Bank for International Settlements, Quarterly Review, September 2009, “Central Counterparties for Over-the-Counter Derivatives.”
Duffie, Darrell and Haoxiang Zhu, “Does a Central Clearing Counterparty Reduce Counterparty Risk?” Working Paper, 2009 (Stanford University, Graduate School of Business).
Singh, Manmohan, and James Aitken (2009a), “Deleveraging post Lehman—Some Evidence from Reduced Rehypothecation,” IMF Working Paper 09/42.
Singh, Manmohan, and James Aitken (2009b), “Counterparty Risk, Impact on Collateral Flows and Role for Central Counterparties.” IMF Working Paper 09/173.
Segoviano, Miguel and Manmohan Singh, (2008) “Counterparty Risk in the Over-The-Counter Derivatives Market.” IMF Working Paper 08/258.
Appendix I: Objective of a Large Bank to Minimize costs of Moving to CCPs
This paper has benefited by comments from Darrell Duffie, Rama Cont, Nadège Jassaud, Laura Kodres, Karl Habermeier, Inci Ötker- Robe, Michael Hsu, John Kiff, and Jodi Scarlata. The author is especially thankful to risk management teams of large banks, hedge funds and CCPs. The author is responsible for any errors. Feedback from participants at the CCP-12 meetings in Budapest (May, 2009), and Austrian National Bank conference on credit derivatives (September, 2009) is greatly appreciated.
The term LCFI is used to denote major dealers/banks and others that are active in the OTC derivative market.
The OTC derivatives market has grown considerably in recent years. According to BIS surveys, notional amounts of all categories of the OTC contracts stood at $605 trillion at the end of June 2009. These include foreign exchange (FX) contracts, interest rate contracts, equity linked contracts, commodity contracts, and credit default swap (CDS) contracts. A comprehensive breakdown of the OTC derivatives market is available in Table 1 of the Bank for International Settlements’ release, “OTC derivatives market activity in the second half of 2009,” issued in October 2009.
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) provides a basis for the measurement of counterparty risk. See section II.
See Morgan Stanley’s study, Intercontinental Exchange, Dec 15, 2007 that suggests about 60 percent of all OTC derivatives outstanding may be centrally cleared in two-three years. In Section III we assume that two-thirds of all eligible contracts could move to CCPs. If a critical mass of derivative contracts does not offload to CCPs, LCFIs will continue to impose systemic risk from such positions since the multilateral netting benefits of a CCP may not be fully attained.
For example, an LCFI may have a positive position (so-called “in-the-money”) via a standardized derivative contract with a hedge fund and a negative position (so-called “out-of-the-money”) via a nonstandard derivative with the same hedge fund. Presently these two positions offset each other on the LCFI’s books.
When Lehman filed for bankruptcy, its derivative payables (also called negative replacement value in Europe) had an immediate impact on Lehman’s counterparties since these payments were not made and the counterparties incurred the costs of replacing the contracts. However, the derivative receivables (also called positive replacement value in Europe) are collected by the bankruptcy court/trustee in due course.
See IMF Working Paper 08/258 and Working Paper 09/173 for further discussion on using derivatives payable as a metric to proxy for systemic risk in the OTC derivatives market.
The U.S. banks also had higher derivative payables as of December 2008 (over $650 billion), as dislocations due to market volatility were higher relative to Q3, 2009 data.
Many LCFIs presently have sizable unencumbered or cash collateral deposited with their central banks. We assume, given the high ratings the LCFIs active in the OTC derivatives market, that the opportunity cost of posting collateral to CCPs will be the same whether LCFIs use their deposits with central banks or opt for new funding in capital markets.
BIS semi-annual survey only includes gross CDS positions (after netting) for the United States. Thus, European and Asian gross CDS positions are not part of this survey and consequently the gross figures for derivative payables will be higher.
BIS Quarterly Review, September 2009, “Central Counterparties for Over-the-Counter Derivatives.”
ECB’s report references EU Commission’s comment on ISDA: “The dominant source of the nature and extent of bilateral collateral is ISDA’s margin surveys. This section is based on the numbers provided by ISDA. However, the Commission services cannot judge the solidity of these numbers, as no information is available about the methodology for calculating the numbers. They should accordingly be considered as indicative only.”
Initial margin in bilateral contracts for CDS contracts are typically high due to their ‘jump risk’ (or sudden change in the price of the reference entity) and can reach 10–30 percent of notionals; for interest rate swaps (IRS) it is much lower, around 1 percent of notional or even less.
Market sources indicate (and the author shares this view) that it is unlikely that CCPi in a country would be allowed access to collateral posted to CCPj registered in another country.
Any excess collateral would have to be returned to the bankrupt estate unless there was some security interest in favour of the second CCP. However, if the bankrupt LCFI is not a member of the second CCP, it is unlikely that it would pledge its collateral to support the second CCP (unless the LCFI is a member of both CCPs). LCFIs are likely to work with one CCP to maximize overall netting and collateral benefits.
According to CPSS-IOSCO Recommendations for CCPs (RCCP 4), a clearing member may not be exposed to significant risks that they themselves cannot control; they control these costs by defining the guarantee/default fund for instance. In other words, a CCP is not allowed, according to CPSS-IOSCO, to expose its members to an unlimited call to bridge losses. Therefore, at least in Europe, a cap is defined on replenishments to the default fund.
Market sources indicate that variation margin is presently paid to mark the portfolio of derivatives to market and is a function of the volatility in the market and covariance within the compressed portfolios. We do not expect movement to CCPs to have a large impact on variation margins, unless the present methods used by LCFIs are more lenient than those of CCPs.
Also see accompanying GFSR, April, 2010, Chapter 3, which makes a similar, but more conservative estimate on foreign exchange, equity, commodities and other unallocated contracts.
We are suggesting a real tax via the levy on derivative payables and not a Basel-like capital charge on derivative payables.
It is uncertain if the present $2.0 trillion for uncollateralized derivative payables will decrease uniformly when 2/3 of OTC derivatives are offloaded to CCPs. So the residual derivative payables may be higher than 1/3 x $2 trillion, due to some loss in netting.
Some LCFIs may be willing to pay the levy, than forego their ‘netting’ benefits; LCFIs know their books and the embedded correlations across products better than any CCP. The tax rate would need to be calibrated to provide enough incentive to move contracts to CCPs, but not so high as to overly burden LCFIs as they attempt to adjust their balance sheets to meet the proposed stringent regulations. Of course, if all non standardized contracts had appropriate collateral posted, then a levy would be unnecessary. Also, timing of the introduction of such levy would need to be carefully considered.
See a recent discussion paper by EuroCCP that is reviving some interest in the linking of CCPs. The basic premise of this paper is that when two CCPs agree to interoperate, they should each increase their default fund as a function of the open positions between them. http://www.euroccp.co.uk/leadership/index.php
For instance, see http://www.ecb.int/paym/cons/html/escb-cesr_otc.en.html, and the work underway by CPSS/IOSCO on these issues.
There may be some additional regulatory capital relief/rebate in offloading more derivatives receivables that are part of N. The present capital charge using (after netting) derivative receivables cannot be compared with what will likely be sizable new funding that will be needed to meet margin requirements at CCPs.
We assume that the two (L x DPafter netting) and (M x N) are additive since the funding cost for the large banks to raise L (i.e., a capital levy to pay regulators ), is roughly the same as the opportunity cost of holding unencumbered assets that will be posted as margin to the CCPs.