregation The difference between Variation and initial margins Net and gross margin Net margin and portability Methods of segregation Omnibus segregation Individually segregated accounts LSOC Example The liquidity impact of segregation Regulatory requirements CPSS-IOSCO Dodd-Frank/CFTC EMIR Basel III and capital implications 229

8 Contents xiii PART IV: ANALYSIS OF THE IMPACT AND RISKS OF CENTRAL CLEARING Analysis of the Impact of Clearing and Margining The Clearing landscape Bilateral vs. central Clearing How much is currently cleared? What should be cleared? The number of CCPs Choosing a CCP Benefits and drawbacks of OTC Clearing Advantages Disadvantages Homogenisation Moral hazard and informational asymmetry Side effects Futurisation Regulatoiy arbitrage Netting optimisation Re-leveraging Pricing behaviour Is there a better idea? The Cost and Impact of Clearing and Margining Overview Strengths and weaknesses of margin Variation margin Initial margin Examples American International Group (AIG) The BP Deepwater Horizon oil spill Ashanti The cost of margining Margin and funding How expensive? Variation margin Initial margin Converting counterparty risk to liquidity risk Manifestation of funding liquidity risks Implications Risks Caused by CCPs Overview General risks created by CCPs Risks for Clearing members Risks for non-clearing members Historical CCP failures and near misses New York Gold Exchange Bank (1869) 267

9 xiv Contents Caisse de Liquidation (1974) COMEX (1980) Commodity Clearing House (1983) Hong Kong Futures Exchange and 1987 crash BM&FBOVESPA (1999) Lessons from past CCP failures Important considerations Hindsight bias Race to the bottom? Distributive effects and the big picture Mutualisation and CCPs as CDOs The need for margin The impact of mandatory Clearing Transparency Interconnectedness Risks faced by CCPS Default risk Non-default loss events Model risk Liquidity risk Operational and legal risk Other risks Keeping CCPs safe Will they be allowed to fail? Governance Disclosure Insurance schemes The Future Impact on Financial Markets Regulatory change The impact Goodorbad? 285 Glossary 287 References 293 Index 299