OTC Derivatives: Bilateral Trading and Central Clearing

An Introduction to Regulatory Policy, Market Impact and Systemic Risk

David Murphy

• Publisher: Palgrave Macmillan
• Year: 2013
• Print ISBN: 9781137293855
• eBook ISBN: 9781137293862
• Topic: Business
• Subtopic: Accounting
• Index: Business

After the credit crisis, supervisors enacted a range of financial reforms. In particular, they radically changed the nature of the OTC derivatives market via a number of measures, notably mandatory central clearing. This book discusses the market before the crisis, explains what central clearing is, and outlines the consequences of the new rules.

1

Over-The-Counter Derivatives

Concepts, like people, have their histories.

They are just as vulnerable to the ravages

of time as individuals.

But in and through all this they keep

a certain homesickness for

the scenes of their youth.

Søren Kierkegaard

Introduction

A derivative is a contractual relationship between two parties. Each entity makes a financial commitment. For instance, one may pay the other a sum of money in exchange for the right to buy something at a fixed price in the future; or both parties may promise to make a series of payments to the other.

One categorisation of derivatives is based on how they are transacted:

Over-The-Counter (or ‘OTC’) derivatives are transacted bilaterally between the two parties; whereas

Exchange-traded derivatives are traded on an organised platform or at an established venue. Typically the exchange (or a related party) acts as counterparty to these transactions.

OTC derivatives, then, involve a promise to make some payment or to deliver some financial asset in the future. One of the sources of risk in such transactions is the fact that the party making the promise might not keep their word. This is counterparty credit risk.

A related danger is that one party might make demands on the other as a result of the transaction that they cannot meet because they cannot raise sufficient funds, or that they can only meet at excessive cost. This is liquidity risk (which can, of course, give rise to counterparty credit risk).

These two risks – counterparty credit risk and liquidity risk – will be discussed further in subsequent sections. First, though, we need to examine OTC trading and the diverse promises made once an OTC derivative has been agreed more closely. We then turn to the risks inherent in OTC derivatives trading and the size of the pre-crisis OTC derivatives market. This defines the magnitude of the problem that the regulations we will discuss in subsequent chapters have to address.

1.1 OTC Derivatives: Trading and its Consequences

We will assume a basic familiarity with swaps and options¹, concentrating here on how derivatives are transacted and the risks that result from this trading.

1.1.1 Engaging in an OTC derivatives transaction

Historically, OTC derivatives markets were simply a collection of dealers and brokers who would advertise the prices at which they might engage in benchmark transactions. A deal was typically conducted by telephone, with two parties privately negotiating the nature of the deal and the price at which it would be done. If the deal was a benchmark transaction – a five year fixed for floating interest rate swap in US dollars, say – then it could be directly compared to advertised prices. If it was less standard, then both parties would need to acquire comfort that the agreed price was acceptable. Often they would do this using a derivatives pricing model². Thus for instance a six year swap might be valued using the prices of the benchmark five and seven year swaps.

More recently, electronic platforms have become commonplace. These allow platform members to view dealer advertisements and, should they wish, engage in a range of transactions. It is worth noting that regardless of the method of dealing:

Historically in the OTC market advertised prices were often not firm commitments to trade. This is a marked contrast with some exchange markets.

OTC markets did not include trade reporting, so advertised prices often represented the only information available to non-dealers.

The negotiation of a trade is a purely bilateral process. If two parties can agree a transaction and they are legally able to enter into it, then they can trade without involving or reporting to a third party.

The bilateral nature of trading inevitably meant that the responsibility for documenting and recording trades lay with the two parties involved. Standard documentation has been developed by a trade body, the International Swap Dealers Association³ (‘ISDA’). This reduced the burden of this process and assisted in the standardisation of trading terms⁴.

Recent years have seen an elaboration of this process as market infrastructure and trade reporting developed, but the OTC market still remains fairly close to these roots in bilateral trading⁵.

1.1.2 Market participants

The parties trading derivatives are often divided into dealers and end users. Dealers (who are often large financial institutions) make markets in OTC derivatives. They advertise standard products, create new forms of transaction, and respond to client requests for solutions to risk management problems. A substantial fraction of OTC derivatives trading is concentrated in a group of 14 large dealers known as the G14 (the ‘G’ for ‘Global’).

The class of end users includes corporates, investment managers (such as pension funds and hedge funds) and governments. Typically this group uses OTC derivatives either to hedge risk or to take it outright. For instance, a corporate might enter into an interest rate swap to hedge risk on a bond issue, or a pension fund might invest in an equity index by purchasing a call option.

1.1.3 OTC derivatives and counterparty credit risk

Counterparty credit arises whenever we are owed money⁶ in the future by a party who might not pay us. The causes of that failure to pay may be simple unwillingness⁷ or more likely it will be inability, for instance due to bankruptcy. All that matters is that there is a risk that we might not get paid.

Figure 1.1: Depicting a promise made via a derivative

OTC derivatives involve an agreement between two parties, and hence it is highly likely that they will involve counterparty credit risk. If A and B are counterparties to each other in an OTC derivatives transaction, then typically either A will pose counterparty credit risk to B; or B to A; or both. We will depict a promise made by A to B via an OTC derivative as in figure 1.1.

Various derivatives create different degrees of counterparty credit risk, alone and in combination. In the rest of this section we examine some common simple situations.

1.1.4 The promises made in plain vanilla options

If I sell a plain vanilla call option, I receive the premium from my counterparty at the beginning of the transaction⁸. I have further obligations to them if the option is exercised when it is in-the-money; but they have none to me. Therefore from my perspective there is no credit risk in selling a plain vanilla option.

The reverse pattern is seen with purchased options. Here we have paid for a promise: the promise that the option writer will give us the required sum if the o...

Table of contents

• Cover
• Title
• Introduction
• 1 Over-The-Counter Derivatives
• 2 The Counterparty Relationship
• 3 The Valuation and Risk of OTC Derivatives
• 4 The Role of OTC Derivatives in the Crisis
• 5 Regulatory Responses to the Crisis
• 6 OTC Derivatives Central Clearing
• 7 The Emerging OTC Market Infrastructure
• 8 Risks in OTC Derivatives Central Clearing
• 9 Design Choices in Central Clearing and Their Consequences
• 10 The Aftermath of Mandatory Central Clearing
• Index