Exchanges

• An exchange is an organization with members who trade with each other. Initially, the main role of an exchange was to simply provide a forum where members could meet and agree to trades. These early exchanges also defined standard contracts, resolved disputes between members, and expelled members who reneged on agreed transactions. However, they did not provide many other services. For example, there were no mechanisms in place to protect members from losses associated with counterparty defaults.
• A natural development was for members to protect themselves by requiring margin. Margin refers to the assets transferred from one trader to another for protection against counterparty default. For example, consider traders A and B, who have entered a trade where Trader A agrees to buy 10,000 bushels of corn from Trader B in September at a price of 400 cents per bushel in September. Suppose further that the price of corn then declines by 5 cents soon after the agreement is made. If there is a margin agreement in place, Trader B can request USD 500
  
  from Trader A. If the price subsequently declined by a further 10 cents per bushel, a further USD 1,000 would be requested, and so on. If the price of corn moved in the other direction, however, then Trader B would be required to provide margin to Trader A. For example, a 20-cent increase in the price of corn would lead to a cumulative transfer of USD 2,000 from Trader B to Trader A. In both cases, margin transfers get rid of the incentive for a party to back out of the transaction to take advantage of more favorable market prices in the market.
• Another development to protect members from losses was netting. Netting is a procedure where short positions and long positions in a particular contract offset each other. For example, if Trader A (from the previous example) subsequently agrees to sell 10,000 bushels of corn for September delivery to Trader B for 380 cents per bushel, the contracts could be netted by Trader A paying USD 2,000 to Trader B in September. Alternatively, the present value of USD 2,000 could be paid at the starting date of the second contract. The key point is that once the two traders have entered into offsetting contracts, there is no need for corn to be exchanged in September. This is illustrated in this figure.

• Other netting arrangements can involve more than two parties. For example, suppose that:
  • Trader A agrees to buy 10,000 bushels of corn from Trader B for 400 cents per bushel, and
  • Trader B agrees to buy 10,000 bushels of corn from Trader C for 400 cents per bushel.

Suppose further that both contracts have the same delivery date. The contracts can then be collapsed into a single contract where Trader A agrees to buy 10,000 bushels of corn from Trader C for 400 cents per bushel. This is illustrated in this figure.

• If the contract between Trader B and Trader C is for 380 cents per bushel, rather than 400 cents per bushel, then netting can be used to collapse the two contracts into a single contract in one of two ways:
  1. Trader A agrees to buy 10,000 bushels of corn from Trader C at 380 cents per bushel and agrees to make a payment equal to the present value of USD 2,000 to Trader B.
  2. Trader A agrees to buy 10,000 bushels of corn from Trader C at 400 cents per bushel, and Trader C agrees to make a payment of the present value of USD 2,000 to Trader B.
• One issue arising from netting arrangements involving more than two market participants is that the parties involved may have different credit qualities. For example, Trader C may be wary about changing a contract with Trader B for one with Trader A if Trader A is more likely to default. This is where the margin arrangements mentioned earlier might be useful. If Trader A agrees to post margin in the event that the price of corn declines, Trader C’s credit exposure to Trader A would be reduced. Margin already posted by Trader A with Trader B would have to be transferred to Trader C at the time of the netting. This can get quite complicated, and a natural market development was for exchanges to handle margin arrangements so that traders did not need to worry about the credit quality of other traders.

Central Counterparties

• Exchanges today are more heavily involved in organizing trading than they were in the past. Specifically, they operate what are known as central counterparties (CCPs) to clear all transactions between members.
• For example, assume that Member A agrees to buy 5,000 bushels of corn (which is defined by the Chicago Mercantile Exchange as one contract) from Member B for delivery in September at 400 cents per bushel (USD 20,000 in total). The exchange (through its CCP) then becomes the counterparty to both members, i.e. the CCP agrees to buy 5,000 bushels of corn from Member B at 400 cents per bushel while Member A agrees to buy 5,000 bushels of corn from the CCP at 400 cents per bushel. The exchange clearinghouse positions itself between two of its members and becomes the counterparty to each member.

Central Counterparties – Advantages

• Member A no longer needs to worry about the creditworthiness of Member B (and vice versa). Indeed, the two members might agree on a trade (either on the floor of the exchange or electronically) without even knowing each other. The CCP becomes the counterparty to both and is a clearinghouse for all transactions.
• Another advantage of CCPs is that it is much easier for exchange members to close out positions. To see how this works, note that Member A has a long position in 5,000 bushels (one contract) of September corn. If Member A decides to close out this position, he or she could agree to sell 5,000 bushels of September corn to any other member of the exchange. That trade will also be transferred to the CCP and Member A would then have two trades with the CCP that offset each other. Without a CCP, Member A would either have to approach Member B to close out the position (and there is no guarantee that Member B will be interested in doing this) or short 5,000 bushels of corn with another member. In the latter case, Member A would have to worry about the creditworthiness of the two members of the exchange that he or she has traded with.

How CCPs Handle Credit Risk

• Once an exchange has decided to establish a CCP, it must find a way of managing the associated credit risk. It can do this with a combination of the following:
  • Netting,
  • Variation margin and daily settlement,
  • Initial margin, and/or
  • Default fund contributions.

• As mentioned earlier, netting means that long and short positions are combined to determine a CCP’s net exposure to a member. For example, suppose that Member X shorts one September corn contract. If it enters into a trade to buy four September corn contracts, this will also become a trade between Member X and the CCP. These two trades would be collapsed to a net long position of three September corn contracts (i.e., contracts to buy 15,000 bushels of corn in September).

How CCPs Handle Credit Risk – Variation Margin and Daily Settlement

• A futures contract is not settled at maturity. Rather, it is settled day-by-day during the time to maturity. Consider Trader X from the previous example (who is long three September corn contracts) and suppose that the September futures price is 400 cents per bushel at the close of trading on Day 1 and 395 cents per bushel at the close of Day 2. Trader X has lost

This is because September corn is now worth five cents less per bushel than it was worth at the close of trading on Day 1. The trader is thus required to pay USD 750 to the CCP. If September corn is 405 cents per bushel at the close of Day 3, Trader X has gained

 In this case, the exchange pays the trader USD 1,500.

• Each day, members who have lost money pay an amount equal to their loss to the exchange CCP, while members who have gained receive an amount equal to their gain from the exchange CCP. These payments are known as variation margins, and they typically occur once per day. However, variation margin may be exchanged more often than once a day when markets are highly volatile.
• When a futures price for a contract increases from the close of trading on one day to the close of trading on the next day, funds flow through the CCP from members who have net short positions to members who have net long positions.
• When a futures price for a contract decreases from the close of trading one day to the close of trading the next day, funds flow through the CCP from members who have net long positions to members who have net short positions.

• The number of long positions always equals the number of short positions. This means that while funds are flowing between the members of CCP, there is no net cash inflow or outflow to the CCP.
• Daily settlement has another important advantage: It makes closing out futures contracts much simpler. A member does not have to worry about when a contract was entered or what the futures price was at that time. For example, suppose that a long contract is closed out at 11 a.m. on a particular day by trading a short contract at 375 cents per bushel. Daily settlement means that the member’s gain or loss up to the close of trading on the previous day has already been recognized. If the futures price was 372 cents per bushel at close of trading the previous day, only a further gain of three cents per bushel needs to be added to the member’s account as a result of the market movement.

How CCPs Handle Credit Risk – Initial Margin

• In addition to variation margin, the CCP requires initial margin. These are funds or marketable securities that must be deposited with the CCP in addition to variation margin.
• To understand the role of initial margin, suppose that a member who has a net long position in 20 September corn contracts is required to make a variation margin payment of USD 7,000 and fails to do so. The CCP then must close out the member’s position by selling 20 September corn contracts. Without initial margin, the CCP would be looking at an immediate loss of USD 7,000 because the variation margin paid to members with short positions would be USD 7,000 higher than that received from members with long positions. Furthermore, the price of September corn could decline by one cent per bushel before the CCP is able to close out the member’s position. This would lead to a further loss for the CCP of
  
  and increase the total loss to USD 8,000.
• Initial margin is designed to prevent these type of losses. In the situation described, the CCP might set the initial margin equal to USD 700 per contract. (The initial margin for a contract is the same regardless of whether the position is short or long). In this situation, the CCP would have required an initial margin of
   This would be more than enough to cover the USD 8,000 loss.

• The initial margin for a futures contract is set by the exchange and reflects the volatility of the futures price. The exchange reserves the right to change the initial margin at any time if market conditions change.
• CCPs do not pay interest on variation margin payments because futures contracts are settled daily (and not at maturity). However, CCPs do pay interest on initial margin because it belongs to that member that contributed it. If the interest rate paid by the CCP is considered unsatisfactory, a member may be able to post securities such as Treasury bills instead of cash. In that case, the CCP would reduce the value of the securities by a certain percentage in determining their cash margin equivalence. This reduction is referred to as a haircut. A haircut for a particular asset is usually increased if the price volatility of the asset increases.
• Multiple contracts on the same asset can affect variation and initial margin requirements. For example, suppose that a member is long one September corn contract (to buy corn for delivery in September) and short one December corn contract (to sell corn for delivery in December). When the member is required to pay variation margin for the September contract, the member will probably also receive variation margin for the December contract (and vice versa). Therefore, there is an automatic netting of variation margin across contracts. Exchanges also typically have rules that reduce initial margin requirements so that the total initial margin for the long September and short December contract is less than the sum of the initial margins for the two contracts considered separately.

How CCPs Handle Credit Risk – Default Fund Contributions

• As a final safety net for the CCP, members are required to make default fund contributions. If the initial margin is not enough to cover losses during a member default, the default fund contributions of that member are used to make up the difference. If those funds are still insufficient, the default fund contributions of other members are used. In the unlikely event that the losses are greater than the sum of the defaulting member’s initial margin and the default fund contributions from all members, the equity of the CCP becomes at risk.

Use of Marginal Accounts in Other Situations

• The margin accounts discussed till now are those between CCPs and their members. If a retail trader contacts a broker to do a futures trade, however, the trader will be required to post margin with the broker. And if the broker is not a member of the CCP, the broker will have to pass the trade to a member, and there will be a margin account kept between the broker and that member.
• The margin accounts between retail traders and brokers are somewhat different from those between CCPs and their members. For instance, there is an initial margin as well as a maintenance margin.
• Contracts are settled daily (as it is for members) with gains (losses) being added (subtracted) to margin accounts. Funds in a margin account in excess of the initial margin requirement can be withdrawn. If the balance in the margin account falls below the maintenance margin level, the trader is required to supply additional margin to bring the account back up to the initial margin level. If the trader does not supply the additional margin, the broker closes out the retail trader’s position by entering an offsetting trade on behalf of the trader. The maintenance margin is typically 75% of the initial margin.

Use of Marginal Accounts in Other Situations – Option on Stocks

• A trader with a
  net LONG position in a particular exchange-traded stock option has NO potential future LIABILITY. Therefore, there is no reason for the exchange to require margin from a trader with a net long position in a call or put option. However, a trader with a net SHORT position in an option contract does HAVE potential future LIABILITY. If the options are exercised, the trader must sell or buy the underlying stock at an unfavorable price.
  Traders with short positions are therefore required to post margin with the CCP.
• The Chicago Board Options Exchange calculates margin that must be maintained each day as follows.

1)For a short call option, the margin requirement is the greater of:

• • 100% of the value of the option plus 20% of the underlying stock price less the amount (if any) that the option is out-of-the-money, or
  • 100% of the value of the option plus 10% of the underlying stock price.

2)For a short put option, the margin requirement is the greater of:

• • 100% of the value of the option plus 20% of the underlying stock price less the amount (if any) that the option is out-of-the-money, or
  • 100% of the value of the option plus 10% of the strike price.

• Example –

  Consider the situation where 100 call options on a stock are sold for USD 5 per option when the stock price is USD 47. If the strike price is USD 50, the option is USD 3 out-of-the-money and the margin required per option (USD) is

  

  The total margin requirement is therefore USD 1,140. As the stock price and option price change, the margin requirement changes and a trader may be requested to contribute more funds to the margin account. If the trader does not post additional margin when required, the trader’s position is closed out. Options (unlike futures) are usually settled at maturity. The margin posted by a trader therefore belongs to the trader and interest is paid by the CCP on a cash margin balance.

Use of Marginal Accounts in Other Situations – Short Sales

• Shorting a stock involves borrowing shares and selling them in the usual manner. At some later date, the shares are repurchased and returned to the account from which they were borrowed. A retail trader who chooses to short a stock in the United States is typically required to post margin equal to 150% of the stock price at the time the short position is initiated. The proceeds of the sale account for two-thirds (100%/150%) of the margin. The trader must therefore contribute a further 50% of the stock price.

Logic – Let stock price be s at the time the short position is initiated. Margin = 150 percent of s which is 1.5s.

From sale proceeds, short seller gets s, and hence 0.5s has to be contributed extra apart from the sales proceeds

• The account is adjusted for changes in the stock price. When the stock price declines, the balance in the margin account increases; when the stock price increases, the balance in the margin account decreases. A maintenance margin is typically set at 125% of the stock price. If the margin account balance falls below the maintenance margin, additional margin is required to bring it up to the maintenance margin level. For example, suppose a trader shorts 100 shares when the stock price is USD 30. The proceeds of the sale (USD 3,000) belong to the trader. The margin that must be initially posted, however, is USD 4,500 (i.e., 150% of USD 3,000). The trader must therefore post margin equal to the proceeds of the sale plus an additional USD 1,500.Suppose further that the share price rises to USD 35. This is bad news for the trader because a short position is designed to do well (poorly) when the price decreases (increases). The value of the shares that have been shorted is USD 3,500, and the maintenance margin is now
  . The USD 4,500 initial margin covers this. If the share price rises again to USD 40, however, the maintenance margin becomes
  
  and there is a USD 500 margin call. If this margin call is not met, the position is closed out. The margin account balance belongs to the trader, and interest should be paid on the balance to the trader.

Use of Marginal Accounts in Other Situations – Buying on Margin

• Buying on margin refers to the practice of borrowing funds from a broker to buy shares or other assets. As an example, consider a situation where a retail trader buys 1,000 shares for USD 60 per share on margin. The trader’s broker states that the initial margin is 50% and the maintenance margin is 25%. The initial margin is the minimum percentage of the trade cost that must be provided by the trader at the time of the trade. In this case, the trader must therefore deposit at least USD 30,000 in cash or marginable securities with the broker.
• Suppose that the trader deposits USD 30,000 in cash. The remaining USD 30,000 that is required to buy the shares is borrowed from the broker, who keeps the shares as collateral. The balance in the margin account is calculated as the value of the shares minus the amount owed to the broker. Initially, the balance in the margin account is USD 30,000 (= USD 60,000 – USD 30,000). Gains and losses on the shares (as well as interest charged by the broker) are reflected in the margin account balance (which can also be viewed as the trader’s equity in the position). The maintenance margin (25% in this case) is the minimum margin balance as a percentage of the value of the shares purchased. If the margin balance drops below this minimum, there is a margin call requiring the trader to provide additional margin in order to bring the balance up to the maintenance margin level.

• Now suppose that the price of the security declines by USD 5. The value of the shares purchased falls to USD 55,000 and the balance in the margin account falls to USD 25,000. The margin as a percentage of the value of the shares purchased is around 45%
  . This is more than 25%, so there is no margin call. ( The calculations here ignore the interest that would be charged by the broker.)
• If the price of the security falls further to USD 39, the cumulative loss on the position is USD 21,000 (=USD 60,000-USD 39,000). The balance in the margin account falls to USD 9,000(=USD 30,000–USD 21,000), and the value of the shares is now USD 39,000.
• The balance in the margin account has now fallen to 23.1% of the value of the shares. Because this is less than 25%, there is a margin call. This requires the trader to bring the margin balance up to 25% of the value of the shares. To do this, the trader must add USD 750 to the margin balance. If it is not provided, the broker sells the shares. If it is provided, the position is maintained, and the amount borrowed from the broker falls to USD 29,250.

Over–The–Counter Markets

• This table provides some statistics on the OTC market in December 2017. The OTC market was about eight times the size of the exchange-traded market at that time (when measured in terms of the notional values of underlying assets). This table shows that the value of all transactions in the OTC market was only around 2% of the value of the underlying assets.

• The value of the underlying assets in this table is the notional principal of outstanding transactions. The transaction values are calculated from the difference between the two interest rates (that are exchanged) being applied to the notional principal.

• Interest rate derivatives are by far the most popular type of derivative in the OTC markets. They account for about 80% the value of the market (measured in terms of underlying assets) and about 75% of the value of outstanding derivatives. Most interest rate derivative transactions are interest rate swaps, which will be discussed in a later chapter.
• Over-the-counter derivatives markets are attractive because derivatives are not standardized by an exchange and they can therefore be tailored to meet the needs of end users.
• OTC derivatives have traditionally been cleared bilaterally. This involves the two parties to a transaction agreeing how it will be cleared, what netting arrangements will apply, and what collateral (if any) will be posted. However, CCPs have existed for some time in the OTC markets, and their role is increasing after the 2007–2008 global financial crisis.
• A major disadvantage of the OTC markets has traditionally been related to credit risk. In the early days of the OTC markets, transactions were generally cleared bilaterally, and measures to alleviate credit risks were relatively unusual. Instead, two market participants would simply agree to certain contingent future cash flows. If one side experienced financial difficulties and was unable to meet its obligations, the other side was likely to experience a loss.

• The credit exposure on a derivative is much less than that on a bond or a loan with the same principal. If no collateral is posted, the credit exposure to a trader on a derivative is max⁡(V, 0), where V is the value of the derivative to the trader. If the derivative has a negative value there is no exposure. If the derivative has a positive value, however, the potential loss equals that positive value. The Value of Transactions column in the previous table is therefore a better indication of potential credit exposure than the underlying principal.
• The total expected cost of defaults on a derivatives portfolio with a counterparty depends on the lives of the derivatives. This is because:
  • There is a greater probability of the counterparty experiencing financial difficulties during the life of a derivative as the life of the derivative increases.
  • The market variables that determine the value of derivatives are likely to move more during the life of a derivative as the life of the derivative increases.

Over–The–Counter Markets – Bilateral Netting

• Netting was adopted fairly early in the development of the bilaterally cleared OTC markets. Two market participants would enter into a master agreement that would apply to all the derivatives they traded. In the event of a default by one side, all the outstanding derivatives transactions between the two participants would be considered as a single transaction. For example, suppose that A and B are two companies trading derivatives with each other in the OTC market and that at a point in time there are the four outstanding transactions between them as listed in this table.

• Suppose that Company B gets into financial difficulties and declares bankruptcy. Without netting, Company B will default on Transactions 1 and 3, but keep Transactions 2 and 4. The potential loss to Company A is then USD 60 million. With netting, all transactions will be considered as a single transaction worth –USD 20 million to Company B. Company B’s default then leads to a potential loss for Company A of only USD 20 million (instead of USD 60 million).
• If Company A gets into financial difficulties and declares bankruptcy, there is a gain from netting to Company B. Without netting, Company B has a potential loss of USD 40 million (on Transactions 2 and 4). With netting, there is no potential loss (In fact, Company B will have to pay the liquidators of Company A USD 20 million to settle outstanding contracts).
• The Bank for International Settlements estimates that, when enforceable netting agreements are considered, the total exposure of participants in derivatives markets was USD 2,683 billion in December 2017. This is about 25% of the market value of transactions, indicating that the beneficial effect of netting agreements for credit exposures in derivatives markets is considerable.

Over–The–Counter Markets – Collateral

• The next stage in the management of credit risk in the bilaterally cleared OTC markets is the posting of collateral. The credit support annex (CSA) of a master agreement between two parties specifies how the required collateral is to be calculated and what securities can be posted. Typically, outstanding derivatives are valued every day, and the net value is used to determine the extra collateral that must be posted. The terminology of the exchange-traded markets is sometimes used (with collateral being referred to as margin).
• For example, suppose that Companies A and B are trading derivatives. On a given day, the net value of outstanding transactions increases by USD 1 million to Company B (and therefore decreases by USD 1 million to Company A). Under the terms of the CSA, Company A might be required to post collateral of USD 1 million to Company B.

Over–The–Counter Markets – Special Purpose Vehicles

• Special Purpose Vehicles (SPV), also called Special Purpose Entities (SPE), are companies created by another company in such a way that the credit risks are kept legally separate. SPVs and SPEs are sometimes created to manage a large project without the organization setting it up being put at risk.
• For example, suppose that Company Y creates SPV/SPE Company X. Typically, Y transfers assets to X and may not control those assets. (In some jurisdictions, Y is not even allowed to own X.) If Y goes bankrupt, X should be able to continue to fulfill its obligations (and vice versa). Company X will typically have a AAA credit rating, but only after rating agencies have carefully examined the legal arrangements and mechanics of how the company operates.
• SPVs and SPEs are frequently used to create derivatives from portfolios of assets such as mortgages or other types of loans. The company setting up the SPV/SPE is not responsible for the payoffs on the derivatives, and anyone who purchases the derivatives has payoffs that may be affected by defaults on the underlying loan portfolio. Because of the SPV/SPE’s high credit rating, however, the payoffs will not be affected by the creditworthiness of the SPV/SPE.

• DPCs were well-capitalized subsidiaries of dealers designed to receive AAA credit ratings. When the dealer traded with Company X, the DPC (rather than the dealer) became Company X’s counterparty. This means that while a dealer may have had a poor credit rating, a well-capitalized DPC would have a AAA credit rating, and therefore counterparties would be comfortable trading with it.
• DPCs were set up so that they took on virtually no market risk. When they traded with a counterparty, they normally entered an offsetting trade with the parent so that the parent was responsible for managing the risk. But credit risk was NOT eliminated by a DPC. The DPC itself may be virtually riskless, but the parent company was exposed to risk, and a default by the parent company would have had consequences for a DPC’s counterparties. Typically, it would have led to the DPC being sold to another entity or all transactions being closed out at mid-market prices. DPCs tried to alleviate the concerns of counterparties by documenting exactly what would happen if the parent experienced financial difficulties.
• DPCs have become virtually nonexistent since the credit crisis of 2007–2008. However, they were made redundant well before then by the increasing use of collateral in the OTC market.

Over–The–Counter Markets – Credit Default Swaps

• Credit Default Swap (CDS) is an insurance-like contract between a protection buyer and a protection seller. The buyer pays a regular premium to the seller, and if there is a default by a specified entity (not the buyer or seller), the seller makes a payment to the buyer. The credit default swap market grew rapidly between 2000 and 2007, but it has declined since then.
• Some companies have specialized in selling credit protection using credit default swaps. Monolines are companies with good credit ratings that do this as their main activity. Also, some insurance companies have sold protection as an extension of their other insurance activities. The most well-known of these insurance companies is AIG, which (through its subsidiary AIG Financial Products) sold a huge amount of protection on products created from mortgage portfolios.
• The 2007–2008 crisis led to many failures among monolines. Meanwhile, AIG suffered severe losses arising from credit default swaps and required a USD 180 billion bailout from the US government (the funds have since been repaid). Banks such as Citigroup and Merrill Lynch at bought protection from monolines also lost several billion dollars.