RDP 2016-07: The Efficiency of Central Clearing: A Segmented Markets Approach 2. Background

2.1 OTC Derivatives

OTC derivatives are a type of financial contract that are traded bilaterally, rather than on a central exchange.^[3] They are contracts that specify a payment (or stream of payments) based on the value of an underlying reference price at a specified date (or dates). Examples of the prices against which OTC derivatives contracts are written include interest rates, credit spreads, commodity prices, equity prices and exchange rates. These contracts are typically used to hedge risks. For instance: resource companies might use them to manage price risks associated with the commodities they produce; non-financial corporations might hedge the interest rate risk on a bond issue; investment funds might hedge the foreign exchange risk of overseas investments; and banks might hedge the credit of a large syndicated loan. The OTC derivatives market is large and is dominated by contracts that reference interest rates (Figure 1). Much of the volume in the market is trades between banks and other large financial firms that are managing risks arising from other transactions. These risks might arise, for instance, from client-facing OTC derivatives transactions, such as with a non-financial corporation.

Because OTC derivatives are traded bilaterally, market participants face ‘counterparty credit risk’ – the risk that their counterparty will fail to honour some or all of its obligations. Although not limited to OTC derivatives, this risk is particularly hard to diversify in these markets because participants tend to have few counterparty relationships across which they can diversify their counterparty risk, relative to the size of their OTC derivatives positions. There are two reasons for this. First, the market is quite concentrated, and for certain product areas there may be only a limited number of available counterparties. Second, before participants can enter into OTC derivatives contracts, they must negotiate extensive documentation. Establishing and negotiating these trading relationships is expensive and time-consuming, particularly for smaller market participants. Once negotiated, these ‘Master Agreements’ cover all trades subsequently struck between counterparties. This means trading relationships for OTC derivatives are characterised by high fixed costs, but low marginal costs. Further, although private insurance against counterparty credit risk exists in the real world through CDS, these are available only for fairly large institutions. Moreover, the protection buyer is still exposed to the credit risk of the counterparty on the CDS.^[4]

2.2 Central Counterparties

A CCP is an entity that stands between counterparties to help alleviate counterparty credit risk. It does so through novation, where the CCP steps in after a contract is struck bilaterally and becomes the buyer to every seller and the seller to every buyer. In doing so, the original bilateral contract is torn up and the CCP assumes the counterparty credit risk. Although the counterparties are still exposed to the credit risk of the CCP, a CCP is designed to be a stronger credit than a bilateral counterparty.

CCPs ensure their high creditworthiness by using three types of financial resources to protect themselves from the default of their participants: initial margin, which is the collateral initially collected by a CCP and retained in the event of default (and so can be used to meet counterparty payments on the defaulting contract); variation margin, where cash is exchanged to reflect changes in the mark-to-market value of a participant's OTC derivatives portfolio; and a mutualised default fund, funded by all of the CCP's participants.^[5]

Initial margin is the collateral that a CCP collects from participants to protect itself from a participant default. Under international standards, ‘initial margin should meet an established single-tailed confidence level of at least 99 percent with respect to the estimated distribution of future exposure’ (CPSS-IOSCO 2012, p 50).^[6]

Variation margin is a payment that reflects mark-to-market changes in the value of participants' OTC derivatives. It is settled in cash, typically daily – although some CCPs settle intradaily. Because the CCP stands between participants (and does not enter transactions for its own account) the transaction is zero-sum for the CCP: variation margin received from participants with mark-to-market losses is passed to participants with mark-to-market gains.

CCPs also collect financial resources from all of their participants through a default fund. The default fund is used by the CCP if a defaulting participant's initial margin is not sufficient to meet the default losses. CCPs generally contribute some of their own capital to this pool, but the majority comes from participants. Under international standards, this pool must be sufficient to cover the simultaneous default of the CCP's two largest participants in extreme but plausible scenarios.^[7] Participants must contribute to the default fund when they join a CCP. Thereafter, the default fund is resized (and contributions called for) relatively infrequently.

If the default fund is insufficient, the CCP can become insolvent. However, CCPs have additional procedures to prevent insolvency in this case, such as calling for additional resources from surviving participants. These steps are known as ‘recovery’ (for further detail, see Gibson (2013), CPMI-IOSCO (2014) and Heath et al (2015)).^[8]

2.3 Literature

Questions surrounding CCPs and OTC derivatives markets have become an active area of research in recent years. Following work by Allen and Gale (2000) on networks and financial contagion, Jackson and Manning (2007) and Duffie and Zhu (2011) use network models to study how CCPs affect the distribution of risk in OTC derivative markets. A number of papers use a similar methodology, including Heller and Vause (2012), Anderson, Dion and Perez-Saiz (2013), and Heath et al (2013, 2015).

These papers focus on the network of links between participants in OTC derivatives markets and how central clearing can affect system-wide exposures and, indirectly, the collateral required by the system. This literature has taken the initial structure of the network as exogenous, and does not allow for optimising behaviour on the part of traders, or for market prices to be determined endogenously.

An alternative strand of literature has allowed for optimising behaviour on the part of traders with the use of general equilibrium finance models, which typically have a few periods. In these models, one core market failure is incomplete information. Acharya and Bisin (2014) show that opacity in OTC derivative markets can lead to a ‘counterparty risk externality’, overleveraging and socially inefficient default. A centralised clearing mechanism – such as a CCP – that is able to provide information on all participants' positions could resolve this market failure. Similar papers in this vein include Koeppl and Monnet (2008, 2010), who study limited commitment, and Biais, Heider and Hoerova (2012) who study costly monitoring.

Haene and Sturm (2009) is also related. They use a model of CCP risk management to analyse the trade-off between initial margin and the default fund. However, their model is static, and does not allow for: optimising behaviour on the part of traders; welfare analysis; or consideration of the optimal level of central clearing. These are the main contributions of our paper. Carter, Hancock and Manning (2015) also examine what factors influence CCPs' choice risk controls and the role that regulation plays. For a broader survey of the issues surrounding central clearing, including the importance of moral hazard (the focus of our paper), see Pirrong (2009).

Footnotes

However, electronic platforms are becoming increasingly common for some of the very commonly traded OTC derivatives, like US dollar interest rate swaps. [3]

Bilateral margin can also provide partial protection; however, we do not consider it in this paper in order to keep the model simple, and to focus on our key research question. [4]

CCPs also contribute their own equity to the default fund, although this is typically small relative to participant contributions. [5]

The distribution underlying this exposure is modelled by the CCP and is typically based on historical price data. [6]

This requirement only applies to systemically important CCPs; non-systemically important CCPs need to cover the largest single participant. The three OTC derivatives CCPs licensed in Australia all meet the ‘cover two’ standard. [7]

For the rest of this paper, we abstract from concerns about CCP default because it does not change the underlying insights of the model. [8]