The fallacy of moving the over-the-counter derivatives market to central counterparties

Manmohan Singh

22 January 2012

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Big moves are afoot when it comes to regulating derivatives trade. G20 leaders, among others, were unhappy with the lack of transparency in the massive customised derivatives market (these are known as ‘over-the-counter’ or OTC derivatives – a name that evokes the distinction between over-the-counter drugs and those that require a doctor’s prescription). OTC derivatives are typically a contract struck bilaterally between a financial intermediary (banks, etc.) and a particular investor. Perhaps the leading reform is a drive to move OTC derivatives on to more market-like settings with a central counterparty. According to BIS surveys, notional amounts for all categories of OTC contracts currently stand at around $600 trillion (BIS 2011).

  • Since the Lehman bankruptcy and AIG bailout in the autumn of 2008, there has been increased momentum to move OTC derivatives from the books of the large banks to central counterparties (which continue to be viewed as payment systems).
  • This is a huge transition because it moves the derivatives risk outside the banking system.
  • The central counterparties in-the-making will become new entities and should be viewed as “derivative warehouses,” or concentrated “risk nodes” of global financial markets.

It is important to note that post-Lehman, little progress has been made on crisis resolution frameworks for unwinding large banks, let alone large non-banks and infrastructures like central counterparties.

All this means that the underlying economics of having more ‘too-big-to-fail’ entities needs to be thought through correctly if the move is to improve things.

Where the risk is now

Table 1 and Figure 1 show that each of the large banks active in the OTC derivatives market in recent years carries an average of $100 billion of derivative-related tail risk; this is the cost to the financial system from the failure of a large bank (measured via the bank’s residual derivative liabilities).

Residual derivative liabilities are the appropriate metric to use when assessing the systemic risk that large banks impose on other derivative users in the financial system. By “residual”, we mean after all possible allowable netting has been done within the OTC derivatives book and after the (limited) collateral posted on the contracts has been subtracted. Thus, residual risk captures the shortfall of collateral stemming from large banks not posting their share of collateral to their clients.

Earlier research finds that the 10-15 largest players in the OTC derivatives market may have about $1.5 trillion in under-collateralised derivatives payables (Oliver Wyman 2011, Singh 2010).

The proposed regulations

A single, central counterparty with an adequate, multicurrency, central-bank liquidity backstop that would be well regulated and spans the broadest range of derivatives would have been an ideal “first-best” solution.

  • In view of the political realities (and subtleties of market organisation), a “second-best” solution from an exposure, netting, and collateral standpoint would limit regulations to a few central counterparties rather than a proliferation of central counterparties.
  • Recent developments suggest a significant departure from the envisaged first-best solution.

In fact, there will be a plethora of central counterparties since many jurisdictions, such as Australia, Canada, etc., do not want to lose oversight of their local currency derivative products to an offshore central counterparty.

  • Furthermore, the proposed regulations are likely to exempt end-users.

They may also exempt foreign-exchange swaps from moving to central counterparties. Large banks are likely to keep some non-standard OTC derivatives on their books due to netting benefits across products and also because central counterparties may not be in a position to clear all OTC derivatives.

Such exemptions will not only dilute the intended objectives of moving all or most OTC derivatives to central counterparties, but will increase the overall collateral requirements due to fragmented netting in the market.

We are not moving the status quo of 10-15 large banks (or “pockets” of risk) to one global “pocket” (which would maximise netting); we are moving towards something like 20-30 “pockets” of risk that include large banks and CCPs.

In short, the bottom line is that the world may be moving part way to the first-best solution. Basic economics tells us that such partial reform can make things worse.

Table 1. Derivative liabilities at a large bank – as shown in their financial statements

Figure 1. Proposed regulations will offload OTC derivatives from large banks to central counterparties (CCPs)

There are several drawbacks associated with central counterparties; we explain a few below:

  • A central counterparty may also need central bank support if it has suffered a series of member defaults and is subject to a run because of credit concerns. In this case, the central bank providing liquidity support will be taking credit/solvency risk on whatever the net central counterparty position is. The line between liquidity and solvency is blurred, at best. In the most extreme scenario, where a temporary liquidity shortfall at a central counterparty has the potential to cause systemic disruption or even threaten the solvency of a central counterparty, it is likely that central banks in major jurisdictions will stand ready to give whatever support is necessary (and recent regulatory proposals suggest that the Fed and ECB will do so). However, such an arrangement creates moral hazard – and a roundabout way for derivatives risk to be picked up by taxpayers.
  • Legal and regulatory constraints indicate that cross-border margin access is subordinate to national bankruptcy laws (such as Chapter 11 in the US). Thus, it is unlikely that central counterparty A in a country would be allowed access to collateral posted by central counterparty B registered in another country. Thus, London Clearing House (LCH – a UK entity) now offers US clients clearing within US laws, so that US clients’ margins do not have to be posted to LCH UK (where the local UK creditors would be senior to US clients). One way interoperability (or linking central counterparties) may work is if each central counterparty increases its default fund as a function of its open positions with the other central counterparties with which it will interoperate. This may get around the cross-border complexities associated with collateral being trapped in a defaulted central counterparties. However, linking central counterparties via augmented default funds will significantly increase the already sizable collateral needed to move OTC derivatives to central counterparties. Also – aside from legal and collateral constraints¬ – the key central counterparties in the OTC derivatives market have established niche franchises that do not encourage interoperability.
  • Collateral is presently fungible (i.e., collateral coming in via a derivative asset or receivable can be used to pay for a derivative liability or payable, Singh 2010). In a central counterparty world, a decrease in the re-use of collateral may be significant, since there is increasing demand from some large banks and/or their clients (asset managers, hedge funds, etc.), for a “legally segregated” margin that they will post to central counterparties. Also, the recent requests for bankruptcy remote structures – another form of collateral segregation – stems from the desire to not post collateral with offshore central counterparties. The MF Global saga will result in increased demand for segregation, so the re-use/churning of collateral within the OTC derivatives market will fall further (Singh 2011b).

Alternative proposal

Present market practices result in residual derivatives liabilities and residual derivative assets because (aside from large banks), sovereigns, AAA insurers, large corporate, multilateral institutions (e.g. EBRD), Fannie, Freddie, and the ‘Berkshire Hathaway’ types of firms do not post their full share of collateral. They are viewed by large banks as privileged and (presumably) safe clients. We thus suggest a tax, or a levy on residual derivative liabilities to be a more transparent approach than moving OTC derivatives to central counterparties, especially if the costs of bailing out central counterparties are to be funded by taxpayers (Singh 2011a). If a levy is punitive enough, then large banks will strive to make derivative liabilities reach zero; as a result, there will be no systemic risk via the OTC derivatives markets if a large bank fails.

Furthermore, as a by-product of the above levy, we would also address the residual derivative assets (that have also averaged $100 billion per large bank in recent years). This will happen since the large banks typically have matched books (i.e., the size of the derivative liability and asset positions at each bank is, on average, roughly the same).

Since, at the time of inception of the OTC derivative contract, we do not know if the contract will be in-the-money (asset) or out-of-the money (liability), the levy on liabilities will force receiving/paying collateral with every client (i.e., no free riding for anyone). Thus, derivative assets will also go to zero. From a risk-management angle, large banks need to hedge their ‘in-the-money’ positions, or derivative receivables, when there is a likelihood that these positions may not be paid in full. For example, hedging derivative receivables due from a sovereign pushes up the credit default swap (CDS) spreads on the sovereign, as seen in peripheral Europe in the past year or so. This, in turn, inflates the sovereign’s debt issuance costs (since CDS spreads impact the spreads of the underlying bonds). Thus, addressing the under-collateralisation issues results in other synergies that are not being considered in the central counterparty CCP discussions.

Conclusions

In summary, placing a levy on derivative payables would be a better alternative, as it addresses the ‘original sin’ (i.e. some derivative users not posting their share of collateral) and also lower CDS spreads from spiralling during distress.

References

Bank for International Settlements (2011), “Semiannual OTC Derivative Statistics at end-June 2011”, November.
Oliver Wyman (2011), “The Future of Capital Markets Infrastructure”, February.
Singh, Manmohan (2010), “Collateral, Netting and Systemic Risk in OTC Derivatives Market”, IMF Working Paper No. 10/99.
Singh, Manmohan (2011), “Making OTC Derivatives Safer – A Fresh Look”, IMF Working Paper No.11/66.
Singh, Manmohan (2011), “Velocity of Pledged Collateral – Analysis and Implications”, IMF Working Paper No. 11/256.

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Topics:  Global crisis International finance

Tags:  financial regulation

Senior Economist at the IMF in Washington DC

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