Counterparty Risk, Impacton Collateral Flows and Role for Central Counterparties
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund

Contributor Notes

Author’s E-Mail Address: msingh@imf.org; ja@aitkenadvisors.com

Counterparty risk in the United States stemming from exposures to OTC derivatives payables (after netting) is now concentrated in five banks?Goldman Sachs, JPMorgan, Bank of America, Morgan Stanley and Citi. This note analyzes how such risks have shifted over the past year. We estimate that the adverse impact of counterparty risk on high-grade collateral flows and global liquidity due to decrease in rehypothecation, reduced securities lending, and hoarding of cash by major banks is at least $5 trillion. In order to mitigate counterparty risk, there have been regulatory initiatives to establish central counterparties (CCPs). From a policy perspective, counterparty risk remains large at present and recent experience has shown that OTC derivative positions are not supported by sufficient capital, constituting a major risk for participants in this market.

Abstract

Counterparty risk in the United States stemming from exposures to OTC derivatives payables (after netting) is now concentrated in five banks?Goldman Sachs, JPMorgan, Bank of America, Morgan Stanley and Citi. This note analyzes how such risks have shifted over the past year. We estimate that the adverse impact of counterparty risk on high-grade collateral flows and global liquidity due to decrease in rehypothecation, reduced securities lending, and hoarding of cash by major banks is at least $5 trillion. In order to mitigate counterparty risk, there have been regulatory initiatives to establish central counterparties (CCPs). From a policy perspective, counterparty risk remains large at present and recent experience has shown that OTC derivative positions are not supported by sufficient capital, constituting a major risk for participants in this market.

I. Introduction

The over-the-counter (OTC) derivatives market has grown considerably in the past two years. Notional amounts of all categories of the OTC contracts reached almost $600 trillion at the end of December 2008. These include foreign exchange (FX) contracts, interest rate contracts, equity linked contracts, commodity contracts, and credit default swaps (CDS) contracts. Interest rate contracts continue to be the largest segment of this market, comprising 70 percent of all OTC derivatives market contracts or about $420 trillion.

There has been very little (if any) research that looks at the full gamut of the OTC derivatives market. Most of the recent discussion has been limited to credit derivatives (or the CDS market), which represents less than 10 percent of the overall notional OTC derivatives market, as per Bank for International Settlements (BIS) data.2 One of the most cited recent works is by Barclays Bank where they acknowledge that “counterparty risk is theoretically present in all asset classes: FX derivatives, interest rate swaps, equity derivatives, commodity derivatives, and credit derivatives.”3 Also, a recent IMF paper (Segoviano and Singh, 2008), looked at all OTC derivatives, but the data and methodology were focused on the situation around the time of Bear Stearn’s demise. Post Bear Stearns and especially after Lehman collapse, much has changed.4

In this paper, we provide a different perspective to measure counterparty risk, compared to other sources (e.g., Office of Comptroller of Currency’s Quarterly Report on Bank and Derivatives Activities, or BIS bi-annual technical report on OTC Derivatives Market Activity). We explain that neither the notional value of OTC contracts nor the gross market value of these contracts (essentially the total value of all the derivatives that are in-the-money) provide a basis to measure counterparty risk. Instead, we discuss the importance of “netting” within and across all categories of OTC derivative contracts and of reducing this netted amount by the “assigned” cash collateral to come up with a relevant measure for exposure to counterparty risk.

The aversion to deal with large complex financial institutions (LCFIs) due to their counterparty risk has implications for global liquidity. Overall, high grade collateral flows have fallen significantly both as LCFI clients have reduced the free flow of collateral to LCFIs, and LFCIs themselves have locked up collateral on their balance sheets.

In order to mitigate counterparty risk, there have been regulatory initiatives to establish central counterparties (CCPs). In theory, CCPs may reduce counterparty risk by multilateral netting of derivative trades when a large financial fails and back-stop the systemic risk stemming from the OTC derivatives market.

The paper is organized as follows. The introductory section provides an overview of counterparty risk, the central theme of the paper. Section II defines counterparty risk when a large institution fails. Section III focuses on the changing profile of counterparty risk and highlights five U.S. banks where this risk is concentrated―Goldman Sachs, JPMorgan, Bank of America, Morgan Stanley and Citi. Section IV estimates the adverse impact of counterparty risk on high-grade collateral flows due to decrease in rehypothecation, reduced securities lending, and hoarding of cash by major banks to be at least $5 trillion. Section V of the paper discusses the role for CCPs, and Section VI concludes with a policy suggestion that unless OTC derivative positions are supported by sufficient capital, counterparty risk will remain large.

II. Counterparty Risk

Counterparty risk largely stems from the creditworthiness of an institution. In the context of a financial system that includes banks, broker dealers, and other nonbanking institutions (e.g., insurers and pension funds), counterparty risk will be the aggregate loss to the financial system from a counterparty that fails to deliver on its OTC derivative obligation.5

In order to highlight the importance of counterparty liabilities, it is necessary to discuss notional amounts of outstanding OTC contracts and the gross market value of OTC contracts. Notional amounts are defined as the nominal value of all OTC derivative deals concluded on the reporting date. These amounts provide a measure of the size of the market, but do not provide a measure of risk. Risk arising from open derivatives stems from several factors including price changes, volatility, leverage and hedge ratios, duration, liquidity, and counterparty risk.

Gross market values are derived from the replacement cost of open contracts that are in a current position at current market prices and thus, in the event of a counterparty default, would roughly represent defaulted claims on counterparties. Although gross market values provide a rough aggregate measure of counterparty risk, these values do not account for netting and therefore overstate the risk from open contracts.

We define the exposure of the financial system to the failure of a particular counterparty as the liabilities of a counterparty to all others in the financial system. These liabilities stem from the counterparty’s OTC derivatives payables after netting under a master netting agreement such as ISDA, or a cross-margining agreement, which have been further reduced by assigning cash or equivalent collateral.

The financial market turmoil of recent months has highlighted the importance of counterparty risk. Recent data show that counterparty risk within U.S. banks, post-Lehman, is now concentrated in five institutions relative to the period before Bear Stearns. Recent data from the Office of the Comptroller of the Currency (OCC) and 10Q reports highlight five U.S. banks (JPMorgan, Citi, Bank of America, Goldman Sachs and Morgan Stanley) that are the major players in the derivatives market.6 From a systemic risk perspective, counterparty risk is the risk to others in the global system if a large financial institution goes under (i.e., bankruptcy or some other form of organized resolution), which would mean that the trade-replacement price for the residual derivatives payable obligations (i.e., the unsecured receivables for those who have lost their counterparty) will need to be agreed upon immediately. The cost of putting on the exact same trade can be very high (see Figure 1).

Figure 1.
Figure 1.

Illustrative Repricing of Derivatives When a Large Financial Institution Fails

Citation: IMF Working Papers 2009, 173; 10.5089/9781451873207.001.A001

Lehman’s bankruptcy illustrates the asymmetry between the treatment of derivatives payables and derivatives receivables. Moody’s (2008) mentions that when Lehman’s default was being considered at the weekend session (September 13-14) at NY Fed, only a limited amount of outstanding derivatives payable trades were re-priced as participants expected significant price changes and operational difficulty in replacing a sizeable volume of trades. S&P (2009) emphasizes that before Lehman’s default, in-the-money contracts in favor of Lehman (derivatives receivables) may not have materialized because clients could elect not to call an early termination of a CDS contract if the mark-to-market value of the CDS was not in their favor. Therefore, terminating the contract would entail a payout to Lehman (or its bankruptcy trust). This asymmetry of legal treatment between derivatives payables and receivables is very important when a firm is near bankruptcy—clients terminate contracts in their favor but not those where Lehman was in favor.

III. The Changing Profile of Counterparty Risk in the United States

The global OTC derivatives market is very concentrated with about ten bank dealers responsible for about 90 percent of trading volume (Fitch 2007).7 It is useful to note that the counterparty liabilities of Lehman (as per their last 10Q filing on July 10, 2008) was about $24 billion.8 This is a useful gauge when comparing counterparty liability exposure of the five key U.S. banks and how they have evolved over the past year.

The counterparty liability exposures of the five major banks changed over the course of the crisis:

  • Citibank’s counterparty liability exposure decreased significantly to $17 billion as of end-March 2009, relative to $126 billion as of March 2008, largely due to continuing concerns on having Citi as a counterparty (see Figure 2).

  • Goldman Sachs’ counterparty risk to the financial system is the largest, at $91 billion as of end-March 2009, relative to around $100 billion as of March 2008; the change is noteworthy since others have gained or stabilized their market share only due to mergers. In other words, Citi and Goldman symbolize two extremes: Citi has been viewed as an unreliable counterparty (with its CDS spreads going over 600 bps prior to the stress test results), while Goldman has strengthened its position since it registered to be a ‘bank,’ and one of the first to repay TARP funds.

  • JPMorgan’s exposure to OTC derivatives payables was about $86 billion at end-March 2009, compared to $68 billion as of March 2008. This was partially due to the absorption of Bear Stearns and WAMU, but markets also suggest the ‘too-close-to-Fed’ factor as being crucial for JPMorgan gaining business (see Singh and Aitken, 2009).

  • Bank of America/Merrill Lynch appears to have almost tripled its counterparty risk exposure to $77 billion as of end-March 2009, relative to March 2008, but this sizeable increase is due to the merger with Merrill Lynch; comparing figures below, BoA and Merrill Lynch had about $88 billion in derivatives payable a year ago.

  • Morgan Stanley’s exposure has fallen slightly from $69 billion as of end-March 2008 to $54 billion as of end-March 2009.9

Figure 2.
Figure 2.

Counterparty Liabilities of Major U.S. Banks

(as of end-March 2009 and end-March 2008)

Citation: IMF Working Papers 2009, 173; 10.5089/9781451873207.001.A001

Source: 10Q reports.

IV. The Adverse Impact of Counterparty Risk on Global Liquidity

The aversion to deal with some large complex financial institutions (LCFIs) due to their counterparty risk has implications for global liquidity. This is because collateral flows, within the financial system has fallen significantly and adversely impacted global liquidity (i.e., funding and trading liquidity). This largely stems from LCFI clients avoiding their high grade collateral to flow freely within the LCFIs, or LCFIs themselves locking up collateral in their balance sheets. This section shows anecdotal evidence of a sizeable drop in global liquidity from reduced rehypothecation, reduced securities lending and from sizeable hoarding of cash/cash equivalent by LCFIs.10

The fair value of securities received as collateral, which can be pledged (or rehypothecated) by major LCFIs, has fallen by about $2.5 trillion since end-2007, (compare Nov 07 with Nov 08 in Table 1).11 Such collateral was mostly posted by clients of the LCFIs (especially hedge funds). Since the freezing of Lehman’s assets in the United Kingdom, hedge funds have been opting not to rehypothecate their collateral and prefer segregated accounts or tri-party custodian arrangements where they retain ownership of their margin that was posted as collateral (see Singh and Aitken, 2009).12

Table 1.

Snapshot of Reduced Collateral Posting Among LCFIs

(In US$ billions)

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Source: 10Q and 10K filings for U.S. firms; Annual reports for European firms.

Securities lending by custodians is also down sizeable. The number is at least $1 trillion if we include other leading custodians such as Citigroup, HSBC etc. Table 2 shows the decline among the top three global custodians—Bank of New York, State Street and JPMorgan since end-2007.

Table 2.

Securities Lending by Major Custodians

(In US$ billions)

article image
Source: 10Q and 10K reports.
There is also evidence of a sizeable hoarding of cash or cash-equivalent by LCFIs. The typical reason provided by them is succinctly illustrated by Goldman Sachs’s in its recent 10Q, page 135:

“Our most important liquidity policy is to pre-fund what we estimate will be our likely cash needs during a liquidity crisis and hold such excess liquidity in the form of unencumbered, highly liquid securities that may be sold or pledged to provide same-day liquidity.”

The U.S. dollar-denominated excess is comprised of only unencumbered U.S. government securities, U.S. agency securities and highly liquid U.S. agency mortgage-backed securities, all of which are eligible as collateral in Federal Reserve open market operations, as well as overnight cash deposits. Our non-U.S. dollar-denominated excess is comprised of only unencumbered French, German, United Kingdom and Japanese government bonds and overnight cash deposits in highly liquid currencies.”

Most large banks annual reports suggest that high-grade and liquid collateral is very much desired and kept on their books, although lower quality and less liquid collateral that is acceptable to the Fed and ECB has been deposited with them to raise cash via the various facilities offered by these central banks. 13 Table 3 gives an illustration of the sizeable cash holdings. If the cash holdings with all the major LCFIs are counted, such cash holdings reach $1.5 trillion.14

Table 3.

Cash Holding by Major LCFIs, end-2008

(In billions of dollars)

article image
Source: 10Q and 10K and similar filings.

In conclusion, several key points can be made. First, collateral flow (especially high-grade liquid collateral) within the financial system has fallen significantly and adversely impacted global liquidity. This is the risk capital and balance sheet capacity that may have otherwise been applied to proprietary trading, market-making and arbitrage activities that are integral to global liquidity. Second, since the velocity of collateral is greater than one, pledged collateral, repo markets and cash hoarding would have ‘turned-over’ more than once, if deployed effectively by the markets. Thus, the impact of the figures mentioned in Tables 13 on global liquidity (about $5 trillion) is much greater than seems apparent from the figures alone and may have implications for monetary policy in some countries. We suggest that the counterparty risk associated with (some) LCFIs last year was a key reason why collateral was not put to full use.15 However, counterparty risk has not abated in the past year, and has perhaps concentrated further post-Lehman.

V. Regulatory Thrust for a Central Counterparty

There have been recent regulatory initiatives, especially in the United States, to establish a central counterparty clearinghouse.16 A clearinghouse or a central counterparty (CCP) interposes itself between the buyer and the seller and assumes the rights and obligations of both parties. In theory, a CCP may reduce systemic risk by applying multilateral netting of trades which not only reduces counterparty risk but also minimizes cash flows between counterparties. However, it is likely that most OTC derivatives will not end up on exchanges but will require central clearing. In this respect, the too-large-to-fail notion will continue to exist unless (i) some of the banks with large counterparty risk, as shown in Figure 2, also reduce their after-netting residual derivatives payables (as Citi has done over the past year), or (ii) CCPs act as the last buffer and inherit such counterparty risk.17

Some issues need to be considered in the context of reducing counterparty risk and establishing a central counterparty clearinghouse:

  • Will a CCP (or more than one), reduce systemic risk from LCFIs by transferring it to the CCP(s)? It is increasingly likely that globally there will be more than one CCP, although optimally, one global CCP that covers all OTC contracts would have the most efficient capital allocation (Duffie and Zhu, 2009). 18

  • Are there presently capacity at large banks for higher (initial) collateral posting, in light of the scarcity of collateral flow discussed above? Collateral requirements are likely to increase overall, despite cross-netting capabilities between CCPs. In general, dealers want more collateral today than prior to the crisis.

  • What would constitute adequate capital for a CCP? Counterparty Liabilities, shown earlier in Figure 2, is a good starting point to estimate the size of capital that will be needed in determining the LCFIs and CCPs initial margin/collateral.

  • Will there be interoperability (or linking of CCPs) and will the pooling of margin/collateral be symmetric? In other words, will all types of contracts be offloaded rather than one or two types that may be encouraged by the specialization and adequate capitalization of a CCP? Will CCPs specializing in interest-rate swaps where margin variation is continuous and not subject to jump risk, be willing to be linked (and back-stop) another CCP that specializes in CDS contracts only.19 Risks may increase if clearing is applicable to only certain types of OTC derivatives, as big dealers in OTC derivatives offset CDS and other OTC positions.

  • Is a CCP a public good with associated implicit (national) guarantees, or will members underwrite all costs associated with a large member defaulting? There have been reports that some CCPs may consider asking for guarantees in (especially those clearing CDS contracts, where jump risk is large when a member fails). This stems from the desire to expand access to CCPs beyond banks (and to include hedge funds and other OTC derivative buyers). Segregating hedge funds margin money, in case a bank fails, gained prominence after Lehman’s collapse (see Singh and Aitken, 2009).

  • Will the existence of a CCP encourage more derivative activity? It is likely that systemic risk from derivatives will be spread from the present 6 to10 LCFIs that dominate the OTC derivative market to about 10 to15 entities (LCFIs plus CCPs).

This may increase derivative activity, provided netting is symmetric and augmented by sufficient capital allocation both at the LCFI and CCP levels, or via national/jurisdictional implicit or explicit guarantees.

VI. Conclusions and Policy Implications

Counterparty risk continues to loom large and has not abated over the past year since Bear Stearns absorption by JPMorgan. LCFIs with large counterparty liabilities that have been considered weak (e.g., Citi) relative to others (e.g., Goldman) have either lost derivative business to stronger derivative players or, have had to come up with sizeable cash or cash equivalent to reduce their derivatives payables position. Furthermore, global liquidity has suffered as a result of LCFI clients avoiding their high grade collateral to flow freely within the LCFIs or LCFIs themselves locking up collateral in their balance sheets.

Recent experience has shown that OTC derivative positions are not supported by sufficient capital, constituting a major risk for participants in this market. CCPs have been proposed recently as a way to reduce systemic risk by applying multilateral netting of trades. Although CCPs are a positive initiative, sufficient collateral and initial margin must back-stop derivative activity at both the LFCI and CCP level. Another key factor will be the interoperability of CCPs, which may entail collaboration (and implicit guarantees) at sovereign levels. Introduction of such a mechanism must be well thought out. In short, removing the “too-big-to-fail” notion genuinely requires additional capital from those LFCIs that are dominant in the OTC derivatives space. Otherwise, regulators risk the possibility that present tax payers bailouts in containing systemic risk to future implicit guarantees via CCPs.

Counterparty Risk, Impacton Collateral Flows and Role for Central Counterparties
Author: James Aitken and Mr. Manmohan Singh
  • View in gallery

    Illustrative Repricing of Derivatives When a Large Financial Institution Fails

  • View in gallery

    Counterparty Liabilities of Major U.S. Banks

    (as of end-March 2009 and end-March 2008)