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Consequences of the OTC derivatives reform

The OTC derivatives reform is nearing completion. It is designed to contain derivatives-related credit and contagion risk through standardization, multilateral netting, and adequate collateralization. However, new risks may arise, due to the enhanced importance of a small group of global banks, institutional weaknesses of central counterparties, limited collateral availability, and cyclicality of margins,

“Assessing the macroeconomic impact of OTC derivatives regulatory reforms”, Stephen G Cecchetti [SC]http://www.bis.org/speeches/sp130912.pdf
“Asset encumbrance, financial reform and the demand for collateral assets”, Committee on the Global Financial System, CGFS Papers No 49, [CGFS]
“Remarks at Panel Discussion on OTC Derivatives Reform and Broader Financial Reforms Agenda”, William C. Dudley, President Remarks at the 2013 OTC Derivatives Conference, Paris, France [WD]http://www.newyorkfed.org/newsevents/speeches/2013/dud130912.html
“Four years after Pittsburgh: 
What has OTC derivatives reform achieved so far”, Speech by Benoît Cœuré [BC]http://www.ecb.europa.eu/press/key/date/2013/html/sp130911.en.html

The below are excerpts from these texts. Cursive text and emphasis has been added.

What is the OTC derivatives reform about?

Over-the-counter derivatives trading denotes transactions in contracts related to commodities, financial instruments or other derivatives prices without the involvement of an exchange. The transaction is typically bi-lateral.

“Regulation…failed to keep up with the dynamics in the OTC derivatives markets over the last two decades, which saw an explosion in outstanding contract volumes. Post-trading infrastructures had become increasingly inadequate for coping with the growing volumes and complexity of such trades…In an unprecedented act of international cooperation, the G20 leaders met in 2008 and 2009 in Washington, London and Pittsburgh to coordinate action and address the regulatory gap….In the area of OTC derivatives, the objective was to have all standardised OTC derivatives contracts traded on exchanges or electronic trading platforms and cleared through central counterparties [CCPs]… OTC derivatives contracts were to be reported to trade repositories, and non-centrally cleared contracts subject to higher capital requirements.” [BC]

What does the derivatives reform aim to achieve?

“Counterparty risk can be reduced substantially by moving [derivatives positions] to centralised clearing, with its combination of collateralisation and, especially, multilateral netting. Multilateral netting can compress gross notional amounts by as much as a factor of 10. So, if LTCM [Long-Term Capital Management, default in 1998] had been forced to clear centrally, they might have had about USD150 billion in swaps outstanding, not USD1.5 trillion…[On collateralization] by end-June 2008, AIG [American International Group] had taken on USD446 billion in notional credit risk exposure as a seller of credit risk protection via credit default swaps (CDS). AIG’s un-hedged and largely uncollateralised sales of nearly half a trillion dollars of insurance represented a significant concentration of credit risk in a financial institution that ultimately did not have the cash to meet crisis-related calls.” [SC]

“Firm-level risk management is being strengthened in a variety of ways such as requiring mandatory margin requirements for bespoke, non-cleared trades. Firms need to understand the risks associated with OTC derivatives activity and set aside capital and exchange margin to cover these risks. Moreover, authorities are developing supervisory approaches to oversee market infrastructures and participants to ensure compliance with evolving regulatory frameworks.” [WD]

“The main benefit of the regulatory reforms is the prospect of a lower frequency of financial crises caused by OTC derivatives exposures. The main cost is a reduction in trading activity resulting from higher prices for risk transfer and other financial services.” [SC]

What are drawbacks and risks of the derivatives reform?

(i) Institutional weaknesses

“Central counterparties need to ensure that their direct members meet adequate standards in terms of financial soundness, technical and operational capacity, and product expertise… many market participants will not meet these stringent requirements and will therefore need to access central counterparties indirectly via a direct clearing member…[As a result] the systemic risk concentration in a small number of global financial institutions is further increased and an increasing number of foreign jurisdictions are exposed to risks arising from the potential default of those banks. This aggravates the risk that these financial institutions may act as contagion channels for financial disturbances.” [BC]

“We should recognize that there is a tension between the profit motive of for-profit CCPs [Central Counterparties] and full compliance with the [principles for financial market infrastructures]. Put simply, some CCPs will prefer to avoid the full costs of compliance. In other words, there will always be a risk of a race to the bottom, which we must continually push against.” [WD]

(ii) Collateral availability

“Current estimates suggest that the combined impact of liquidity regulation and OTC derivatives reforms could generate additional collateral demand to the tune of USD4 trillion. At the same time, the supply of collateral assets is known to have risen significantly since end-2007. Outstanding amounts of AAA- and AA-rated government securities alone – based on the market capitalisation of widely used benchmark indices – increased by USD10.8 trillion between 2007 and 2012.” [CGFS]

(iii) Cyclicality of margins

“[A] concern is that requiring market participants to post initial margins and capital to cover the risk of potential changes in counterparty credit quality will destabilise the system as these measures would be procyclical. Here, I would like to stress that this is only true if initial margins and capital requirements related to credit valuation adjustments are set too low initially.” [SC]

(iv) Subordination of other claims

“Critics have argued that, by focusing on derivatives exposures, the Group [Macroeconomic Assessment Group on Derivatives] has ignored the impact of multilateral netting on other unsecured creditors. The main claim is that multilateral netting dilutes other unsecured creditors…However, this is neither new, nor is it unique to derivatives. In fact, repos, covered bonds and any other secured loans result in dilution and subordination.” [SC]

(v) Lack of data and transparency

“Does… the supervisor responsible for the supervision of a large cross-border financial institution at the consolidated level have direct and immediate access to information on OTC derivatives transactions that encompass all transactions entered into by all entities of this group? Is the information accessible, in other words can it be easily aggregated across trade repositories and jurisdictions? My answer would be a clear no!… I see three main issues that have to be addressed. First, information gaps still exist, either due to a lack of or differences in reporting requirements. Second, data are fragmented across trade repositories and jurisdictions. And third, there are still obstacles impeding authorities’ access to data.” [BC]

Costs of the derivatives reforms

“Bank capital requirements…arise from the new CVA [Credit Value Adjustment] charge that will be levied against uncollateralised bilateral OTC derivatives exposures and the new charges against trade and default fund exposures to CCPs. These requirements will likely make banks reduce their leverage and finance more of their assets with equity rather than debt…Additional financing cost [are] the difference between the cost of equity and the cost of debt, multiplied by the dollar value of the additional equity that will be required.” [SC]

“Financial institutions…[must] post additional margin for OTC derivatives – whether because of new requirements for OTC trades or from the reallocation of exposures to central counterparties…This cost…[is] the difference between the cost of funding the purchase of collateral-eligible assets and the interest received when they are posted as collateral, multiplied by the volume of extra collateral that will be needed.” [SC]

“The direct cost of central clearing infrastructure…[is represented by]the known clearing fees and spreads on collateral already levied by major CCPs currently operating.” [SC]


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