OTC derivatives are sighted by many as a primary player in the current credit crisis. Unlike listed derivatives that are backed by the credit worthiness of the clearing house, these bilateral contracts between counterparties have been a subject of debate for many years. Regulators argue the lack of transparency associated with these instruments makes it difficult to assess the systemic risk posed by them.
When the market for OTC derivatives was booming in 2007, there were few takers for what regulators, economists or risk managers had to say. But having witnessed one of the biggest risk management failures of our times, the financial industry’s focus has shifted dramatically to systemic risk management, regulatory oversight and sustainable exposures.
Why regulate OTC derivatives?
We agree with regulators that lack of transparency with OTC derivatives poses serious risk to the entire economy - a prime case in point being Lehman Brothers. Following the Lehman bankruptcy, close to US$400bn worth of credit default swaps (CDS) were presented for settlement. But once offsetting bilateral trades were netted, only US$6bn changed hand! These offsetting trades were invisible to the outside world. That's how 'connected' large financial firms are to each other. One shake, and a huge ripple effect is unleashed on the entire system. Another example is AIG. Without regulatory oversight, AIG accumulated a large exposure to OTC derivatives. It kept selling credit derivatives without setting aside commensurate capital, taking advantage of its AAA credit rating. Forget the systemic risk posed by such transactions, AIG discounted the impact of these uncovered trades on its own balance sheet (and had to pay for it!).
Besides credit and systemic risk, OTC derivatives present another concern for regulators. They believe valuation of these instruments - especially credit derivatives - is tricky. Each broker-dealer has its own proprietary valuation models. To some extent this is fair, given the subjective nature of these instruments. But with no active marketplace or exchange, traders find it difficult to get market data for valuation of similar contracts.
Centralized clearing of OTC derivatives
With the bankruptcies of Lehman and Bear Sterns behind them, and after injecting close to US$ 2.5 trillion as bailouts in the system, regulators and Congress are pushing for stringent rules and guidelines in the OTC derivatives market. Both SEC and CFTC have recently testified before Congress on regulation in OTC markets and have suggested centralized clearing for OTC derivatives. This is not a new idea - many private players offer centralized clearing of OTC derivatives today. But none of these ‘clearing houses’ are regulated the way exchanges are regulated. Notable examples are ICE Trust, CME, NYSE and Euronext (Bclear).
Congress is yet to finalize the eventual mechanism for centralized clearing of OTC derivatives. However, the three probable models are as follows:
- Trade Information Warehouse (TIW) e.g. DTCC Trade Information Warehouse
Each trade involving OTC derivatives is reported to a central TIW or Trade Information Warehouse. This will assist in managing systemic risk as regulators can identify concentration with respect to instruments, industry, individual firms and so on.
DTCC is pushing hard to get approval from Congress that will establish its trade repository as the single, nationwide TIW. Its Chairman & CEO recently spoke of the proposal at an event of United States Chamber of Commerce.
- Centralized Clearing Party (CCP)
Two parties agree on a trade and then approach a centralized clearing party (CCP) for clearing the opposite positions of each trade. This ensures the freedom of customization associated with OTC derivatives is not compromised and yet credit risk is mitigated. In this model:
- The CCP in turn reports all trades to a TIW
- Each counterparty posts requisite margin with the CCP
- The CCP performs mark-to-market activities and makes margin calls
- Exchange based model
In this model, OTC derivatives are standardized to trade on an exchange. As the case with listed derivatives, the exchange will promote liquidity of the instruments. In fact, this model effectively erases the distinction between OTC and listed derivatives.
As an example of how this would work, consider a customized CDS with a notional value of US$10M @ 200 bp (a non-standard rate). To ‘standardize’ this contract, it would be broken into two contracts; one with a notional value of US$ 7.5M @ 100bp (standard rate) and the second with a notional value of USD 2.5M @ 500bp (standard rate).
Potential issues with this approach:
- While simpler to achieve with vanilla derivatives, standardization of exotic derivatives and swaps will be difficult.
- This is an expensive approach for infrequently traded instruments.
Of all these models, we believe the CCP model will find most favor with market participants. Mainly because it would ensure credit and systemic risk mitigation while maintaining the USP of OTC derivatives – namely, their flexibility and customizability. The TIW model will help keep a tab on large players accumulating unsustainable exposure levels but does little to mitigate credit risk . The exchange model provides all the benefits of the CCP model, but hampers innovation in high notional value exotic derivatives.
Arguments in favor of a CCP
Credit risk: With the introduction of a CCP or centralized clearing party, OTC derivatives would be virtually credit-risk free as each trade would be backed by the clearing house. Plus, each participant would post margins and daily mark-to-market would reduce credit risk in the event of default.
Systemic risk: CCP will prevent large players from accumulating unsustainable exposures by mandating margin and collateral requirements. Also, the clearing house will report each trade to a Trade Information Warehouse, which in turn will report large exposures taken by any single counterparty to regulators. With a larger view of the entire market, regulators will be in a position to manage systemic risk better. They could require firms with abnormal exposures to either liquidate a fraction of their positions or post extra collateral/ margin with the clearing house.
Valuation risk: Buy-side is already pushing for third-party, neutral valuation of OTC contracts before putting pen to paper. There are players like Markit who specialize in providing reference (pricing) data for OTC derivatives. There is thus a concerted effort by the industry to have some kind of standardization in valuation of OTC contracts. We believe an eventual CCP will tie up with leading market data providers to standardize the valuation process. It would not be surprising if the CCP itself offered valuation services or verification of price quoted by sell-side. Currently clearing houses reject trades if prices quoted are much higher than prevailing market rates (or rates derived from prevailing market data).
Operational Risk: CCPs will tackle operational risk on three fronts:
- Trade Booking: Front office operations (especially trade capture) in OTC derivatives are error-prone. A high percentage of errors or breaks are due to improper trade data and detail capture. Reasons include the highly subjective nature of trades and the use of manual spread sheets for booking trades. Additionally, there is no standard protocol for communication. The use of FpML has gained popularity but many firms still rely on proprietary standards for product definition. The opportunity cost of errors made by the front office is very high, as it impacts all subsequent processes in the workflow, including confirmations, mark-to-market and so on. The later an error is detected the higher the cost of resolutions. According to a survey by ISDA, more than 50% of errors occur in the front office and specifically during trade booking.
We can expect some automation as well as standardization in the trade capture process, once a government-regulated CCP is introduced. The current private CCPs like ICE Trust already provide many value-added options and interfaces for brokers to enter trades e.g. file upload on FTP site or through a UI. Plus, FpML is likely to become the standard language for trade capture and communication between various entities.
Standardization & automation will help firms on multiple fronts. It will reduce operational risk by reducing the number of errors. And it will reduce per-trade processing cost substantially.
- Confirmations: This has been an industry-wide problem. Even today, confirmation rates are close to 60%, no more. Most of the current private CCPs provide T+0 confirmations with a success rate of 90% - testimony to the CCP model. More and faster confirmations reduce the number of conflicts related to contract terms besides providing early identification of errors in trade capture.
- Collateralization: This will witness large scale reforms under the CCP regime. Currently counterparties post bilateral collaterals with each other. Collateral is netted only at the counterparty level. The level of automation is low, and there’s high usage of cash (up to 90%). With CCP as the central counterparty, each clearing member will have to post collateral with the clearing house only.
The crux is that besides a central counterparty for backing trades, the CCP model, by its very nature, catalyzes and enforces standardization of processes and operations, resulting in significant workflow ‘reforms’.
Arguments against the CCP model
Introduction of a CCP would change the face and body of the OTC world. Despite the benefits and cost advantages associated with a CCP, many market participants have raised serious doubts over its success. Some of these arguments include:
- All products won’t fit into the central clearing house model and rightly so. For instance, there is a shift towards exotic products because of decline in the margin of vanilla derivatives. A CCP would be hard-pressed to satisfactorily clear such products e.g how will it set the amount of collateral required?
- Clearing is good, but what about settlement of products that last over 30 years, like IR swaps? Settlement risk continues in such cases.
- Implementing a one-size-fits-all solution will not fit the bespoke nature of OTC transactions.
- With all the expectations from the CCP model, wouldn’t it be too much for a single entity to achieve, in too little time?
- Costs are bound to increase with transaction fees being charged by the CCP. The standardization of valuation and contracts will also reduce margins significantly. Would the reduced credit and systemic risk make up for this reduced return?
- And the biggest concern of all: the introduction of a CCP will in fact increase concentration risk. Although no exchange has ever defaulted in the history of trading, this fact does contribute to the same systemic risk the CCP was set up to reduce.
As things stand today, it is highly probable Congress will introduce a bill for centralized clearing of OTC derivatives, and more specifically credit derivatives. We also believe regulators will create an all-together new entity instead of appointing any of the existing private players like ICE Trust or CME as the CCP.
Risk is out, Safety is in: Central clearing of Credit derivatives, TowerGroup, Jan 2009
Managing OTC derivatives Risk, Building capabilities to tame the Giant, Celent, Sep 2008
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