OTC Derivatives under Central Clearing

Recent regulatory efforts, especially in the U.S. and Europe, are aimed at reducing moral hazard so that the next financial crisis is not bailed out by tax payers. Central Clearing was proposed by G20 as the solution (for OTC trading) after the financial crisis and mandated all these derivatives should move to Central Clearing by end of 2012. Failing to comply with this may result in charge of significant amount of capital. What this means is that rather than these derivatives being traded as mere contracts between two parties, these should go through one single entity. The financial crisis following Lehman’s demise and AIG’s bailout has provided the impetus to move the lightly regulated over-the-counter (OTC) derivative contracts from bilateral clearing to central counterparties (CCPs).The motive behind this proposal was to increase transparency on positions, reduce counterparty risk and reduce operational risk. This intends to reduce the exposure to default of each party. Per the OTC derivatives reform, standardized derivatives (~60% of the current OTC market) need to be electronically executed (SEFs), centrally cleared and publicly reported. Under the present regulatory overhaul, the OTC derivative market could become more fragmented. Furthermore, another taxpayer bailout cannot be ruled out. A key incentive for moving OTC derivatives to CCPs is higher multilateral netting, i.e., offsetting exposures across all OTC products on systemically important financial institutions’ (SIFIs) books. 

Of course, all this works only if the Central party is safe. The intent is also to keep Central counterparty  to be remote from bankruptcy and thus immunize it from default. For this CCP needs to have line of defence. Each of the parties trade with CCP and even though the trade is long-dated, those are marked to market every day and settle up with CCP. This is not how futures work. This entire process expedites the CCP’s ability to address any default immediately. Secondly, CCP maintains buffer to offset the default risk which is called risk/initial margin which accounts for the fact that the market move a bit or substantially. Third thing in the line of defence is guarantee or default fund which comes into involvement when these risk margins are not sufficient to handle the default risk. 

    

So the parties (which may include hedge funds, banks, and asset managers) now face new kind of risk. Earlier, the main exposure was to credit but the price of moving out the credit part out is liquidity. The market is going to move to either side of the pendulum every day and this calls for cash in hand. There are varieties of different entities providing services in different types of derivatives. Following figure shows how all these stakeholders' roles fit together. 

An important distinction among these is the degree to which they allow cross-margining. Cross margining is the ability to offset the marginal requirement of product trading with one in another product with the same counter party. The main three CCPs are CME, ICE and LCH.Clearnet. At the moment, the flow is really with these big three. LCH has cleared around 40% of IRS (interest-rate swaps) market. ICE cleared around 65% of the CDS market. Credit Valuation and Adjustment (CVA) is the mechanism that the banks used to account for the possibility of the counterparty default when they do derivatives trading with bilateral counterparties. This was very relevant when the main risk was credit. As we move into CCP world, arguably CVA becomes less important. The majority of dealing houses have moved to OIS (Overnight Index Swap) for the valuation of collateralized derivatives, however no such consensus exists for the valuation of uncollateralized derivatives. The recent Libor scandal has put the spotlight on the debate around how banks measure their cost of funding and highlighted the possibility of banks introducing a funding valuation adjustment (FVA) to more accurately reflect the cost of funding in their valuations.

All these are measures for standardized derivative products. There is a need for managing more complex products. It is expected to have higher margins for non-cleared swaps. CFTC is suggesting that it may double the initial margin for the non-cleared swaps. So the complex derivative trading is expected to become more expensive. Therefore, the P&L is going to be affected for these entities.

Making OTC derivatives more accessible to the investment community poses significant risks, as well as benefits. Whenever more firepower is vested into the hands of investors, the risk that they will do themselves damage increases. Although a number of factors will help to mitigate those risks—including increased transparency, the attraction of new forms of liquidity, and a central clearing structure to minimize bilateral counterparty credit risk—there is still the possibility that a rush of interest in OTC derivatives stokes the next bubble.