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Moving the OTC Derivatives Market to CCPs

Journal 34: Cass-Capco Institute Paper Series on Risk

Manmohan Singh

Recent regulatory efforts, especially in the U.S. and Europe, are aimed at reducing moral hazard so that the next financial crisis is not bailed out by tax payers. This paper looks at the possibility that central counterparties (CCPs) may be too-big-to-fail entities in the making. The present regulatory and reform efforts may not remove the systemic risk from OTC derivatives but rather shift them from banks to CCPs. Under the present regulatory overhaul, the OTC derivative market could become more fragmented. Furthermore, another tax-payer bailout cannot be ruled out. A reexamination of the two key issues of (i) the interoperability of CCPs, and (ii) the cost of moving to CCPs with access to central bank funding, indicates that the proposed changes may not provide the best solution. The paper suggests that an appropriate levy/tax on derivative liabilities could make the OTC derivatives market safer, rather than the present regulatory push to CCPs.

In the aftermath of Lehman and AIG, regulators, especially in the U.S. and Europe, have focused on reducing the risks in the credit-default-swap (CDS) market, initially, and subsequently in the overall over-the-counter (OTC) derivatives market. In order to achieve their objectives, the regulatory bodies require all – subject to some exceptions – users of derivatives to post the requisite margins so that there is no under-collateralization in this market. Recent surveys [BIS, 2011] have shown that this U.S. $600 trillion OTC derivatives market is seriously under-collateralized and thus contributes to systemic risk. However, recent studies have shown that the associated demand for additional collateral to satisfy the envisaged regulatory efforts will be onerous [Singh (2010); Oliver Wyman (2011)]. Thus, the regulatory effort(s) are meeting resistance from the financial services industry. Another group that is lobbying to avoid posting collateral are the “end-users,” who (presumably) are genuine hedgers and thus do not contribute toward the systemic risk stemming from the use of OTC derivatives. This article provides an overview of the OTC derivatives market and the associated drawbacks in the proposed regulatory initiatives that continue to unfold.

The financial crisis following Lehman’s demise and AIG’s bailout has provided the impetus to move the lightly regulated over-the-counter (OTC) derivative contracts from bilateral clearing to central counterparties (CCPs). The debate about the future of financial regulation has heated up as regulators in both the U.S. and the European Union seek legislative approval to mitigate systemic risks associated with systemically important financial institutions (SIFIs) that include large banks and non-banks such as hedge funds. In order to mitigate systemic risk that is due to counterparty credit risks and failures, either the users of derivative con-tracts will have to hold more collateral from bilateral counterparties, or margins will have to be posted to CCPs.

There are several initiatives to move the systemic risk from SIFIs’ derivative books to CCPs, including the Dodd Frank Act in the U.S. and proposals by the European Union that are pending legislative approval. However, there has been very little research that looks at the overall costs to SIFIs of offloading derivative contracts to CCPs. Much of the initial discussion and research [Barclays (2008); ECB (2009)] on risks associated with derivatives was focused on credit derivatives (or the CDS market), which now represents only about 6 percent of the overall notional OTC derivatives market, as reported in Bank for International Settlements (BIS) data. 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 $583 trillion at the end of June, 2010. These include foreign exchange (FX) contracts, interest rate contracts, equity linked contracts, commodity contracts, and credit default swap (CDS) contracts.

Furthermore, especially in the present Basel III’s regulatory environment, the demand for high quality collateral has increased significantly, while the supply of collateral has been reduced due to the hoarding of (unencumbered) collateral by SIFIs as reserves.

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