One of the themes of the analysis of the global crash has been the role of derivatives in magnifying losses. Part of the concern here has been a focus on the scale of the derivatives market, which is measured in trillions of dollars, and its opacity. Because OTC derivatives have tended to be bilateral, private deals between two parties (both of which are often financial institutions), the scale of the risk being run by either individual institutions or the financial system as a whole is almost impossible to quantify.
The solution which many, including most politicians in senior positions in developed market governments, have hit on is to try to use legislation to push derivatives dealing through central counterparties (CCPs), as is the case with securities lending, for example. The thinking here is that CCPs will then have a register of all outstanding derivatives transactions. The task then for regulators who need to ascertain the total derivatives risk being run by any one institution, or by the system as a whole, will be vastly simpler. At the same time, since the CCPs are financed (usually) by their members, they have much deeper pockets than any one institution and have a range of ways of mitigating risk.
The disadvantages of CCPs
In its latest quarterly report, the Bank for International Settlements points out that while the risk of a CCP defaulting is low, it is not zero, and in a very real sense, adding a CCP into the derivatives equation doubles the volume of derivatives being traded. That is an interesting thought for politicians to contemplate. Nicholas Vause, for the BIS, puts the argument thus:
Central clearing doubles the outstanding volume of any OTC derivative to which it is applied. This is because it involves replacing a contract between two counterparties, say A and B, with one contract between A and a central counterparty (CCP) and a second contract between B and the CCP… While central clearing doubles the number of contracts, it does not change the volume of underlying risk that is being transferred by OTC derivatives. If the aim is to measure the size of this risk transfer, then it is appropriate to halve outstanding contract volumes with CCPs. It is also appropriate if the objective is to establish the volume or proportion of contracts in OTC derivatives markets that is centrally cleared.
However, if one is interested in counterparty risk, then the total volume of outstanding derivatives contracts (i.e. without halving the amounts cleared with CCPs) is the relevant figure. Although CCPs are intended to have very low default probabilities, these are not zero. It is therefore necessary to count all contracts to which they are a counterparty, along with all other contracts, when evaluating the total volume of counterparty risk in OTC derivatives markets.
However, in their article on the expansion of central clearing in the BIS quarterly review, Daniel Heller and Vause argue that standardizing derivatives trading through CCPs by 2012 – the current target date – will be a good thing. Bilateral trading of derivatives contains a range of rather nasty risks. These include the possibility of default cascades, as one organisation’s failure knocks over another, which knocks over a third and so on. There is also the very real likelihood that the individual parties are not collateralizing their exposures properly. CCPs will do a better job by bringing standardized processes to bear as they stand between the two parties and take on their respective counterparty risks.
Positive or negative?
According to Heller and Vause, today central clearing covers around 50% of the $400 trillion of outstanding interest rate swaps, easily the biggest category of derivatives trading by volume. It covers only 20-30% of the $2.5 trillion of outstanding commodity derivatives and under 10% of the $30 trillion of outstanding credit rate swaps. These are mind boggling sums, and, as the authors point out, focusing on these figures highlights “the importance of protecting CCPs, which lies at the heart of counterparty networks, against possible counterparty defaults.”
The key to this is for CCPs to ensure that every trade is properly collateralized, but this, of course, makes doing a derivatives deal with a CCP more expensive to participants than doing a bilateral OTC deal. Given the scale of the derivatives market this increase in cost to all participants is non trivial. However, Heller and Vause’s paper argues that by adopting proper margin setting techniques, the expansion of CCP clearing of derivatives can actually reduce the resources needed by both dealers and the CCP. This is a fiercely complicated area, but the experience of CCPs in the related case of securities lending activities suggests that the world will gain, rather than lose, from a greater involvement by CCPs in derivatives trading.
Further reading on OTC derivatives and CCPs:
- Staying in the Dark about Derivatives Will Bring Economic Collapse by Hernando de Soto
- Dangers of Corporate Derivative Transactions by David Shimko
- The new emerging structure for derivatives by Anthony Harrington (blog)
Tags: Bank for International Settlements , BIS , BIS quarterly review , CCP , central counterparty , clearning , Daniel Heller , derivatives , Nicholas Vause , OTC , OTC derivatives , risk