OTC derivatives. A new market infrastructure is taking shape

Transcription

1 International topics Current Issues April 28, 2010 OTC derivatives A new market infrastructure is taking shape The global derivatives market has expanded enormously in recent years. Interest rate products (options and futures) have seen a particularly rapid increase over the past eight years. When volumes peaked in 2007, gross notional amounts outstanding of over-the-counter (OTC) derivatives amounted to USD 605 trillion. A number of structural deficiencies in the market infrastructure of OTC derivatives were revealed during the financial crisis. Inherent counterparty risk and its inadequate management, the intransparency and complexity concerning actual risk exposures, and the danger of contagion, i.e. the risk of a default of one firm spreading through the financial system, are the issues that were brought to the collective consciousness in conjunction with the systemic relevance of these markets. Author Michael Chlistalla michael.chlistalla@db.com Editor Bernhard Speyer Technical Assistant Sabine Kaiser Deutsche Bank Research Frankfurt am Main Germany Internet: marketing.dbr@db.com Fax: Managing Director Thomas Mayer Traditionally, counterparty risk used to be mitigated between trading partners by means of bilateral collateralisation. While in principle collateral can be an effective insurance against counterparty credit exposure, prevalent market practices such as asynchronous collateral cycles or incomprehensive collateral coverage resulted in uncollateralised exposures in the past. Central counterparty (CCP) clearing is the most immediate way of addressing these limitations. CCPs also reduce systemic risk, as they reduce the likelihood of contagion. Hence, regulators in the EU and the US are pushing for more OTC business to be cleared via CCPs. Reform of market infrastructure will alter competitive structures in the industry. Rules on the eligibility of contracts for central clearing, interoperability of CCPs and ownership of the market infrastructure are issues set to shape the industry, but are undetermined at the moment. Regulators should ensure that legislation drafted is commensurate with the risks faced. While transparency and standardisation are objectives worth of being promoted, the future of the industry will critically hinge not so much on market forces but on the outcome of the regulatory process. Regulation must strike an appropriate balance between greater stability and preserving the benefits of solid, yet dynamic derivatives markets.

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3 OTC derivatives Introduction The recent financial crisis, fuelled in particular by the 2008 collapse of Bear Stearns, the bankruptcy of Lehman Brothers, and the bailout of major derivatives trader American International Group (AIG), has led to ample discussions among regulators and policymakers in both Europe and the US about structural improvements to be made to the financial markets. Already today, it is foreseeable that efforts to improve the stability and resilience of the international financial system will cover a variety of aspects: first and foremost, the effectiveness of banks' own risk management processes and practices; so-called macro-prudential financial supervision that monitors systemic risk; reform of capital requirements, resulting in banks needing to hold more and higher-quality capital; revised liquidity regulations under an internationally co-ordinated approach; better market infrastructure that reduces interconnectedness between individual market participants; and last but not least, strong supervisory authorities that can monitor compliance, as well as identify and react in time to emerging risks. In terms of the structural deficiencies in financial market infrastructure, it can be stated that whilst over-the-counter (OTC) derivatives were not a central cause of the crisis, weaknesses in the design of derivatives markets became apparent. This market s complex and opaque nature and the corresponding inability of regulators and market participants to have a clear view of risk exposures held increased the systemic risk of contagion and exacerbated the crisis as some market participants built up excessive risk positions. Derivatives have a long-standing history as financial tools for risk insurance (hedging) and risk acquisition (speculation), thus providing important risk management and liquidity benefits to financial institutions as well as to non-financial corporations and other market participants. Past growth rates of these markets indicate the intensified desire of both real-economy and financial institutions to manage risks inherent to their industry or to manage financial risks stemming from changes in macroeconomic conditions. Regulators efforts to comprehensively reorganise derivatives markets threaten to hamper the viability and innovative powers of these segments. The apparent focus on Credit Default Swaps (CDSs), which had been singled out for blame for increasing systemic risk, is particularly unfortunate as this segment constitutes less than 10 percent of the overall OTC derivatives market, while other products (such as interest rate or currency swaps) that are by far more relevant in terms of volume proved robust during the crisis. In this study, we intend to shed light on the organisation, shortcomings and merits of derivative markets. This report provides a brief overview of the size, structure and scope of the USD 600 trillion OTC derivative markets, and also seeks to serve as a guide, explaining the two most immediate ways of mitigating counterparty risk: bilateral collateralisation and centralised clearing. An overview and discussion of the current regulatory initiatives in the US and the EU aimed at overhauling the financial markets and in particular the OTC derivatives markets complement this analysis. April 28,

4 Current Issues 1. Derivatives and their underlying assets Global derivatives market Notional amounts outstanding, USD bn, annual data, OTC vs. on exchange 800, , , , , , , , OTC On exchange On-exchange derivatives Gross notional amounts (USD bn), by segment, annual data Equity Index Options Currency Options Interest Rate Options Equity Index Futures Currency Futures Interest Rate Futures Other Equity FX Source: BIS OTC derivatives market 100,000 80,000 60,000 40,000 20,000 0 Source: BIS 2 Notional amounts outstanding, USD bn, annual data 600, , , , , ,000 0 Commodity CDS Interest Source: BIS 1 3 Compared to cash equity markets, derivative markets differ substantially in terms of global volumes, organisation and complexity of trading and post-trading. We therefore provide some information on the size of the market, the range of products available and the way they are traded. Derivatives may be distinguished according to the market in which they trade, the type of their underlying, or the contract type, i.e. the relationship between the underlying and the derivative product itself. Derivative contracts can either be traded in a public venue, i.e. on a (specialised derivatives) exchange, or off-exchange, i.e. directly and privately negotiated between two parties over-the-counter (OTC). Today, the OTC market dwarfs exchange trading as the bulk of contracts is traded OTC (roughly 90% of the market in terms of notional amounts outstanding as of December 2008, see chart 1). As illustrated in chart 1, the global derivatives market had expanded quickly over recent years, but contracted in 2008 for the first time since monitoring started in Chart 2 shows the development of the on-exchange part of the global derivatives market by traded instrument segment. Interest rate products (options and futures) have seen a particularly rapid increase over the past eight years. When volumes peaked in 2007, gross notional amounts of onexchange derivatives amounted to nearly USD 80 trillion. On the OTC side, notional amounts outstanding of OTC derivatives amounted to USD 605 trillion in 2007 (see chart 3). By comparison, worldwide annual GDP came to roughly USD 50 trillion in In terms of evaluating the risks associated with the OTC derivatives market, it is important to understand that the reference to gross notional amounts of USD 605 trillion as quoted by the Bank for International Settlements (BIS) is a misleading figure. A more meaningful risk indicator is the gross market value of global OTC derivatives, also reported by BIS, which is the total value of all derivative contracts globally if they had to be closed out and settled at market value on a specific date (see chart 4). As of June 2009, this amount was USD 22.5 trillion. Real risk exposure after use of netting as a means of reducing counterparty risk is reflected by gross credit exposure, also quoted by the BIS, which is just 15% of the gross market value. As of June 2009, this figure stood at USD 3.7 trillion (International Swaps and Derivatives Association ISDA, 2010). OTC derivatives markets are characterised by flexible and tailormade products, satisfying the demand for bespoke contracts customised to the specific risks that a user wants to hedge. Exchange-traded derivative contracts, on the other hand, are by definition standardised contracts. Whether a derivative contract is standardised or bespoke determines how the market has structured the delivery of trade and post-trade chain functions. An important feature of derivatives markets is that while exchange-traded derivatives leave a transparent trail in terms of positions, prices and exposures, OTC derivatives markets are largely unregulated with respect to the disclosure of information so that information available to market participants and supervisors is limited. The overall derivatives market is based on five major classes of underlying asset: interest rate derivatives, foreign exchange derivatives, credit derivatives, equity derivatives, and commodity derivatives. In conjunction with numerous variants of contract types, 4 April 28, 2010

5 OTC derivatives OTC gross market values USD bn, semi-annual data H1 05 H1 06 H1 07 H1 08 H1 09 FX Equity CDS Interest Commodity 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 Source: BIS Non-financial companies primarily use interest rate, currency, and commodity derivatives... while financial companies typically engage in all types of derivatives Derivative usage % of Fortune 500 companies, by risk type FX Interest rate Commodity Equity Credit Source: ISDA 5 these various underlying assets lead to a cornucopia of available product types. In the recent political debate on derivatives regulation, much attention has been focused on CDSs. However, a very large proportion of OTC derivatives had no involvement at all in the financial crisis. Interest rate derivatives and FX derivatives, which together account for some 80% of all OTC derivatives trades, were not found to be contributors to the financial crisis, and of the remaining 20%, equity derivatives played virtually no part and commodity derivatives only a small part in the crisis. Usage of OTC derivatives In the past, derivatives seem to have been used primarily by financial institutions. However, demand for derivatives exists in all industries: A recent ISDA survey reports that 94% of Fortune 500 firms are using derivatives to manage business and macroeconomic risks. Foreign exchange and interest rate derivatives are the instruments most heavily traded by these corporations. Breaking usage down into financial and non-financial companies shows that the latter typically use derivatives to help protect the company from unanticipated events such as adverse foreignexchange or interest-rate movements and unexpected increases in input costs 1, as evidenced by the widespread use of interest rate, currency, and commodity derivatives. For that reason, non-financials are by and large less involved in equity and credit derivatives. Financial companies (banks, insurers, and diversified financial firms) are generally engaged in all types of derivatives and make particular use of these instruments to mitigate interest-rate and exchange-rate fluctuations, industry-specific credit risk and equity price risk. Banks apart from their role as dealers (see section 3) use credit derivatives for managing their loan portfolios. Chart 5 provides an overview of the use of derivatives by type of risk covered (the numbers are % of Fortune 500 companies that use derivatives 2 ). Foreign exchange and interest rate risks clearly dominate. Amounts outstanding of OTC derivatives by counterparty Derivatives usage in the three largest market segments (interest rate swaps IRS, foreign exchange, and equity & commodity derivatives) varies as regards the composition of counterparties (see chart 6). Statistics from the BIS indicate that of the USD trillion market in single-currency interest rate derivatives, transactions of non-financial firms comprise only 9%, while dealer-to-dealer transactions comprise 34% and other financial institutions transactions 57% of the market. In foreign exchange (FX) derivatives, transactions of non-financial firms comprise 17% of the USD 48.7 trillion market, while 39% are dealer-to-dealer transactions and 44% are other financial institutions transactions. Of the USD 6.6 trillion market in equity-linked and commodity derivatives, transactions of non-financial firms comprise 10%, while dealer-to-dealer transactions amount to 40% and other financial institutions transactions to 50% (BIS, 2009). 1 2 Utilities and companies in basic materials, for instance, typically use commodity derivatives. The sample includes financial institutions and corporate users. April 28,

6 Current Issues OTC derivatives by counterparty Amounts outstanding (USD bn) 38, ,069 21,441 8, , % 80% 60% 40% 148,150 18,891 2,656 IRS FX Equity & Commodity 20% 0% Non-financial customers Other financial institutions Reporting dealers Sources: DB Research, BIS 6 2. Organisation of OTC markets Broker: An individual or firm that charges a fee or commission for executing buy and sell orders submitted by an investor. Dealer: An individual or firm willing to buy or sell securities for their own account. Broker-dealer: A person or firm in the business of buying and selling securities operating as both a broker and a dealer depending on the transaction. The organisation of OTC markets has ever and anon and in particular since the offset of the financial crisis been portrayed in the public debate as the weak link in financial markets. Given the extraordinary size of the OTC derivatives markets, the question arises how these are organised in terms of how contracts are concluded between market participants. OTC derivatives markets have traditionally been organised around one or more dealers who make a market by maintaining bid and offer quotes to market participants (Dodd, 2002). The trading process of negotiating by phone nowadays also enhanced through the use of electronic bulletin boards is referred to as bilateral trading because only the two market participants directly observe the quotes or execution. OTC markets have also adopted electronic brokering platforms (sometimes referred to as electronic brokering systems), which resemble electronic trading platforms used by exchanges as they create a multilateral trading environment. In an OTC market organised through an electronic brokering platform, the firm operating the platform acts only as a broker and does not take a position or act as a counterparty to any of the trades made through the system (Dodd, 2002). Lastly, composites of the traditional dealer and the electronic brokering platform have developed in which OTC derivatives dealers set up their own proprietary electronic trading platforms. In such one-way multilateral platforms 3, bids and offers are posted exclusively by the dealer who upon execution ultimately becomes the counterparty to every trade. Thus, OTC markets, which have been known as informally organised markets in the past, are in fact well-organised market places noticeably lacking regulatory oversight in comparison to an exchange (Dodd, 2002). Individuals or firms may act as either a broker or a dealer. While a broker merely mediates as an agent between a buyer and a seller, a dealer takes ownership of an asset as a principal, even if only for an instant, between a purchase from one party and a sale to another party. The dealer is thereby exposed to some risk, for which he is compensated by the spread between the price paid and the price 3 One way because only the dealer s quotes are observable; those of other market participants might at best be inferred from changes in the execution price. 6 April 28, 2010

7 OTC derivatives received. Dealers tend to be broker-dealers 4 and/or large global banking institutions. 3. Counterparty risk and limitations of bilateral collateralisation One of the most important purposes of the derivatives market is risk management, i.e. risk redistribution, mitigation, and acquisition or in other words, the process of identifying the desired and the actual level of risk and altering the latter to equal the former. End users, which can include financial institutions, have specific risk management concerns that can be mitigated ( hedged ), whereas other market participants do not necessarily aim to minimise risk but rather to benefit from the inherently stochastic nature of the market by taking speculative positions. They aim to profit from the very price change that hedgers are protecting themselves against. However, the financial crisis has brought to light many weaknesses in OTC derivative markets, such as their intransparency, inherent counterparty risks, or the danger of contagion, i.e. the risk of a default of one firm spreading through the financial system. To mitigate such risks, collateralisation and counterparty risk management are essential practices. This section explores the classic method for market participants to protect themselves against the risks inherent from trading derivative contracts, outlining also the limitations and deficiencies of this practice. Derivatives contracts bind counterparties together for the duration of the contract. The duration varies depending on product type and market segment, ranging from e.g. a few days sometimes in FX derivatives to several decades for certain interest rate derivative contracts. Throughout the life of the contract counterparties build up claims against each other as the rights and obligations contained in the contract evolve with the price of the underlying the contract is derived from. This gives rise to counterparty credit risk, i.e. the risk that the counterparty may not honour its obligations under the contract. It is difficult to calculate this counterparty risk in view of the opaque nature of OTC derivatives markets, in particular for parties outside a certain bilateral transaction and due to the high level of concentration in the market in terms of participants which leads to a lack of risk diversification possibilities. The market s opaqueness is also critical due to the fact that the price determined in the derivatives markets may be used to calculate the price of other instruments, which could spill over to further segments. In the public debate, the term bilateral clearing is frequently used to describe the bilateral collateralisation of uncleared OTC transactions. In the following, the more appropriate term bilateral collateralisation will be used. The underlying principle of bilateral collateralisation is that both parties will mark-to-market (MTM) contracts so as to monitor the evolution of their residual value. Should the MTM process show that one party has built up a claim on the counterparty, it is then entitled to ask its counterparty for collateral in order to mitigate the risk that the counterparty may not honour its obligation or may default during the lifetime of the contract. 4 A person or firm in the business of buying and selling securities operating as both a broker and a dealer depending on the transaction. April 28,

8 Current Issues Further issues relating to bilateral collateralisation raised by the COM: Bilateral collateralisation fundamentally relies on each party's internal approach to and method for assessing the current value of and risk associated with the constituent components of its OTC derivatives portfolio. Collateral is generally based on mark-tomarket values only. It does not incorporate the potential cost of replacing the contract in the market should the original counterparty default. The level of collateral that is effectively provided often also takes into account the perceived credit quality of the counterparty. The crisis has shown that the reliance on only one single source of credit rating may be detrimental to the bilateral collateral model (Paulson 2010). Bilateral collateralisation and in particular each institution s individual risk management approach is vulnerable to competing intra-institutional considerations, such as the aim to maximise commercial opportunities and associated profits. The crisis has highlighted the difficulty faced by institutions to uphold a conservative approach to risk in a competitive market environment. Under bilateral collateralisation, sovereigns, AAA insurers, corporates and large banks do not post or mark-to-market collateral. Those who do post collateral only meet the threshold as per the ISDA Credit Support Annex, which does not mandate a 100 percent coverage. Source: COM, Singh Cash is the dominant source of collateral, amounting to 84% of collateral received in 2008 and 83% of collateral delivered (ISDA 2009). 5 Cash is exchanged on a net basis, i.e. a single net cash value is calculated for the overall OTC derivative portfolio between the two counterparties in question. Each counterparty therefore benefits from cross-margining (i.e. compensation of claims built up in one derivative market segment by liabilities built up in another). Government securities are the second source of collateral (9% of collateral received and 15% of collateral delivered). Other sources include corporate bonds, letters of credit and commodities. Collateral is only an effective insurance against counterparty credit exposure if exposure is calculated frequently and collateral is effectively exchanged in a timely manner. This is not consistently the case, so bilateral collateralisation, while essential, may have a number of potential weaknesses: weekly and even monthly valuation and exchange of collateral continue to be market practice, although the collateral cycle should ideally mirror the (daily) valuation cycle. Collateral coverage is not comprehensive: while collateral now covers 66% of credit exposure overall, more than one-third remains uncollateralised. From an operational perspective, too, bilateral collateralisation is not ideal as it requires the management of numerous counterparty relationships. The European Commission (COM) has identified a number of further weaknesses of bilateral collateralisation (see box). 4. Central Counterparty Clearing One common practice to reduce counterparty risk in derivatives markets is trade compression, a method of multilateral consolidation independent of any central counterparty (CCP) where the number of redundant contracts is minimised. Here, existing trades are terminated and substituted by a far lower number of new replacement trades which have the same risk profile and cash flows as the initial portfolio, but with less capital exposure. This practice brings gross exposures closer to the net risk positions (see Weistroffer, 2009) and improves settlement efficiency. Moving from bilateral collateralisation to central clearing by using one or several central counterparties takes this principle one step further and is the most immediate way of addressing the limitations cited in the previous section, as CCPs will, for example, require collateral to be posted by all participants, without exception. CCP clearing may have significant benefits, but requires a certain number of market characteristics for it to work. This section briefly describes the concept of multilateral CCP clearing and its prerequisites, and addresses issues potentially arising in multiple CCP environments. We will subsequently elaborate on four selected aspects of centralised clearing: firstly, the benefits of CCP clearing for market participants and infrastructure providers; secondly, the implications for financial stability; thirdly, the optimal number of CCPs per market; and lastly, CCP ownership structure and supervision. 5 The ISDA Margin Survey tracks the gross amount of collateral, defined as the sum of all collateral delivered out and all collateral received in by survey respondents, and does not adjust for double counting of collateral assets. Double counting of collateral is discussed in Appendix 2 of ISDA (2009). 8 April 28, 2010

9 OTC derivatives Standardisation Transparency Fungibility Concept and prerequisites of CCP clearing When a CCP is involved in the post-trade processes, the single contract between two initial counterparties that characterises an OTC trade is executed and replaced by two new contracts between the CCP and each of the two contracting parties. This process is referred to as novation if an existing contract is terminated and replaced by two contracts with the CCP, or as open offer if a contract is concluded with the CCP immediately after the matching of trading details. The original buyer and seller are no longer counterparties to each other; instead, the CCP becomes the buyer to every seller and the seller to every buyer. This structure has three clear benefits: First, it improves the management of counterparty risk. Second, it allows the CCP to perform multilateral netting of exposures and payments. Third, it increases transparency by making information on market activity and exposures both prices and quantities available to regulators and the public (BIS, 2009). What is most important for a successful introduction of CCP clearing to a certain market is that the CCP must be able to mark positions and to manage counterparty risks. For this purpose, a number of prerequisites that have also been recognised as relevant by European policymakers 6 have been defined which must be met in order for CCP clearing to be used: Standardisation of trade flows throughout the trading and posttrading chain in order to allow a CCP to step in after a transaction has been concluded (electronic trade confirmation largely facilitates this process). Transparency of price discovery venues as to facilitate risk valuation in mark-to-market processes. CCPs rely on the price discovery process on liquid, transparent markets for the prices used to mark positions and to determine collateral; CCPs should therefore not only been seen as producers of transparency, but also as its consumers. 7 Fungibility in order to enable novation and netting. This requires minimum levels of industry-wide standardisation of the main legal parameters contained in contracts (varying according to segment) in order for OTC derivatives to be able to be transferred between one exchange or electronic trading system and another (COM, 2009a; CFTC, 2009). The concept of fungibility allows contracts traded at different locations with different parties to substitute for one another, provided that they have identical legal construct and contract specifications. 8 Netting through a CCP does have advantages as, in contrast to bilateral clearing / collateralisation, multilateral clearing (and netting) yields private and public benefits, for example, via robust and homogeneous margining procedures that guarantee that the collateral cycle is in sync with the valuation cycle. In many OTC derivative transactions today initial margin is negotiated between dealers and clients, and has commonly been zero in CDS trading. In Cf. COM (2009a). Cf. Pirrong (2009). Because of non-fungibility, market participants that wish to close a position can only do so by going back to the original counterparty (usually a dealer). This gives the dealer a certain amount of market and hence pricing power. Market participants could also achieve the same economic effect by entering into an opposite position with a different counterparty; while this would effectively eliminate the risk related to the instrument itself, it would not eliminate counterparty risk: if one of the counterparties defaulted, the hedge would be undone (COM, 2009a). April 28,

10 Current Issues a centrally cleared market, clearing houses and regulators will impose initial and variation margin requirements. 9 Clearing members derive economic benefits from the fact that contracts between different counterparties are made fungible so that they can be offset against each other, and from a reduced number of counterparties (ideally only one, the CCP) where they have to deposit collateral. Thus, central clearing reduces interconnectedness between counterparties. However, the fact that not everyone can easily become a member of a clearing house but that clearing member status is only granted to applicants that meet the necessary admission criteria restricts the potential multilateral netting benefits (notwithstanding the fact that such minimum standards can have a stabilising overall effect). Such minimum requirements may include, for instance, satisfying minimum capital requirements, being authorised by the home country banking supervisors or maintaining an adequately staffed and equipped back office. Multilateral netting is likely to be more difficult in a multiple-ccp environment (as opposed to a single-ccp environment) unless sufficient international coordination takes place. Difficulties mainly relate to two aspects: Issues arising between the CCPs: Generally, all CCPs are structured differently and their approach to risk management and thus the risk protection they offer will vary. CCPs typically operate in a similar, but not necessarily identical, manner when managing risk; primary risk protection is generally standard amongst CCPs (see section on CCP risk bearing). However, practical issues such as payment and collateral timings, legal arrangements, regulatory oversight, insolvency laws, and most notably the balance of risks intended to be covered by initial margin and those covered by the, often mutualised, post-default backing are often arranged differently in each CCP, so that the exact approach and the overall risk management framework is typically different for each CCP (European Association of Central Counterparty Clearing Houses EACH 2008). These risks must be managed effectively when setting up an interoperability arrangement between two (or more) CCPs. Issues arising between users and CCPs: Multiple clearing entities present a challenge for users because of the need to commit collateral to several guarantee funds for separate clearing houses as well as to meet the connectivity demands of each of them. We should point out that netting, in conjunction with CCP clearing, leads to a redistribution of wealth among a defaulter s creditors. This redistribution depends inter alia on the insolvency scheme in force and on the order of the claims and does not necessarily enhance welfare. 10 Moreover, by transferring counterparty risk to the CCP, the bank or broker is assuming a new type of risk: mutualisation risk. This refers to the possibility that in case of a default where the defaulting member s initial margin turns out to be insufficient, the 9 Initial margin is intended to cover potential future losses on open positions and is calculated by taking the worst probable one or two-day loss that the position could sustain. It can be paid in cash or collateral. Variation margin consists of funds to cover losses on open positions and is calculated by the CCP using recent market prices (Wendt, 2006). 10 This hypothesis is exemplified in Pirrong (2009). Under pro rata distribution of the defaulter s assets, netting effectively transfers wealth in a default from a defaulter s other creditors to its derivatives counterparties. 10 April 28, 2010

11 OTC derivatives clearing house is forced to draw on its other members default fund and in extremis to allocate contracts to its non-defaulting members. Risk mitigation and mutualisation of losses Positive effect on market liquidity Increase in operational efficiency Reduction of operational risk Improved transparency Benefits for market participants and infrastructure providers The benefits and advantages for users of introducing central counterparty clearing are straightforward given the above discussion of the limitations arising from bilateral collateralisation. Introducing CCPs would firstly allow risk mitigation, which has a fundamental qualitative difference to bilateral collateral provisioning. Risk mitigation is guaranteed by multilateral netting, by novation/open offer as well as by robust margining procedures and other risk management controls performed by the CCP. Secondly, the introduction of CCP clearing may have a positive effect on market liquidity: the usage of a CCP for OTC derivatives may allow a user (clearing member) to free capital for other purposes, as less collateral should be required, thanks to multilateral netting, payment netting and possible cross-margining arrangements. Instead of collateralising with each individual counterparty bilaterally, with a CCP as the central counterparty, each clearing member will ideally need to post collateral with the clearing house only. However, to what extent this advantage materialises will depend on ex ante conditions: against the background of current bilateral under-collateralisation and re-hypothecation (i.e. re-use) of collateral, some maintain that even more collateral may be required once a (mandatory) CCP starts to systematically and comprehensively call for collateral to be posted. A third benefit of CCP clearing is that its introduction may reduce disruptive information problems by mitigating uncertainty, may increase operational efficiency through centralisation and may allow for regulatory capital savings since the CCP is considered a zerorisk counterparty. Last, but not least, the CCP model, by its very nature, catalyses and enforces standardisation of processes and operations, resulting in significant workflow reforms that provide the opportunity for a substantial reduction of operational risk: while initially costly to set up, standardisation brings the opportunity to drive down the potential cost of errors made by the front office. 11 Benefits for financial stability Central counterparty clearing for derivatives may not only be favourable for market participants and infrastructure providers, but may also benefit financial stability in several ways: introducing CCPs would improve transparency by allowing for central collection of high-frequency, market-wide information on market activity, transaction prices and counterparty exposures. The centralisation of information in a CCP enables market participants, policymakers and researchers to be provided with the information necessary to better gauge developments in the positions of individual market participants in the different market segments (BIS, 2009). 11 According to Dhall (2009), front office operations (especially trade capture / booking) in OTC derivatives are highly error-prone. A large percentage of errors or breaks are due to improper trade data and detail capture. Reasons include the highly subjective nature of trades and the manual use of spreadsheets for booking trades. Standardisation is likely to reduce operational risk by substantially reducing the number of errors and thus the per-trade processing cost. Another industry-wide problem has been the low level of confirmation rates, which are at present near 60%. In contrast, currently operating CCPs provide T+0 confirmations with a success rate of 90%, which is further strong evidence of the benefits stemming from the introduction of CCP clearing. April 28,

12 Current Issues Level playing field CCPs lines of defence provide more financial resources to cover losses from default Reduction of systemic risk from LCFIs The introduction of central clearing would create a more level playing field as identical, non-discriminatory admission to a CCP would guarantee small banks the same opportunities for access as large banks. In that sense, a centrally cleared world may lead to an improved competitive environment for smaller institutions. Equities CCPs in Europe and the US have typically installed several lines of defence to protect themselves against the negative consequences of a possible default of a clearing member. These include membership criteria, daily marking-to-market, the calculation of initial margin to cover potential future losses in normal market conditions, and in extremis some form of post-default backing to cover exceptional market events. CCP clearing would entail that through participants margins and default fund contributions more financial resources were available to cover potential losses in the event of a participant s default. Margins are called by the CCP and posted by the participants to cover the losses incurred should a participant default. If the margin deposited by the defaulting clearing member appears to be insufficient to cover the loss of the closing out of its positions under normal market circumstances, the CCP can use the contribution to the clearing fund of this defaulting clearing member to cover the losses in excess of these margins. If this contribution appears to be insufficient, the CCP may use the contributions from the non-defaulting clearing members. The final line of defence comprises other financial resources, like the own funds of the CCP or the CCP s contingent claims on parent organisations or insurers (Wendt, 2006, Bliss/Papathanassiou, 2006). A dichotomous effect may be anticipated in terms of procyclicality: on the one hand, more netting should result in less use of collateral, which would tend to reduce procyclicality. A CCP may involve fewer downgrade-induced jumps in collateral, as it would require collateral to be posted by all counterparties, including those that are AAArated; this feature may in turn reduce pressure on markets for the securities used as collateral. On the other hand, though, because of their higher frequency in a CCP, centralised and uniform margin calls (compared with decentralised and less uniform collateral practices in bilateral OTC markets) could aggravate procyclicality. By lowering counterparty risk concerns in periods of market stress, a CCP might help ensure that trading continues in situations in which bilateral OTC markets might seize up. In addition, introducing CCPs may reduce systemic risk from Large and Complex Financial Institutions (LCFI) by partially transferring the risk to an entity, the CCP, that is better able to bear it and tends to be more capable of collateralising it and which is from a regulatory aspect easier to monitor and to supervise. In the course of the financial crisis market participants displayed an aversion to dealing with some LCFIs due to their counterparty risk. LCFIs clients feared that their high-grade collateral might get stuck in the LCFIs, while LCFIs themselves locked up collateral in their balance sheets. 12 This had negative implications for global liquidity. With the existence of derivatives 12 Goldman Sachs, for instance, argued in terms of hoarding good quality collateral: Our most important liquidity policy is to pre-fund what we estimate will be our likely cash needs during a liquidity crisis and hold such excess liquidity in the form of unencumbered, highly liquid securities that may be sold or pledged to provide same-day liquidity. Across the entire market, these liquidity buffers amounted to almost USD 5 trillion of risk capital and balance sheet capacity; considering the velocity of collateral (which is greater than 1), the adverse impact on global liquidity was even greater than USD 5 trillion (Singh, 2009). 12 April 28, 2010

13 OTC derivatives CCPs, it is likely that systemic risk will be spread to about 10 to15 entities (LCFIs plus CCPs) instead of being borne by the present 6 to 10 LCFIs that currently dominate the OTC derivatives market (IMF, 2009). One single CCP per derivative class seems to be optimal but regulators favour competition Reasons for little CCP usage Considering the positive effects from a central clearing infrastructure, the question arises why CCP usage has not hitherto become more widespread in OTC derivatives markets. Most likely, insufficient economic incentives are the main motive: existing rules allowing firms to treat derivatives processed through a clearing house as zero risk did not apparently provide enough motivation for the market to introduce CCPs. Incomprehensive bilateral collateralisation and the possibility to re-hypothecate collateral for other purposes instead of dedicating and segregating it explicitly to the purpose for which it was received were apparently stronger incentives. Possible further reasons include: Regulatory requirements for CCPs (e.g. in France and Germany: the obligation for CCPs to have banking licences; in Italy: the constraint that prohibits participants in Italian settlement systems from settling trades on behalf of clearing houses). Higher operational costs that arise from putting in place a margining and collateral management process. Optimal number of CCPs per market An economically interesting question is the discussion of the optimal number of CCPs per market or market segment: should clearing be channelled via a single CCP or through multiple CCPs? In their academic research, Duffie and Zhu (2009) find that introducing a CCP for a particular asset class, such as credit derivatives, improves the efficiency of counterparty risk mitigation and collateral demands, relative to bilateral netting between pairs of dealers. They show that adding a second CCP for one class of derivatives such as CDSs can reduce netting efficiency and thereby lead to an increase in collateral demands and in average exposure to counterparty default. They therefore conclude that (from a purely efficiency-based view) whenever it is efficient to introduce a CCP for a certain class of derivatives, it cannot be efficient to introduce more than one CCP for the same class of derivatives. From the perspective of market participants, a single CCP would make economic sense due to improved efficiency, firstly in terms of reaping economies of scale and secondly in terms of risk mitigation and collateral demands (collateral would need to be posted only with that specific clearing house). However, the common problem of monopolistic markets in terms of dynamic gains (innovation) arises. From the perspective of regulators and supervisors, the efficiency argument in favour of a centralised CCP clearing market structure has to be aligned with the stability argument which favours a more competitive, diverse and reliable structure. In times of crisis, a single CCP would be the single point of failure, putting all market participants at risk, which must be avoided from a regulatory and supervisory perspective. If a CCP is successful in clearing a large quantity of derivatives trades, the CCP is itself a systemically important financial institution. The failure of a CCP could suddenly expose many major market participants to losses (Federal Reserve Bank, 2010). April 28,

14 Current Issues CCP supervision and regulators' access to trade data still undetermined In order to effectively avoid a race to the bottom in terms of risk management, the European Commission intends to include in its legislative proposals rules to ensure that CCPs do not employ low risk management standards (COM, 2009b).This will probably entail that ESMA 13 will be mandated to develop technical standards and guidelines. Market participants will benefit from high standards to the extent that compliance with them should result in the lowest possible regulatory capital charge for counterparty credit risk of centrally cleared contracts. In general, CCPs should not compete on price (i.e. the amount of margin required for a particular position), but rather on the quality of the service offered. An EU directive could ensure a level playing field for all EU CCPs. Authorisation and supervision to a specified level will give market participants worldwide the confidence that such CCPs are robust and well run. Public discussion, though, does not currently seem to be focused on the number of CCPs per market segment, but rather on the global number of CCPs and in particular on the jurisdiction and supervision under which they should fall. This latter question is of special importance in the debate on which party might act as a possible lender of last resort in case of a CCP s failure (nature of public support and possible access to central bank credit facilities; see next paragraph). Access to market-wide OTC derivative contract information held by CCPs is another issue still undetermined. Information on OTC trades may be needed by different public and private entities, depending on their nature and mandate; it may be recorded by CCPs or specialised trade repositories (TRs). The current debate focuses on the granularity of information (aggregated vs. trade-level), to whom it should be provided (regulators, market participants, and/or the general public) and on whether (foreign) TRs should be mandated to provide trade data to any regulator that has requested it. CCP loss bearing and access to facilities of last resort The public discussion has also focused on how and by whom potential losses of a CCP should be borne in the case of a defaulting member, if losses exceed collateral. A clear procedure is needed for defining a default event, for valuation and for margining. In order to avoid cross-border distortions, uniform application of standards is needed across all CCPs handling derivatives. For this purpose, a working group was set up in July 2009 to review the application of the 2004 CPSS-IOSCO risk management recommendations for central counterparties in order to reflect future clearing of OTC derivatives. Proposals are expected for the first half of 2010, addressing in particular five issues, namely: conduct of business and governance, risk standards, legal protection to collateral and positions, authorisation and recognition of third-country CCPs. One important but as yet unresolved question is whether CCPs should have access to central bank credit facilities and, if so, when. Keeping a CCP liquid in the face of the failure of one or more participants requires that liquidity be available somewhere. Currently, however, access to central bank liquidity varies widely across jurisdictions. The Association Française des marchés financiers (AMAFI) urges that each CCP should have intraday/overnight access to central bank money in the currency it operates in to be in a position to rapidly and securely obtain the necessary liquidity for it to limit systemic risk (AMAFI, 2009). 13 ESMA: European Securities Markets Authority. 14 April 28, 2010

15 OTC derivatives Interoperability of CCPs is currently a major unresolved issue Interoperability of multiple CCPs The European Code of Conduct for Clearing and Settlement, which is a voluntary self-commitment by the undersigning organisations, comprises, inter alia, the provision of clearing and CCP services by clearing houses, CCPs and potentially also central securities depositories (CSDs). All signatories of the Code must adhere to the principle of interoperability, i.e. the creation of links between CCPs to facilitate cross-border clearing and to give traders a choice over where to send their deals for clearing, rather than being reliant upon a single monopoly clearer. 14 The Code specifically states that CCPs should be able to access other CCPs (see FESE, EACH & ECSDA, 2006). Pursuant to the Code of Conduct, there are three types of access and interoperability between CCPs: 1. Standard access: one CCP becomes a normal participant (member) in another CCP. This means that the market infrastructure gaining access assumes all rights and obligations associated with regular participation. However, this may be inconsistent with the subordinate CCP s status as a CCP with the question arising whether it is fully collateralised for the purposes of its users regulators for capital requirements calculation. 2. Data feed access: a CCP accesses a continuous flow of data from another CCP and/or trading venue that is necessary to perform the function of a CCP in the market of the other CCP and/or trading venue in question. 3. Interoperability: two or more CCPs enter into an arrangement with one another on an equal basis (peer-to-peer relationship) which involves cross-system execution of transfer orders. This implies advanced forms of relationships where a CCP does not generally connect to existing standard service offerings of the other CCP but where they agree to establish mutual solutions. Here, the problem lies in the asymmetry in inter-ccp collateralisation; moreover, there are no internationally agreed standards for inter-ccp risk management. A number of issues unresolved up to now are currently preventing access and interoperability between CCPs: in the wake of the financial crisis, European regulators are concerned that the creation of these links could be the source of another systemic crisis. The worry is that the weakest link in the chain could bring others down if it were involved in a default and was insufficiently capitalised to meet margin calls (contagion risk). And even if covered by collateral, inter-ccp exposures could give rise to liquidity risk, i.e. the risk that a CCP cannot find the necessary liquidity to cover the collateral call. Attempting to link together CCPs has proved complex enough in the case of cash equities, and interoperability for derivatives would exacerbate the difficulties. 15 Besides, while the protection of financial 14 MiFID already gives some access rights in the post-trade area to regulated markets and to investment firms, and this Code is not intended to contradict any of those rights. 15 In October 2009, efforts to promote competition between clearing houses in Europe were stalled by regulators concerned by the risks that such an arrangement might pose to the wider financial system: The UK s FSA and the Dutch regulator AFM had blocked the plans of a three-way link between LCH.Clearnet, EMCF, and SIX x-clear in light of concerns that such a link might cause excessive systemic risk. Concerns were prompted by ambiguities about how clearing houses handle margin and perform risk management between each other in the event that one clearer fails. April 28,