Central Counterparties

Mandatory Central Clearing and Initial Margin Requirements for OTC Derivatives

Jon Gregory

• Publisher: Wiley
• Year: 2014
• Print ISBN:
  9781118891513
• Edition: 1
• eBook ISBN:
  9781118891582
• Topic: Business
• Subtopic: Finance
• Index: Business

Practical guidance toward handling the latest changes to the OTC derivatives market

Central Counterparties is a practical guide to central clearing and bilateral margin requirements, from one of the industry's most influential credit practitioners. With up-to-date information on the latest regulations imposed after the global financial crisis, this book covers the mechanics of the clearing process and analyses the resulting consequences. Detailed discussion explains the ways in which the very significant clearing and margining rules will affect the OTC derivatives market and the financial markets in general, with practical guidance toward implementation and how to handle the potential consequences.

Over-the-counter derivatives were blamed by many for playing a major role in the 2007 financial crisis, resulting in a significant attention and dramatic action by policymakers, politicians, and regulators to reduce counterparty credit risk which was seen as a major issue in the crisis. The two most important regulatory changes are the mandatory clearing of standardised OTC derivatives, and the requirements for bilateral margin posting in non-standard OTC contracts. Central Counterparties is a complete reference guide to navigating these changes, providing clarification and practical advice.

• Review the mitigation of counterparty credit risk with the historical development of central clearing
• Clarify the latest regulatory requirements imposed by Dodd-Frank, EMIR, Basel III and more
• Learn the mechanics of central clearing, with special attention to complex issues such as margin calculations, the loss waterfall, client clearing and regulatory capital rules
• Gain insight into the advantages and disadvantages of clearing and bilateral margin requirements, and the potential issues that arise

As the clearing and margining mandates are phased in, the associated costs will be severe enough to dramatically shift the topology of the financial markets and transform the nature of risk. Central Counterparties provides the information, clarification and expert insight market practitioners need to get up to speed quickly.

Part I

Background

Chapter 1

Introduction

What we know about the global financial crisis is that we don’t know very much.

Paul Samuelson (1915–2009)

1.1 THE CRISIS

In 2007, a US housing crisis led to a credit crisis, which caused the failures of large financial institutions and a severe economic downturn. The aftermath of the ‘global financial crisis’ (GFC) is still being felt across the general economy, and has led to significant changes in the functioning of financial markets and the way in which financial institutions are regulated. The GFC highlighted the importance of controlling risk in over-the-counter (OTC) derivatives to maintain global financial stability. Whilst OTC derivatives did not cause the GFC, they likely contributed to amplifying various problems and provided channels for systemic risk to propagate.

A derivative trade is a contractual relationship that may be in force from a few days to several decades. During the lifetime of the contract, the two counterparties have claims against each other such as in the form of cashflows that evolve as a function of underlying assets and market conditions. Derivatives transactions create counterparty credit risk (counterparty risk) due to the risk of insolvency of one party. This counterparty risk in turn creates systemic risk due to derivatives trading volume being dominated by a relatively small number of large derivatives counterparties (‘dealers’) that are then key nodes of the financial system. Counterparty risk refers to the possibility that a counterparty may not meet its contractual requirements under the contract when they become due. Counterparty risk is managed over time through clearing: this can be performed bilaterally, where each counterparty manages the risk of the other, or centrally through a central counterparty (CCP). Historically, bilateral clearing is far more dominant for OTC derivatives.

During the GFC, authorities had to make key decisions over large failing financial institutions such as Bear Stearns, Lehman Brothers, the Royal Bank of Scotland and AIG. These decisions were made with a very opaque view of the situation the firms were in and the potential knock-on impact of any choices made. One of the reasons for the opacity was the large volume of bilateral OTC derivatives contracts on the balance sheets of such large financial institutions. Bilateral OTC derivatives are essentially private contracts that may be illiquid and have non-standard or exotic features. A key concern over the global OTC derivatives market has always been systemic risk, which in this context refers to financial system instability exacerbated by the distress of financial institutions. In the context of the GFC, systemic risk arose due to the failure of large financial institutions and the resulting domino effects.

Bilateral OTC derivatives were clearly in the eye of the financial storm from 2007 onwards, and the creditworthiness of financial institutions and counterparty risks between them clearly contributed to the ongoing crisis. The large web of OTC derivatives positions between banks and other financial institutions suddenly became a major issue as the creditworthiness of such institutions worsened. For example, American International Group (AIG) exploited its strong credit rating to sell protection via credit default swaps (CDS). When AIG could not post additional collateral (referred to hereafter as ‘margin’) and was required to provide funds to counterparties in the face of deteriorating reference obligations in the CDS, the US government bailed them out. Politicians and regulators were concerned that default of AIG would ripple through the counterparty chains and create a systemic crisis. This led to the view that counterparty risk and the interconnectedness of large financial institutions was a channel of contagion that could amplify and transmit financial shocks.

One particular problem in relation to counterparty risk in OTC derivatives is the close out process. When a party to a contract defaults, their counterparties typically need to terminate and replace the underlying trades. In the aftermath of a large default, the OTC derivative replacement process can be associated with market illiquidity and large volatility of prices during a scramble to replace trades. Such problems were clearly illustrated in the Lehman bankruptcy and are a key reason behind some financial institutions being ‘too big to fail’.

In contrast to OTC derivatives, the derivatives market that was cleared via central counterparties (CCPs) or ‘clearinghouses’ was much more stable during the GFC. CCPs such as LCH.Clearnet coped well with the Lehman bankruptcy when virtually every other element of the OTC derivative market was creaking or failing. One of the reasons for this is that, unlike most market participants, they had actually envisaged and prepared for such a situation. Hence, whilst CCPs still experienced problems (such as identifying the positions of Lehman’s clients), they were able, with help from their members, to transfer or close out a large volume of Lehman derivatives positions without major issues. Indeed, within a week of Lehman’s bankruptcy most of their outstanding OTC-cleared positions had been hedged, and within another week most of their client accounts had been transferred. Centrally cleared OTC derivatives were seemingly much safer than their bilateral equivalents.

1.2 THE MOVE TOWARDS CENTRAL CLEARING

In the aftermath of the GFC, policymakers (not surprisingly) embarked on regulatory changes that seemed largely aimed at moving risk away from global banks, and the dangerous bilateral OTC derivatives market. This seemed to be driven generally by the view that the size, opacity and interconnectedness of the market were too significant. One aspect of these policy changes were greater bank capital requirements for OTC derivatives, hardly surprising given the seemingly high leverages and accordingly low capital bases of stricken banks. Another aspect was in relation to mandatory central clearing for certain products, with CCPs seemingly emerging as a panacea for financial markets’ stability. For example:

How do we establish good regulatory structure without destroying the incentive to innovate, without destroying the marketplace? We agree that we need to improve our regulations and to ensure that markets, firms, and financial products are subject to proper regulation and oversight. For example, credit default swaps – financial products that ensure against potential losses – should be processed through centralized clearinghouses.

George Bush, 15 November 2008.

As a part of financial reform, important legislative changes with respect to the OTC derivatives market were introduced. In September 2009, G20 leaders agreed that all standardised OTC derivatives would, in the future, need to be cleared through CCPs. This was done with the belief that a CCP can reduce systemic risk, operational risks, market manipulation and fraud, and contribute to overall market stability. It is interesting to note that the original push towards central clearing seemed to be much lighter. The G20 meeting in 2008 defined a regulatory goal to be:

Strengthening the resilience and transparency of credit derivatives markets and reducing their systemic risks, including by improving the infrastructure of over-the-counter markets

G20 declaration, Washington, November 2008

Less than a year later, the clearing mandate was clear and the focus on credit derivatives had expanded greatly to cover potentially all OTC derivatives:

All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements. We ask the FSB [Financial Stability Board] and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.

G20 declaration, Pittsburg, September 2009

The Dodd–Frank Wall Street Reform and Consumer Protection Act enacted in July 2010, and the European Market Infrastructure Regulation (EMIR) proposed in September 2010 were legislative responses to this call for a new regulation of OTC derivatives markets. Key parts of both Dodd–Frank and EMIR were formal legislative proposals that all standardised OTC derivatives should be cleared through CCPs.

In the period since the G20 agreement on mandatory clearing, the scale and complexity of the task has gradually emerged. The requirement to clear a large fraction of OTC derivatives that are more complex and illiquid than existing cleared products is far from trivial. Furthermore, the number and variety of OTC derivative users represents a massive challenge for CCPs, who will have to develop the capability to clear new OTC derivatives and develop their offerings in the area of client clearing (where CCP ‘clearing members’ clear trades on behalf of clients). The case of client clearing gives rise to many important questions such as where the risk lies in the CCP–clearing member–client chain. Additional problems arise around the possible fragmentation of regulatory regimes globally, leading to potential arbitrages. Questions have also been raised regarding the systemic and operational risks represented by a large ‘OTC CCP’. CCPs may also need to develop linkages with each other to be ‘interoperable’, leading to the question of the increased risk that may arise out of such connections.

1.3 WHAT IS A CCP?

Clearing is a process that occurs after the execution of a trade in which a CCP may step in between counterparties to guarantee performance. The main function of a CCP is, therefore, to interpose itself directly or indirectly between counterparties to assume their rights and obligations by acting as buyer to every seller and vice versa. This means that the original counterparty to a trade no longer represents a direct risk, as the CCP to all intents and purposes becomes the new counterparty. CCPs essentially reallocate default losses via a variety of methods including netting, margining and loss mutualisation. Obviously, the intention is that the overall process will reduce counterparty and systemic risks.

CCPs are not a new idea and have been a part of the derivatives landscape for well over a century in connection with exchanges. An exchange is an organised market where buyers and sellers can interact to trade. Central clearing developed to control the counterparty risk in exchange-traded products, and limit the risk that the insolvency of a member of the exchange may have. CCPs for exchange-traded derivatives are arguably a good example of market forces privately managing financial risk effectively. The two clearing structures, bilateral and central, share many common elements such as netting and margining but also have fundamental differences. The fact that neither has become dominant suggests that they may each have their own strengths and weaknesses that are more or less emphasised in different markets.

CCPs provide a number of benefits. One is that they allow netting of all trades executed through them. In a bilateral market, an institution being long a contract with counterparty A and short the same contract with counterparty B has counterparty risk. However, if both contracts are centrally cleared then the netted position has no risk. CCPs also manage margin requirements from their members to reduce the risk associated with the movement in the value of their underlying portfolios. CCPs also allow loss mutualisation; one counterparty’s losses are dispersed throughout the market rather than being transmitted directly to a small number of counterparties with potential adverse consequences. Moreover, CCPs can facilitate orderly close out by auctioning off the defaulter’s contractual obligations with netting reducing the total positions that need to be replaced, which reduces price impact. A well-managed centralised auction mechanism can be liquid, and result in smaller price disruptions than uncoordinated replacement of bilateral positions during periods of pronounced uncertainty. CCPs can also facilitate the orderly transfer of client positions from financially troubled intermediaries. The margins and other financial resources they hold protects against losses arising from this auction process.

The general role and mechanics of a CCP are:

• A CCP sets certain standards for its clearing members.
• The CCP takes responsibility for closing out all the positions of a defaulting clearing member.
• To support the ab...

Table of contents

• Cover
• Half Title page
• Title page
• Copyright page
• Dedication
• Acknowledgements
• Part I: Background
• Part II: Counterparty Risk, Netting and Margin
• Part III: Structure and Mechanics of Clearing
• Part IV: Analysis of the Impact and Risks of Central Clearing
• Glossary
• References
• Index