Derivatives

• Derivatives involve agreements to exchange payments or trade an underlying asset in the future, ranging from weeks to years. Their value fluctuates based on underlying assets, indices, and contractual decisions. Usually, initial values are often set at zero for both parties.
• Derivatives have long existed, but their complexity and size have soared in recent decades. They offer efficient hedging tools, addressing risks like –
  • Interest rate risk – Interest rate swaps help manage liabilities.
  • Foreign exchange risk – FX forwards hedge cash inflows.
  • Commodity risk – Commodity futures lock in prices for consumption or production needs.
• Derivatives mirror underlying variables, enabling synthetic positions. For example, an airline fearing rising oil prices can use a long hedge on cash-settled oil futures without storage costs. Firms reduce exposure through derivatives like total return swaps without direct asset sales.
• Various users like sovereigns, central banks, hedge funds, and corporations, employ derivatives for investment or risk hedging. Due to unique needs like accounting, many derivatives are custom-made to match specific requirements, such as precisely aligning with loan terms.
• Banks offer derivative contracts to clients and hedge risks among themselves. Markets are often dominated by a few major counterparties, like the globally systemically important banks (G- SIBs), subject to stringent regulations due to their critical role.
• Derivatives involve evolving claims between counterparties based on market conditions, creating counterparty credit risk. This risk stems from the potential insolvency of one party, leading to concerns about meeting contractual obligations.
• Counterparty risk is mitigated through bilateral arrangements or central clearing via a central counterparty (CCP). The expanding derivatives market underscores the significance of managing counterparty risk, especially after events like Lehman Brothers’ bankruptcy emphasized the challenges posed by defaults.

Derivatives Market – Exchange-Traded And OTC Derivatives

• • Derivatives exchanges facilitate the trading of standardized products like futures and options at specified prices, enhancing market efficiency and liquidity. Centralized in a single location, these exchanges simplify entering and exiting positions. The standardized contracts actively traded and easily bought or sold to close positions, provide transparency and accessibility to a broad range of market participants, fostering a dynamic and liquid marketplace.

• • OTC derivatives, unlike exchange-traded counterparts, are less standardized and typically traded directly between two parties, offering flexibility in transaction terms. These private contracts lack active secondary markets but provide inherent adaptability. Customized OTC derivatives are valuable for specific hedging needs that may not be met by standardized exchange-traded options, reducing basis risk, especially for large companies managing financial risks through derivatives.
  • Customized OTC derivatives have drawbacks, as unwinding involves negotiating with the original counterparty, potentially leading to unfavourable terms. Assigning transactions to other counterparties often requires the original counterparty’s consent, limiting flexibility. The lack of fungibility in OTC transactions poses challenges. While customization serves client needs, some OTC derivatives are criticized for regulatory arbitrage or misleading clients, particularly exotic OTC derivatives, contributing to broader criticism of the OTC derivatives market.
  • OTC markets differ significantly from exchange-traded ones. Historically lacking trade reporting, OTC trades, often between a dealer and end-user or two dealers, can be private and untraceable. Legal documentation is bilaterally negotiated, though some standards exist.

Features	Exchange-Traded	Over-the-Counter (OTC)
Terms of contract	• Standardized (maturity, size, strike, etc.)	• Flexible and negotiable
Maturity	• Standardized maturity, typically at most a few months	• Negotiable and non-standard, often many years
Liquidity	• Very good	• Limited and sometimes very poor for non-standard or complex products

Derivatives Market – Clearing

• • The figure shows the OTC derivatives process starts with execution and ends with settlement. Counterparties are legally obligated to make payments related to underlying securities or cash flows based on market variables. Settlement completes these obligations either through successful payments or contract closure. Clearing involves computing and often netting payment obligations between firms, managing counterparty risk. It bridges the period from execution to settlement, addressing the risk of failure to meet contractual responsibilities.

• • OTC derivatives typically have longer maturities compared to exchange-traded products, often spanning years or even decades. In contrast, exchange-traded products settle within days or months. OTC clearing processes can extend over extended periods, highlighting the growing significance of central clearing for these products as they become more prevalent.
  • Clearing can be bilateral or central. In central clearing, a 3rd party (CCP), manages counterparty risk and related aspects for derivatives exchanges. Historically, OTC derivatives were cleared bilaterally, but the recent trend is towards central clearing for enhanced risk management.
  • Bilateral clearing involves counterparties managing risk directly in OTC contracts, but centrally cleared transactions transfer risk management to a CCP. Exchanges, historically offering efficient price discovery, also mitigated counterparty risk through central clearing facilities since the mid-1980s. This practice has extended to OTC derivatives in recent years.

• Central clearing extends the exchange model but faces limitations due to the required standardization, making it unsuitable for all OTC derivatives. Although centrally cleared OTC derivatives are growing, a large portion remains bilaterally cleared. Alternative methods, like multilateral compression, used in bilateral markets, use some central clearing functionalities.

Derivatives Market – Overview

• • In 1986, OTC derivatives’ notional was slightly below exchange-traded derivatives at $500 billion, but OTC markets were deemed more significant due to longer maturities. Over the next two decades, the OTC derivatives market exponentially expanded, driven by customized hedging and investment use. This growth included the development of new products, such as the CDS market increasing tenfold from 2003 to 2008. Contracts tailored to client needs contributed to the popularity of OTC products.

• • The growth slowed, especially after the global financial crisis, as banks moved away from certain derivatives due to high capital charges, and clients showed reduced interest, particularly in structured products. Recent reductions are also attributed to compression exercises aimed at minimizing counterparty risk by eliminating offsetting and redundant positions.
  • OTC derivatives encompass five primary classes: interest rate and inflation derivatives, foreign exchange derivatives, equity derivatives, commodity derivatives, and credit derivatives. Interest rate products dominate outstanding notional, while foreign exchange and (CDSs) appear less significant but carry large counterparty risk. Cross-currency swaps, although short-dated, involve huge counterparty risks due to their long-dated nature and notional exchange. CDSs, with high volatility and wrong-way risk, contribute largely to counterparty risk, emphasizing the importance of other products beyond interest rate derivatives.

• • Derivatives’ notional value can be misleading (compared to loans or bonds) as derivatives’ exposure is very small. In interest rate swaps, for example floating and fixed payments are exchanged with no principal risk. Cash flow exchanges involve only the net difference at payment dates. In case of counterparty default, the institution isn’t obligated to continue cash flow payments; instead, the swap is unwound based on a defined valuation. If the swap has a negative value, the institution may stand to lose nothing if the counterparty defaults.
  • Market value, reflecting the maximum potential loss if all parties fail to meet contractual payments and contracts are replaced at current market prices, is a more pertinent measure of derivatives risk than gross notional outstanding. Incentives, like central clearing, aim to minimize gross market value, with around 60% of OTC derivatives (mostly interest rate contracts) being centrally cleared in recent years.

Derivatives Market – Participants And Collateralization

• • Exchange-traded derivatives settle daily with margin, while OTC derivatives are typically collateralized rather than settled. Collateralization involves pledging cash and securities to neutralize net exposure between counterparties, reducing counterparty risk. However, it introduces legal and operational risks, along with funding and liquidity risks.
  • The market can be divided into three broad categories –
    • Large players – Global banks (dealers), dominate the OTC derivatives market. Operating across all asset classes, they collateralize positions, even when their counterparty doesn’t. These dealers, typically members of most or all exchanges and CCPs, concentrate market liquidity, with the largest 14 holding around four-fifths of the total notional outstanding.
    • Medium-sized players – Smaller banks or financial institutions, engage in OTC derivatives activities, making markets in specific products. They cover many asset classes, excluding credit derivatives or commodities, and may focus on specific markets, such as regional banks dealing in local currencies. With a smaller clientele, they usually collateralize positions, are members of local exchanges and CCPs, and might participate in global ones as well.
    • End users – Large corporates, sovereigns, or small financial institutions, engage in OTC derivatives for hedging or investment. They do limited transactions with few counterparties, often dealing in a specific asset class. Their positions are often directional, lacking offsetting transactions, and they may be unwilling or unable to commit to regular margining or posting collateral. Many OTC derivatives market participants lack strong credit quality, making counterparty risk an unavoidable aspect of the derivatives market.
  • End users, like sovereigns or multilateral development banks, historically enjoyed favourable collateral arrangements where they receive but don’t post collateral. This arrangement is subject to rating triggers and has become costlier due to funding and capital requirements.
  • Third parties provide services such as settlement, margining, collateral management, software, trade compression, and clearing. These services help market participants reduce counterparty risk, manage risks like legal issues, and enhance overall operational efficiency.
  • Derivatives can be grouped by transaction and collateralization methods, ranging from simpler to more complex and risky.
    • Exchange-traded derivatives – These are the simplest and most liquid, and are traded on exchanges. They feature short maturities and central clearing with daily margin postings, often considered the safest part of the derivatives market, despite recent challenges. Settlement involves daily cash payments, known as variation margin.
    • OTC centrally cleared – These derivatives, unsuitable for exchange trading due to complexity and non-standard nature, are cleared centrally. Regulatory changes mandate central clearing for standardized OTC derivatives. OTC CCPs typically demand daily cash collateralization, termed variation margin, even though it’s not a settlement.
    • OTC collateralized – These derivatives use bilateral agreements without central clearing. Parties post collateral (cash or securities) to each other to mitigate counterparty risk.
    • OTC uncollateralized – These derivatives are bilateral agreements where parties (end users) don’t post collateral due to commitments or limitations. With no mitigation for counterparty risk, these derivatives get more attention for their underlying risks.
  • The figure breaks down the total notional, revealing that around 10% is exchange-traded, and the majority is OTC. Over half of the OTC market is centrally cleared, with around four-fifths being collateralized. The remaining 20%, which is under-collateralized, poses significant risks, leading to issues related to counterparty risk, funding, and capital.

• The focus should be on the seemingly small 7% (20% of the 40% of the 91% in the figure) of the market that lacks proper collateralization, either bilaterally or through central clearing. Despite being a fraction, it still amounts to tens of trillions of dollars in notional, making it crucial for counterparty risk. Beyond counterparty risk, considerations of funding, capital, and collateral underscore the importance of all derivative groups in the figure.

Derivatives Market – Banks And End Users

• • Counterparty risk and aspects, like funding, collateral, and capital, arise in two situations. The first involves end users transacting derivatives for hedging, resulting in a directional portfolio aiming to offset economic risk elsewhere. This leads to high mark-to-market volatility and varying margin (collateral) requiring huge collateral over a short time. Many end users avoid collateral agreements due to this, and the directional portfolios may limit netting benefits. In practice, end users trade with many banks based on business volume and risk appetite.
  • End users hedge risks on a one-for-one basis, tying the terms of OTC swaps directly to specific bonds rather than hedging interest rate exposure more generically. Unwinding transactions can be difficult, as the original counterparty may not offer good terms. Executing offsetting transactions may result in less favourable terms, especially if borrowing and lending are hedged on a one-to-one basis. Defaults are challenging, requiring replacements on a one- for-one basis, making the process more time-consuming and costly.
  • Derivatives-based hedging can create imbalances. Suppose a firm borrows at a floating rate and hedges interest rate risk using an interest rate swap with the same terms, paying fixed and receiving the floating rate. Even if both transactions occur with the same bank, differences in practices related to accounting and collateralization may arise. From the bank’s perspective, capital treatment for the loan and swap will be separate, with the loan in the banking book and the swap in the trading book.

• Banks aim for a flat, hedged book from a market risk view by offsetting client transactions either on a macro basis or directly with other market participants. This leads to a chain of hedges in the interbank market, possibly concluding with an offsetting position with an end user. While banks may have minimal MTM volatility or market risk, they still carry counterparty risk to both counterparties.
• In this situation, client transactions are often uncollateralized, while hedges are bilaterally collateralized or exchange/centrally cleared. The counterparty risk is prominent in uncollateralized transactions, leading to asymmetry in collateral flows. Dealers face challenges due to clients’ directional hedging needs, such as significant margin or collateral posting for receiver interest rate swaps in a falling interest rate environment. The second figure serves as a crucial starting point for various analyses throughout the book.

Derivatives Market – ISDA Documentation

• The OTC derivative market’s growth relied on standardized legal documentation to manage efficiency and counterparty risk. The International Swaps and Derivatives Association (ISDA) provides the ISDA Master Agreement (since 1985) that is widely used for OTC transactions.
• This bilateral framework establishes terms governing multiple transactions under a single, indefinite-term legal contract. It includes a core section and an adjustable schedule covering netting, collateral, termination events, default definition, and close-out processes. This approach aims to reduce legal uncertainties and counterparty risk. Trade confirmations detail the commercial terms, referencing the Master Agreement. Negotiations for the agreement can be time-consuming, but once finalized, trading often occurs without updating general aspects. English or New York law is typically applied, with occasional use of other jurisdictions.
• The agreement has the following features for mitigating counterparty risk –
  • The contractual terms regarding the posting of collateral
  • Events of default and termination
  • All transactions referenced are combined into a single net obligation
  • The mechanics around the close-out process are defined.
• Default events trigger the termination of transactions before their original maturity date, initiating a close-out process. Events of default covered in the ISDA Master Agreement are –
  • failure to pay or deliver
  • breach of agreement
  • credit support default (collateral terms)
  • Misrepresentation
  • default under the specified transaction
  • cross-default (default on another obligation)
  • Bankruptcy
  • merger without assumption.
• Common default events include failure to pay (subject to a defined threshold) and bankruptcy. The Lehman Brothers bankruptcy underscored the importance of risk mitigants for OTC derivatives, sparking extensive litigation on offsetting obligations and asset/liability valuation. This emphasizes the crucial role of documentation in outlining processes in case of a counterparty default.

Derivatives Market – Credit Derivatives

• The credit derivatives market expanded rapidly before the GFC, driven by the need for efficient credit risk transfer. The central instrument, Credit Default Swaps (CDS), streamlined credit risk trading but can be toxic due to embedded counterparty risk. While efficient for credit risk transfer, improper use can be counterproductive. The credit derivatives market has stagnated post-GFC, with increased awareness of the risks associated with CDS.
• A key motivator for the central clearing of standard OTC derivatives is the counterparty risk in the CDS market. Central clearing is viewed as providing default remoteness for CDS hedges against counterparty risk. However, the untested ability of central counterparties to manage the more illiquid and risky CDS product remains a critical concern.

Derivatives Market – Financial Weapons Of Mass Destruction

• ISDA (20146) notes that –
  • Derivatives are essential to global economic activity and growth.
  • Thousands of companies use OTC derivatives to manage the risks.
  • Derivative users are corporations, investment managers, governments, insurers, and banks.
  • Derivatives are transacted around the world in more than 30 currencies.
  • Most of the world’s 500 largest companies use derivatives to manage risk.
• Not all derivatives transactions are socially useful, as some exploit regulatory capital, tax rules, or accounting practices. Misusing derivatives can lead to huge losses and financial crises, as seen in incidents like Orange County (1994), Proctor and Gamble (1994), Barings Bank (1995), Long-Term Capital Management (1998), Enron (2001), and Societe Generale (2008).
• Derivatives offer huge leverage, allowing firms to gain exposure with small upfront payments. For example, if a firm expects lower US rates, it might opt for a receiver interest rate swap in US dollars instead of US treasury bonds. This provides similar exposure without an initial investment. This increased leverage, regulated by the institution, counterparty, or regulator, has been shown to contribute to significant market disturbances in the past.
• The OTC derivatives market is dominated by a handful of dealers who serve as common counterparties for numerous end users and engage in active inter-dealer trading. Previously perceived as adding stability, this setup is now recognized as a source of substantial systemic risk, where the potential failure of one institution could lead to a domino effect, threatening the stability of the entire financial market. This risk can be triggered not only by actual losses but also by a heightened perception of potential losses.
• In 2002, Warren Buffett labelled derivatives as ‘financial weapons of mass destruction’ due to several concerns –
  • Their value is tied to the creditworthiness of the counterparty, introducing counterparty risk
  • Derivatives valuations may lack symmetry, leading to overstated earnings (‘mark-to-myth’)
  • Downgrade triggers could force sudden collateral demands, creating liquidity issues
  • They pose a daisy-chain risk, hindering prudent counterparty diversification
• These points were insightful with respect to events from 2007 onwards, and some of the issues captured by post- GFC regulation were foreseen by Buffett.
• Critiques of derivatives, particularly OTC derivatives, arise from their rapid and sometimes less regulated nature. Unlike the gradual evolution of exchange-traded contracts, OTC markets move swiftly, fostering innovation but also facilitating the growth of potentially hazardous risks. Before 2007, OTC derivatives were largely opaque and lacked comprehensive regulation.
• While derivatives have undergone standardization initiatives, OTC markets persist as decentralized and less transparent compared to exchanges. This complexity poses challenges for managing counterparty risk, addressed historically through risk mitigants.

Derivatives Market – The Lehman Brothers Bankruptcy

• Derivatives clearing complexity poses challenges in handling counterparty defaults, which may be linked to losses on derivatives. Major derivatives defaults, like Barings Bank and Long-Term Capital Management, are infrequent due to the lack of secondary markets and objectively- defined valuations in derivatives.
• Lehman Brothers’ 2008 bankruptcy highlights the complexity of managing derivatives. With over 200 subsidiaries across 21 countries and a million derivatives transactions, navigating insolvency laws from more than 80 jurisdictions posed significant challenges.
• The steps taken to fully settle with a derivative counterparty are –
  • Reconciliation of the universe of transactions.
  • Valuation of each underlying transaction.
  • Agreement of a net settlement amount.
• As shown in the figure settling Lehman’s OTC derivatives, involving numerous counterparties and transactions, has been a prolonged and intricate process, lasting several years.

Derivatives Risks

• Financial risk is often not fully eliminated but rather transformed into different forms, such as collateral reducing counterparty risk but introducing market, operational, legal, and liquidity risks. These new risk forms may appear benign but often come with hidden dangers. Additionally, some financial risks result from a combination of underlying risks, like counterparty risk being a blend of market and credit risk. While this book primarily addresses counterparty risk and related facets like funding, it’s crucial to comprehend this within the broader context of other financial risks such as –
  • Market Risk
  • Credit Risk
  • Operational and Legal Risk
  • Liquidity Risk
  • Integrated Risk
  • Counterparty Risk

Derivatives Risks – Market Risk

• • Market risk arises from short-term market variable fluctuations, presenting as linear (tied to stock prices, etc.) or non-linear (tied to market volatility or basis risk). Quantitative risk management, notably value-at-risk approaches, emerged after notable losses like Barings Bank in the 1990s. Basel I amendments in 1995 enabled institutions to use mathematical models for computing capital requirements, advancing market risk management.
  • Offsetting contracts can neutralize market risk, but if done with different counterparties, it leads to counterparty risk. The discrepancy in collateral agreements and central clearing arrangements across the market results in funding imbalances and costs.

• Banks strive for market risk neutrality to reduce accounting volatility and capital requirements, complying with regulations. The figure shows that despite market risk hedging, party X faces exposure to the failure of counterparty A or party B.

Derivatives Risks – Credit Risk

• Credit risk refers to the possibility that a debtor may fail to fulfill payment or contractual obligations, commonly termed ‘default’. Quantifying credit risk requires a comprehensive characterization of default probability and recovery value (loss given default) throughout the exposure’s lifetime.
• Deterioration in credit quality, less severe than default, can result in a mark-to-market (MTM) loss due to increased future default probability. Counterparty risk assessment involves characterizing the term structure of the counterparty’s default probability, with a higher probability linked to greater credit deterioration.
• Derivatives expose counterparty risk as a combination of credit and market risk, unlike debt instruments where credit risk relies on default probability and recovery value due to deterministic exposure.

Derivatives Risks – Operational And Legal Risk

• Operational risk in derivatives arises from various sources, including human error, failed processes, model inaccuracies, fraud, and legal challenges. While some losses are common, significant ones often result from rare or unforeseen events. Quantifying operational risk is challenging, particularly with counterparty risk mitigation methods like collateralization, which introduces operational complexities in its timely processing.
• Legal risk, a subset of operational risk, arises when assumed legal treatment is not upheld, leading to losses. This can result from incorrect documentation, counterparty fraud, mismanagement of contractual rights, or unexpected court decisions. Mitigating financial risk introduces legal risk, especially during defaults, which are infrequent and subject to regional jurisdiction variations, complicating their resolution.

Derivatives Risks – Liquidity Risk

• Liquidity risk takes two forms –
  • Asset liquidity risk arises when a transaction cannot be executed at market prices, potentially leading to losses, especially in a ‘fire sale.’ Non-cash collateral in derivatives faces this risk, emphasizing the need for liquid assets as collateral.
  • Funding liquidity risk involves the inability to timely fund outflows like cash flows, margin, or collateral payments. This may lead to forced asset liquidation, causing losses and triggering a negative feedback loop with further funding issues.
• Reducing counterparty risk through margining or collateralization increases funding liquidity risk, demanding timely payments, often daily. Some derivatives end users resist collateral posting due to the requirement for liquid financial securities, more accessible to financial institutions than corporations. Banks, favoured for market access, prefer liquid collateral, whereas clients prefer less liquid forms. Recent regulations on liquidity risk incentivize banks to receive cash, reinforcing this preference.

Derivatives Risks – Integration Of Risks

• Financial risk management has historically lacked integration across various risk types, despite crises typically involving a mix of risks. Counterparty risk, a blend of market and credit risks, illustrates this challenge. Mitigating counterparty risk introduces additional risks like liquidity and operational issues. It’s crucial to recognize counterparty risk as an intersection of various financial risks and acknowledge that its mitigation can generate further complexities.

Derivatives Risks – Counterparty Risk

• Counterparty risk, traditionally associated with credit risk in derivatives transactions, involves potential exposure arising from the varying market value of transactions in the event of a counterparty’s default. This risk combines elements of credit (default) and market risks (transaction value fluctuations), known as ‘wrong-way risk’. Factors like recovery value and collateral impact are crucial considerations.

Systemic Risk Of Derivatives – Overview

• OTC derivatives raise concerns about systemic risk, referring to an uncontained crisis that could lead to the failure of an entire financial system or market. Their complexity, opacity, and volume may contribute to systemic risk by causing episodes or catalyzing crises, exemplified by cases like Barings Bank and Lehman Brothers.
• Historically, the derivatives market aimed to mitigate systemic risk by minimizing the default risk of key market participants, striking a balance between risk reduction and fostering financial growth. Processes like netting and margining/collateralization were employed to lessen counterparty risk and systemic risk. However, these measures, while intended to reduce systemic risk, may inadvertently fuel complexity and growth, potentially becoming sources or catalysts for systemic risk.
• Reviewing historical methods in the derivatives market to mitigate systemic risk, while somewhat obsolete, offers valuable context for analyzing recent developments like central clearing.

Systemic Risk Of Derivatives – Special Purpose Vehicles

• A special purpose vehicle (SPV) or special purpose entity (SPE) is a legal entity formed to isolate a firm from financial risk. It’s commonly used in the OTC derivatives market to mitigate counterparty risk. Assets are transferred to the SPV for management or to finance projects without risking the entire firm or a counterparty.
• SPVs, often used in structured notes, alter bankruptcy rules, ensuring clients receive their full investment ahead of other claims if a counterparty becomes insolvent. This guarantees a high-level counterparty risk on the note’s principal, typically triple-A, surpassing that of the issuer. SPV creditworthiness undergoes thorough assessment by rating agencies, focusing on mechanics and legal specifics. While reducing risk in one area, this mechanism may increase it elsewhere by favouring certain parties and imposing a less favourable environment on others.
• An SPV shifts counterparty risk to legal risk, particularly concerning consolidation, where a bankruptcy court may combine SPV assets with the originator’s. Consolidation’s applicability varies by jurisdiction; US courts are prone to it, while UK courts less so unless fraud is involved.
• Legal documentation’s enforceability in SPV structures was untested for years. Lehman Brothers’ case revealed jurisdiction-dependent challenges. The ‘flip’ provision, prioritizing investors in Lehman’s bankruptcy, faced conflicting rulings. US courts deemed it unenforceable, contrary to UK courts. Many cases settled out of court, highlighting jurisdiction-specific uncertainties.

Systemic Risk Of Derivatives – Derivatives Product Companies

• The derivatives product company (DPC) emerged to address counterparty risk in OTC derivative markets. DPCs, typically triple-A-rated entities, are established by banks as separate, well-capitalized subsidiaries. Unlike SPVs, DPCs aim to shield external counterparties from counterparty risk by safeguarding against their parent company’s failure.
• Sponsors could establish high-credit-quality derivatives counterparts with DPCs, thanks to advancements in risk management models and credit rating agencies. DPCs typically upheld a triple-A rating by managing capital, margin, and activity within strict limits. Each DPC employed its risk assessment model, benchmarked against triple-A standards, often using dynamic capital allocation to maintain compliance. DPC ensured triple-A rating through –
  • Market Risk Management: DPC aimed for market risk neutrality by executing offsetting contracts, striving for a matched book, often with their parent entity.
  • Parental Support: DPC operated with bankruptcy remoteness from their parent, akin to SPVs, to enhance their credit rating. In case of parental default, the DPC would transition to another institution or close trades at mid-market.
  • Credit Risk and Operations: DPC imposed restrictions on external counterparty credit quality and activities, implementing measures like position limits, margin requirements, and daily MTM for counterparty risk management.
• DPCs ensured additional security by outlining an orderly workout process in the event of triggers like a parent company’s rating downgrade. This “pre-packaged bankruptcy” aimed for simplicity and rarity compared to standard bankruptcies. Two bankruptcy approaches existed: continuation, where a manager hedged existing positions, and termination, where transactions were closed.
• DPCs, introduced in the early OTC derivatives market, aimed to enable trading for lower-rated counterparties. However, during the GFC, their viability was questioned. Bear Stearns DPCs were dissolved by J.P. Morgan post-rescue, while Lehman Brothers’ DPCs filed for Chapter 11 protection, highlighting their reliance on parent companies. Consequently, rating agencies withdrew ratings, reflecting concerns over DPC autonomy.

Systemic Risk Of Derivatives – Monolines And CDPCs

• Monoline insurance companies and similar entities like AIG offered ‘credit wraps’, guaranteeing financial products. They ventured into areas like single-name CDS and structured finance for diversification and better returns. To maintain high ratings, they followed dynamic capital requirements based on potential losses and wrapped asset portfolios, akin to DPCs. They usually didn’t post collateral due to their strong credit ratings.
• During the 2007-2008 financial crisis, monolines faced challenges due to mark-to-market (MTM) valuation losses on their insurance products. Concerns arose regarding their triple-A ratings and capital adequacy. Monolines, like ACA Financial Guarantee Corporation, faced collateral posting requirements triggered by rating downgrades, leading to swift declines as they couldn’t meet obligations.
• From November 2007, monolines like XL Financial Assurance Ltd, AMBAC Insurance Corporation, and MBIA Insurance Corporation faced failure. In 2008, AIG got a $182bn bailout from the US Government. These failures resulted from rating downgrades, collateral posting demands, and MTM losses, creating a downward spiral. Banks like UBS, Citigroup, and Merrill Lynch faced huge exposure to monoline counterparty risks, with billions at risk.
• CDPCs, akin to monolines, were highly leveraged and typically didn’t post collateral. Their better performance during the GFC was largely due to timing; many weren’t fully operational until after its onset in July 2007, missing the initial losses. However, their business model similarities to monolines haven’t been overlooked.

OTC Derivatives And The Crisis

• In 2008, the global derivatives market soared to over $700 trillion, with around 90% being OTC. This surge has since been seen as a risky blend of complexity, leverage, and interconnectedness, notably exemplified by the swift expansion of credit derivatives pre-GFC.
• Moreover, the majority of OTC derivatives were traded by large banks, which had grown even larger through mergers and acquisitions, like Citigroup. Additionally, firms like AIG had significant exposure to the complex, lightly regulated, and opaque OTC derivatives market.
• During the GFC, governments struggled to address the risk posed by financial institutions whose collapse could destabilize the entire system, particularly through the OTC derivatives market. Central banks like the Federal Reserve had to manage systemic risk on an ad hoc basis, facilitating sales of some institutions (e.g., Bear Stearns) and injecting capital into others (e.g., Bank of America, AIG) to prevent widespread defaults and systemic breakdowns.
• The GFC highlighted the challenge of managing institutions that were both “too big to fail” and “too interconnected to fail,” largely due to the OTC derivatives market. Regulators recognized the imperative to establish a robust regulatory framework to address the systemic risk posed by this market and its participants.

OTC Derivatives Clearing

• Since the late 1990s, major CCPs have expanded their services to include clearing/settling OTC derivatives and non-exchange-traded products like repos. LCH.Clearnet established two OTC CCPs for repos and interest rate swaps in 1999, while Intercontinental Exchange (ICE) began offering cleared OTC energy derivatives solutions in 2002, later expanding to CDS contracts. Although these developments were limited to certain products and markets suggesting both positives and negatives of using a CCP.
• CCPs act as intermediaries between counterparties, assuming their rights and obligations. They become the new counterparty, mitigating direct risks and reallocating default losses through methods like netting and margining. This reduces counterparty and systemic risks overall and is achieved through mechanisms like portfolio compression and increased collateralisation.
• In a centrally-cleared system, CCPs absorb the impact of counterparty defaults like Lehman Brothers, acting as financial shock absorbers. They swiftly terminate relations with defaulting members without losses and replace them with other members through auctions, ensuring continuity for surviving members.
• CCPs also introduce features beyond those seen in bilateral markets like –
  • Loss mutualization – Losses from one counterparty are spread across all clearing members, avoiding
    direct transmission to a smaller group of counterparties.
  • Orderly close-out/transfer – CCPs enable orderly close-outs by auctioning the defaulter’s obligations, reducing the need for total position replacements, and reducing price impacts and market volatility. They also enable the smooth transfer of client positions from financially distressed members.
• The general role of a CCP is:
  • to sets certain standards and rules for its clearing members and sometimes for its clients
  • to take responsibility for closing out all the positions of a defaulting clearing member.
  • to maintain financial resources to cover losses in the event of a clearing member default:
    • cash variation margin to closely track market movements.
    • initial margin to cover the worst-case liquidation or closeout costs above the variation margin.
    • a default fund to mutualise losses in the event of a severe default.
  • to have a plan for extreme situations when all financial resources (initial margin and default fund) are depleted.
• Some banks and many OTC derivatives end users, like pension funds, access CCPs through clearing members instead of becoming members themselves due to operational and liquidity requirements such as CCP auctions and regular fire drills.

CCPs (Central Counterparties) In The Global Financial Crisis

• Even before the GFC, some OTC derivatives, like interest rate swaps, were centrally cleared. Despite OTC derivatives being central to the financial chaos during the GFC, CCPs, such as LCH.Clearnet and DTCC handled the Lehman Brothers bankruptcy well. They swiftly suspended insolvent Lehman entities from trading, preventing further risk buildup, while allowing solvent entities to continue trading. CCPs also facilitated the transfer of solvent client accounts to other clearing members, providing stability and safety to counterparties and clients. This mitigated the potential systemic effects of Lehman’s bankruptcy in cleared markets.
• LCH.Clearnet’s SwapClear service, a prominent example of CCPs for OTC derivatives, handled interest rate swaps for 20 large banks, including Lehman Brothers. With a portfolio exceeding $100 trillion notional, it represented a significant portion of the global interest rate swap market. Despite previous defaults, Lehman’s failure marked the largest default in CCP history. Lehman Brothers Special Financing Inc. (LBSF), with a $9 trillion OTC portfolio, was declared in default on September 15, 2008, prompting LCH.Clearnet to swiftly close out the portfolio of 66,390 trades using around $2 billion in initial margin held for such emergencies.
• Following Lehman’s default, LCH.Clearnet’s SwapClear service swiftly initiated a structured response:
  • Clearing members provided representatives to aid SwapClear in managing the default.
  • A default management group comprising senior traders from six banks was formed.
  • Hedges were implemented to mitigate macro-level market risks in Lehman’s portfolio.
  • Daily reviews adjusted hedges based on evolving portfolio and market conditions.
  • Bulk of Lehman client positions were transferred to solven members within a week.
  • Successful auctions were conducted to sell Lehman portfolios and their hedges to remaining SwapClear
    members in five currencies, concluding by October 3.
• The Lehman close-out at LCH.Clearnet was largely successful, requiring only a portion of the initial margin, with the remainder returned to administrators. However, challenges arose, including delays in returning client margins, attributed to Lehman’s record-keeping and UK legal constraints on customer segregation.
• The Lehman bankruptcy had mixed outcomes for other CCPs. The Chicago Mercantile Exchange (CME) faced losses in clearing various positions for Lehman, offsetting them with gains from other asset classes. Additionally, three winning bidders in the CME auction reportedly made a combined profit of $1.2bn. In another instance, Hong Kong Exchanges and Clearing Ltd (HKEx) disclosed a loss of HK$157m related to closing out Lehman Brothers Securities Asia’s portfolio, leading to calls for additional default fund contributions from active members, resulting in default losses for other CCP members.

The Clearing Mandate

• Before the GFC, regulators did not mandate central clearing for OTC derivatives. However, following the Bear Stearns bailout and the Lehman brothers’ collapse, regulators globally began advocating for central clearing. CCPs emerged as a shock absorber for the OTC derivatives market during defaults, mitigating disruptions by managing replacements swiftly. They offered transparency and risk reduction through margining practices, enabling them to set and enforce rules for the OTC derivatives market.
• In 2009, the G20 leaders agreed in Pittsburgh to require:
  • all standardised OTC derivatives to be traded on exchanges or electronic platforms
  • mandatory central clearing of standardised OTC derivatives
  • the reporting of OTC derivatives to trade repositories
  • higher capital requirements for non-centrally cleared OTC derivatives.
• Initially, clearing mandates on OTC derivatives risks were centred on credit derivatives like credit default swaps but soon expanded to cover the entire OTC derivatives market. It is important to note that the clearing is feasible only for standardized and liquid OTC derivatives, but the mandate aims to enhance the number of cleared contracts.

Bilateral Margin Requirements

• Mandatory clearing can be sidestepped by trading non-standardized contracts. To encourage central clearing, regulators imposed mandatory margin rules on bilateral derivatives. These rules aim to replicate central clearing margin requirements, reducing the incentive to avoid it.
• In November 2011, G20 leaders in Cannes mandated margin requirements for non-centrally- cleared derivatives. They tasked the Basel Committee on Banking Supervision (BCBS) and the International Organization for Securities Commissions (IOSCO) to develop margining standards for consultation by June 2012. The Financial Stability Board (FSB) was also called upon to report on progress towards meeting the commitments on OTC derivatives.
• In response, the BCBS and IOSCO produced a consultative paper (BCBS-IOSCO 2012) on the subject of bilateral margin requirements. Further, they collaborated with the Committee on Payment and Settlement Systems (CPSS) and the Committee on the Global Financial System (CGFS) to form the Working Group on Margin Requirements (WGMR).

CCPs In Context

• SPVs, DPCs, monolines, and CDPCs are nearly absent in today’s OTC derivatives market due to fundamental flaws in risk mitigation methods and the clearing mandate encouraging the use of central counterparties. CCPs differ from these but share the reliance on exceptional credit quality. A CCP’s failure could trigger systemic risk, highlighting the importance of its creditworthiness.
• CCPs mitigate systemic risk by managing clearing member defaults. They guarantee contracts of defaulted parties, preventing panic actions by institutions. Losses from defaults are shared among CCP members, akin to insurance, reducing systemic risk and averting a domino effect.
• The shift of priorities in risk management from one party to another, as seen in SPVs and DPCs, raises concerns about its overall systemic impact. While CCPs prioritize OTC derivative counterparties to reduce risk in this market, it may adversely affect other stakeholders, potentially increasing risks elsewhere. Moreover, heavy reliance on precise legal frameworks exposes vulnerabilities, especially in large bankruptcies where challenges to payment priorities can arise. Additionally, the cross-border nature of CCP activities exposes them to varied regulatory regimes and bankruptcy laws.
• CCPs share similarities with monolines and CDPCs as strong credit entities managing counterparty risk. However, critical differences exist. CCPs maintain a ‘matched book,’ avoiding market risk except during member defaults, unlike monolines and CDPCs with substantial one- way exposure to credit markets. Additionally, CCPs mandate margining (variation and initial margin), unlike monolines and CDPCs, which typically posted limited collateral, often only during rating downgrades. While all aim to mitigate systemic risk, the term ‘systemic risk insurance’ for CCPs is inaccurate, as systemic risk cannot be diversified.
• While CCPs don’t face the same flaws as monoline insurers or AIG, there are lessons to be gleaned about concentrating counterparty risk in a single, potentially too-big-to-fail entity. Recent history has shown potential issues with central clearing, like the default of a clearing member at the Nasdaq Nordic commodity exchange in September 2018.