Current Issues

OTC derivatives
April 28, 2010 A new market infrastructure is taking shape
International topics

The global derivatives market has expanded enormously in recent

years. Interest rate products (options and futures) have seen a particularly rapid
increase over the past eight years. When volumes peaked in 2007, gross
notional amounts outstanding of over-the-counter (OTC) derivatives amounted
to USD 605 trillion.

A number of structural deficiencies in the market infrastructure of

OTC derivatives were revealed during the financial crisis. Inherent
counterparty risk and its inadequate management, the intransparency and
complexity concerning actual risk exposures, and the danger of contagion, i.e.
the risk of a default of one firm spreading through the financial system, are the
issues that were brought to the collective consciousness in conjunction with the
systemic relevance of these markets.

Traditionally, counterparty risk used to be mitigated between

trading partners by means of bilateral collateralisation. While in
principle collateral can be an effective insurance against counterparty credit
exposure, prevalent market practices such as asynchronous collateral cycles or
incomprehensive collateral coverage resulted in uncollateralised exposures in
the past.

Central counterparty (CCP) clearing is the most immediate way of

addressing these limitations. CCPs also reduce systemic risk, as they
reduce the likelihood of contagion. Hence, regulators in the EU and the US are
pushing for more OTC business to be cleared via CCPs.

Reform of market infrastructure will alter competitive structures in

the industry. Rules on the eligibility of contracts for central clearing,
interoperability of CCPs and ownership of the market infrastructure are issues
set to shape the industry, but are undetermined at the moment.

Regulators should ensure that legislation drafted is commensurate

Author with the risks faced. While transparency and standardisation are objectives
Michael Chlistalla
worth of being promoted, the future of the industry will critically hinge not so
+49 69 910-31732
michael.chlistalla@db.com much on market forces but on the outcome of the regulatory process. Regulation
Editor
must strike an appropriate balance between greater stability and preserving the
Bernhard Speyer benefits of solid, yet dynamic derivatives markets.
Technical Assistant
Sabine Kaiser
Deutsche Bank Research
Frankfurt am Main
Germany
Internet: www.dbresearch.com
E-mail: marketing.dbr@db.com
Fax: +49 69 910-31877
Managing Director
Thomas Mayer
OTC derivatives

Introduction
The recent financial crisis, fuelled in particular by the 2008 collapse
of Bear Stearns, the bankruptcy of Lehman Brothers, and the bail-
out of major derivatives trader American International Group (AIG),
has led to ample discussions among regulators and policymakers in
both Europe and the US about structural improvements to be made
to the financial markets. Already today, it is foreseeable that efforts
to improve the stability and resilience of the international financial
system will cover a variety of aspects: first and foremost, the
effectiveness of banks' own risk management processes and
practices; so-called macro-prudential financial supervision that
monitors systemic risk; reform of capital requirements, resulting in
banks needing to hold more and higher-quality capital; revised
liquidity regulations under an internationally co-ordinated approach;
better market infrastructure that reduces interconnectedness
between individual market participants; and last but not least, strong
supervisory authorities that can monitor compliance, as well as
identify and react in time to emerging risks.
In terms of the structural deficiencies in financial market
infrastructure, it can be stated that whilst over-the-counter (OTC)
derivatives were not a central cause of the crisis, weaknesses in the
design of derivatives markets became apparent. This market’s
complex and opaque nature and the corresponding inability of
regulators and market participants to have a clear view of risk
exposures held increased the systemic risk of contagion and
exacerbated the crisis as some market participants built up
excessive risk positions.
Derivatives have a long-standing history as financial tools for risk
insurance (hedging) and risk acquisition (speculation), thus
providing important risk management and liquidity benefits to
financial institutions as well as to non-financial corporations and
other market participants. Past growth rates of these markets
indicate the intensified desire of both real-economy and financial
institutions to manage risks inherent to their industry or to manage
financial risks stemming from changes in macroeconomic
conditions.
Regulators’ efforts to comprehensively reorganise derivatives
markets threaten to hamper the viability and innovative powers of
these segments. The apparent focus on Credit Default Swaps
(CDSs), which had been singled out for blame for increasing
systemic risk, is particularly unfortunate as this segment constitutes
less than 10 percent of the overall OTC derivatives market, while
other products (such as interest rate or currency swaps) that are by
far more relevant in terms of volume proved robust during the crisis.
In this study, we intend to shed light on the organisation,
shortcomings and merits of derivative markets. This report provides
a brief overview of the size, structure and scope of the USD 600
trillion OTC derivative markets, and also seeks to serve as a guide,
explaining the two most immediate ways of mitigating counterparty
risk: bilateral collateralisation and centralised clearing. An overview
and discussion of the current regulatory initiatives in the US and the
EU aimed at overhauling the financial markets and in particular the
OTC derivatives markets complement this analysis.

April 28, 2010 3

 Current Issues

1. Derivatives and their underlying assets

Compared to cash equity markets, derivative markets differ
Global derivatives market substantially in terms of global volumes, organisation and
Notional amounts outstanding, USD bn,
annual data, OTC vs. on exchange
complexity of trading and post-trading. We therefore provide some
800,000 information on the size of the market, the range of products
700,000 available and the way they are traded. Derivatives may be
600,000 distinguished according to the market in which they trade, the type
500,000 of their underlying, or the contract type, i.e. the relationship between
400,000 the underlying and the derivative product itself.
300,000
200,000 Derivative contracts can either be traded in a public venue, i.e. on a
100,000 (specialised derivatives) exchange, or off-exchange, i.e. directly and
0 privately negotiated between two parties over-the-counter (OTC).
00 02 04 06 08 Today, the OTC market dwarfs exchange trading as the bulk of
OTC On exchange contracts is traded OTC (roughly 90% of the market in terms of
Source: BIS 1 notional amounts outstanding as of December 2008, see chart 1).
As illustrated in chart 1, the global derivatives market had expanded
quickly over recent years, but contracted in 2008 for the first time
since monitoring started in 1998. Chart 2 shows the development of
the on-exchange part of the global derivatives market by traded
instrument segment. Interest rate products (options and futures)
On-exchange derivatives have seen a particularly rapid increase over the past eight years.
Gross notional amounts (USD bn), by When volumes peaked in 2007, gross notional amounts of on-
segment, annual data exchange derivatives amounted to nearly USD 80 trillion. On the
OTC side, notional amounts outstanding of OTC derivatives
100,000 amounted to USD 605 trillion in 2007 (see chart 3). By comparison,
80,000
worldwide annual GDP came to roughly USD 50 trillion in 2006.
60,000
40,000 In terms of evaluating the risks associated with the OTC derivatives
20,000 market, it is important to understand that the reference to gross
0 notional amounts of USD 605 trillion as quoted by the Bank for
00 02 04 06 08
International Settlements (BIS) is a misleading figure. A more
meaningful risk indicator is the gross market value of global OTC
Equity Index Options derivatives, also reported by BIS, which is the total value of all
Currency Options
derivative contracts globally if they had to be closed out and settled
Interest Rate Options
at market value on a specific date (see chart 4). As of June 2009,
Equity Index Futures
this amount was USD 22.5 trillion. Real risk exposure after use of
Currency Futures
netting as a means of reducing counterparty risk is reflected by
Interest Rate Futures
gross credit exposure, also quoted by the BIS, which is just 15% of
Source: BIS 2 the gross market value. As of June 2009, this figure stood at USD
3.7 trillion (International Swaps and Derivatives Association – ISDA,
2010).
OTC derivatives markets are characterised by flexible and tailor-
made products, satisfying the demand for bespoke contracts
OTC derivatives market customised to the specific risks that a user wants to hedge.
Notional amounts outstanding, USD bn, Exchange-traded derivative contracts, on the other hand, are by
annual data definition standardised contracts. Whether a derivative contract is
600,000
standardised or bespoke determines how the market has structured
500,000
the delivery of trade and post-trade chain functions. An important
400,000
300,000
feature of derivatives markets is that while exchange-traded
200,000 derivatives leave a transparent trail in terms of positions, prices and
100,000 exposures, OTC derivatives markets are largely unregulated with
0 respect to the disclosure of information so that information available
00 02 04 06 08 to market participants and supervisors is limited.
Other Commodity The overall derivatives market is based on five major classes of
Equity CDS underlying asset: interest rate derivatives, foreign exchange
FX Interest
derivatives, credit derivatives, equity derivatives, and commodity
Source: BIS 3
derivatives. In conjunction with numerous variants of contract types,

4 April 28, 2010

OTC derivatives

these various underlying assets lead to a cornucopia of available

OTC gross market values product types.
USD bn, semi-annual data
35,000
In the recent political debate on derivatives regulation, much
30,000 attention has been focused on CDSs. However, a very large
25,000 proportion of OTC derivatives had no involvement at all in the
20,000 financial crisis. Interest rate derivatives and FX derivatives, which
15,000 together account for some 80% of all OTC derivatives trades, were
10,000
not found to be contributors to the financial crisis, and of the
5,000
0
remaining 20%, equity derivatives played virtually no part and
commodity derivatives only a small part in the crisis.
H1 05 H1 06 H1 07 H1 08 H1 09
FX Interest Usage of OTC derivatives
Equity Commodity
CDS
In the past, derivatives seem to have been used primarily by
Source: BIS
4
financial institutions. However, demand for derivatives exists in all
industries: A recent ISDA survey reports that 94% of Fortune 500
firms are using derivatives to manage business and macro-
economic risks. Foreign exchange and interest rate derivatives are
the instruments most heavily traded by these corporations.
Non-financial companies primarily Breaking usage down into financial and non-financial companies
use interest rate, currency, and shows that the latter typically use derivatives to help protect the
commodity derivatives ... company from unanticipated events such as adverse foreign-
exchange or interest-rate movements and unexpected increases in
input costs1, as evidenced by the widespread use of interest rate,
currency, and commodity derivatives. For that reason, non-financials
are by and large less involved in equity and credit derivatives.
… while financial companies typically Financial companies (banks, insurers, and diversified financial firms)
engage in all types of derivatives are generally engaged in all types of derivatives and make particular
use of these instruments to mitigate interest-rate and exchange-rate
fluctuations, industry-specific credit risk and equity price risk. Banks
– apart from their role as dealers (see section 3) – use credit
derivatives for managing their loan portfolios.
Chart 5 provides an overview of the use of derivatives by type of risk
covered (the numbers are % of Fortune 500 companies that use
Derivative usage derivatives2). Foreign exchange and interest rate risks clearly
% of Fortune 500 companies, by risk type
dominate.
FX
Amounts outstanding of OTC derivatives by counterparty
Interest rate Derivatives usage in the three largest market segments (interest
rate swaps – IRS, foreign exchange, and equity & commodity
Commodity
derivatives) varies as regards the composition of counterparties (see
Equity chart 6). Statistics from the BIS indicate that of the USD 437.2 trillion
market in single-currency interest rate derivatives, transactions of
Credit
non-financial firms comprise only 9%, while dealer-to-dealer
transactions comprise 34% and other financial institutions’
0 50 100
transactions 57% of the market. In foreign exchange (FX)
Source: ISDA 5 derivatives, transactions of non-financial firms comprise 17% of the
USD 48.7 trillion market, while 39% are dealer-to-dealer
transactions and 44% are other financial institutions’ transactions. Of
the USD 6.6 trillion market in equity-linked and commodity
derivatives, transactions of non-financial firms comprise 10%, while
dealer-to-dealer transactions amount to 40% and other financial
institutions’ transactions to 50% (BIS, 2009).

1
Utilities and companies in basic materials, for instance, typically use commodity
derivatives.
2
The sample includes financial institutions and corporate users.

April 28, 2010 5


Broker:
An individual or firm that charges a fee or
commission for executing buy and sell orders
submitted by an investor.
Dealer:
An individual or firm willing to buy or sell
securities for their own account.
Broker-dealer:
A person or firm in the business of buying and
selling securities operating as both a broker
and a dealer depending on the transaction.
6 April 28, 2010
Current Issues
OTC derivatives by counterparty
Amounts outstanding (USD bn)
100%
38,979 8,442 686
80%
250,069 21,441 3,277 60%
40%
148,150 18,891 2,656 20%
0%
IRS FX Equity & Commodity
Non-financial customers Other financial institutions Reporting dealers
Sources: DB Research, BIS 6
2. Organisation of OTC markets
The organisation of OTC markets has ever and anon and in
particular since the offset of the financial crisis been portrayed in the
public debate as the weak link in financial markets. Given the
extraordinary size of the OTC derivatives markets, the question
arises how these are organised in terms of how contracts are
concluded between market participants.
OTC derivatives markets have traditionally been organised around
one or more dealers who “make a market” by maintaining bid and
offer quotes to market participants (Dodd, 2002). The trading
process of negotiating by phone – nowadays also enhanced through
the use of electronic bulletin boards – is referred to as bilateral
trading because only the two market participants directly observe
the quotes or execution. OTC markets have also adopted electronic
brokering platforms (sometimes referred to as electronic brokering
systems), which resemble electronic trading platforms used by
exchanges as they create a multilateral trading environment. In an
OTC market organised through an electronic brokering platform, the
firm operating the platform acts only as a broker and does not take a
position or act as a counterparty to any of the trades made through
the system (Dodd, 2002). Lastly, composites of the traditional dealer
and the electronic brokering platform have developed in which OTC
derivatives dealers set up their own proprietary electronic trading
platforms. In such “one-way” multilateral platforms3, bids and offers
are posted exclusively by the dealer who upon execution ultimately
becomes the counterparty to every trade.
Thus, OTC markets, which have been known as informally
organised markets in the past, are in fact well-organised market
places noticeably lacking regulatory oversight in comparison to an
exchange (Dodd, 2002).
Individuals or firms may act as either a broker or a dealer. While a
broker merely mediates as an agent between a buyer and a seller, a
dealer takes ownership of an asset as a principal, even if only for an
instant, between a purchase from one party and a sale to another
party. The dealer is thereby exposed to some risk, for which he is
compensated by the spread between the price paid and the price
3
“One way” because only the dealer’s quotes are observable; those of other market
participants might at best be inferred from changes in the execution price.
OTC derivatives

received. Dealers tend to be broker-dealers4 and/or large global

banking institutions.

3. Counterparty risk and limitations of

bilateral collateralisation
One of the most important purposes of the derivatives market is risk
management, i.e. risk redistribution, mitigation, and acquisition – or
in other words, the process of identifying the desired and the actual
level of risk and altering the latter to equal the former. End users,
which can include financial institutions, have specific risk
management concerns that can be mitigated (“hedged”), whereas
other market participants do not necessarily aim to minimise risk but
rather to benefit from the inherently stochastic nature of the market
by taking speculative positions. They aim to profit from the very price
change that hedgers are protecting themselves against. However,
the financial crisis has brought to light many weaknesses in OTC
derivative markets, such as their intransparency, inherent
counterparty risks, or the danger of contagion, i.e. the risk of a
default of one firm spreading through the financial system. To
mitigate such risks, collateralisation and counterparty risk
management are essential practices. This section explores the
classic method for market participants to protect themselves against
the risks inherent from trading derivative contracts, outlining also the
limitations and deficiencies of this practice.
Derivatives contracts bind counterparties together for the duration of
the contract. The duration varies depending on product type and
market segment, ranging from e.g. a few days sometimes in FX
derivatives to several decades for certain interest rate derivative
contracts. Throughout the life of the contract counterparties build up
claims against each other as the rights and obligations contained in
the contract evolve with the price of the underlying the contract is
derived from. This gives rise to counterparty credit risk, i.e. the risk
that the counterparty may not honour its obligations under the
contract. It is difficult to calculate this counterparty risk in view of the
opaque nature of OTC derivatives markets, in particular for parties
outside a certain bilateral transaction and due to the high level of
concentration in the market in terms of participants which leads to a
lack of risk diversification possibilities. The market’s opaqueness is
also critical due to the fact that the price determined in the
derivatives markets may be used to calculate the price of other
instruments, which could spill over to further segments.
In the public debate, the term “bilateral clearing” is frequently used
to describe the bilateral collateralisation of uncleared OTC
transactions. In the following, the more appropriate term “bilateral
collateralisation” will be used. The underlying principle of bilateral
collateralisation is that both parties will mark-to-market (MTM)
contracts so as to monitor the evolution of their residual value.
Should the MTM process show that one party has built up a claim
on the counterparty, it is then entitled to ask its counterparty for
collateral in order to mitigate the risk that the counterparty may not
honour its obligation or may default during the lifetime of the
contract.

4
A person or firm in the business of buying and selling securities operating as both
a broker and a dealer depending on the transaction.

April 28, 2010 7


Further issues relating to bilateral
collateralisation raised by the COM:
— Bilateral collateralisation fundamentally
relies on each party's internal approach to
and method for assessing the current
value of and risk associated with the
constituent components of its OTC
derivatives portfolio.
— Collateral is generally based on mark-to-
market values only. It does not incorporate
the potential cost of replacing the contract
in the market should the original
counterparty default.
— The level of collateral that is effectively
provided often also takes into account the
perceived credit quality of the
counterparty. The crisis has shown that
the reliance on only one single source of
credit rating may be detrimental to the
bilateral collateral model (Paulson 2010).
— Bilateral collateralisation and in particular
each institution’s individual risk
management approach is vulnerable to
competing intra-institutional
considerations, such as the aim to
maximise commercial opportunities and
associated profits. The crisis has
highlighted the difficulty faced by
institutions to uphold a conservative
approach to risk in a competitive market
environment.
— Under bilateral collateralisation,
sovereigns, AAA insurers, corporates and
large banks do not post or mark-to-market
collateral. Those who do post collateral
only meet the threshold as per the ISDA
Credit Support Annex, which does not
mandate a 100 percent coverage.
Source: COM, Singh
8 April 28, 2010
Current Issues
Cash is the dominant source of collateral, amounting to 84% of
collateral received in 2008 and 83% of collateral delivered (ISDA
2009).5 Cash is exchanged on a net basis, i.e. a single net cash
value is calculated for the overall OTC derivative portfolio between
the two counterparties in question. Each counterparty therefore
benefits from cross-margining (i.e. compensation of claims built up
in one derivative market segment by liabilities built up in another).
Government securities are the second source of collateral (9% of
collateral received and 15% of collateral delivered). Other sources
include corporate bonds, letters of credit and commodities.
Collateral is only an effective insurance against counterparty credit
exposure if exposure is calculated frequently and collateral is
effectively exchanged in a timely manner. This is not consistently the
case, so bilateral collateralisation, while essential, may have a
number of potential weaknesses: weekly and even monthly
valuation and exchange of collateral continue to be market practice,
although the collateral cycle should ideally mirror the (daily)
valuation cycle. Collateral coverage is not comprehensive: while
collateral now covers 66% of credit exposure overall, more than
one-third remains uncollateralised. From an operational perspective,
too, bilateral collateralisation is not ideal as it requires the
management of numerous counterparty relationships. The European
Commission (COM) has identified a number of further weaknesses
of bilateral collateralisation (see box).
4. Central Counterparty Clearing
One common practice to reduce counterparty risk in derivatives
markets is “trade compression”, a method of multilateral
consolidation – independent of any central counterparty (CCP) –
where the number of redundant contracts is minimised. Here,
existing trades are terminated and substituted by a far lower number
of new ‘replacement trades’ which have the same risk profile and
cash flows as the initial portfolio, but with less capital exposure.
This practice brings gross exposures closer to the net risk positions
(see Weistroffer, 2009) and improves settlement efficiency.
Moving from bilateral collateralisation to central clearing by using
one or several central counterparties takes this principle one step
further and is the most immediate way of addressing the limitations
cited in the previous section, as CCPs will, for example, require
collateral to be posted by all participants, without exception. CCP
clearing may have significant benefits, but requires a certain number
of market characteristics for it to work.
This section briefly describes the concept of multilateral CCP
clearing and its prerequisites, and addresses issues potentially
arising in multiple CCP environments. We will subsequently
elaborate on four selected aspects of centralised clearing: firstly, the
benefits of CCP clearing for market participants and infrastructure
providers; secondly, the implications for financial stability; thirdly, the
“optimal” number of CCPs per market; and lastly, CCP ownership
structure and supervision.
5
The ISDA Margin Survey tracks the gross amount of collateral, defined as the sum
of all collateral delivered out and all collateral received in by survey respondents,
and does not adjust for double counting of collateral assets. Double counting of
collateral is discussed in Appendix 2 of ISDA (2009).
OTC derivatives

Concept and prerequisites of CCP clearing

When a CCP is involved in the post-trade processes, the single
contract between two initial counterparties that characterises an
OTC trade is executed and replaced by two new contracts –
between the CCP and each of the two contracting parties. This
process is referred to as “novation” if an existing contract is
terminated and replaced by two contracts with the CCP, or as “open
offer” if a contract is concluded with the CCP immediately after the
matching of trading details. The original buyer and seller are no
longer counterparties to each other; instead, the CCP becomes the
buyer to every seller and the seller to every buyer. This structure has
three clear benefits: First, it improves the management of
counterparty risk. Second, it allows the CCP to perform multilateral
netting of exposures and payments. Third, it increases transparency
by making information on market activity and exposures – both
prices and quantities – available to regulators and the public (BIS,
2009).
What is most important for a successful introduction of CCP clearing
to a certain market is that the CCP must be able to mark positions
and to manage counterparty risks. For this purpose, a number of
prerequisites that have also been recognised as relevant by
European policymakers6 have been defined which must be met in
order for CCP clearing to be used:
Standardisation — Standardisation of trade flows throughout the trading and post-
trading chain in order to allow a CCP to step in after a transaction
has been concluded (electronic trade confirmation largely
facilitates this process).
Transparency — Transparency of price discovery venues as to facilitate risk
valuation in mark-to-market processes. CCPs rely on the price
discovery process on liquid, transparent markets for the prices
used to mark positions and to determine collateral; CCPs should
therefore not only been seen as “producers” of transparency, but
also as its consumers.7
Fungibility — Fungibility in order to enable novation and netting. This requires
minimum levels of industry-wide standardisation of the main legal
parameters contained in contracts (varying according to
segment) in order for OTC derivatives to be able to be
transferred between one exchange or electronic trading system
and another (COM, 2009a; CFTC, 2009). The concept of
fungibility allows contracts traded at different locations with
different parties to substitute for one another, provided that they
have identical legal construct and contract specifications.8
Netting through a CCP does have advantages as, in contrast to
bilateral clearing / collateralisation, multilateral clearing (and netting)
yields private and public benefits, for example, via robust and
homogeneous margining procedures that guarantee that the
collateral cycle is in sync with the valuation cycle. In many OTC
derivative transactions today initial margin is negotiated between
dealers and clients, and has commonly been zero in CDS trading. In

6
Cf. COM (2009a).
7
Cf. Pirrong (2009).
8
Because of non-fungibility, market participants that wish to close a position can
only do so by going back to the original counterparty (usually a dealer). This gives
the dealer a certain amount of market and hence pricing power. Market
participants could also achieve the same economic effect by entering into an
opposite position with a different counterparty; while this would effectively eliminate
the risk related to the instrument itself, it would not eliminate counterparty risk: if
one of the counterparties defaulted, the hedge would be undone (COM, 2009a).

April 28, 2010 9

 Current Issues

a centrally cleared market, clearing houses and regulators will

impose initial and variation margin requirements.9 Clearing members
derive economic benefits from the fact that contracts between
different counterparties are made fungible so that they can be offset
against each other, and from a reduced number of counterparties
(ideally only one, the CCP) where they have to deposit collateral.
Thus, central clearing reduces interconnectedness between
counterparties. However, the fact that not everyone can easily
become a member of a clearing house but that clearing member
status is only granted to applicants that meet the necessary
admission criteria restricts the potential multilateral netting benefits
(notwithstanding the fact that such minimum standards can have a
stabilising overall effect). Such minimum requirements may include,
for instance, satisfying minimum capital requirements, being
authorised by the home country banking supervisors or maintaining
an adequately staffed and equipped back office.
Multilateral netting is likely to be more difficult in a multiple-CCP
environment (as opposed to a single-CCP environment) unless
sufficient international coordination takes place. Difficulties mainly
relate to two aspects:
— Issues arising between the CCPs: Generally, all CCPs are
structured differently and their approach to risk management and
thus the risk protection they offer will vary. CCPs typically operate
in a similar, but not necessarily identical, manner when managing
risk; primary risk protection is generally standard amongst CCPs
(see section on CCP risk bearing). However, practical issues
such as payment and collateral timings, legal arrangements,
regulatory oversight, insolvency laws, and most notably the
balance of risks intended to be covered by initial margin and
those covered by the, often mutualised, post-default backing are
often arranged differently in each CCP, so that the exact
approach and the overall risk management framework is typically
different for each CCP (European Association of Central
Counterparty Clearing Houses – EACH – 2008). These risks
must be managed effectively when setting up an interoperability
arrangement between two (or more) CCPs.
— Issues arising between users and CCPs: Multiple clearing
entities present a challenge for users because of the need to
commit collateral to several guarantee funds for separate
clearing houses as well as to meet the connectivity demands of
each of them.
We should point out that netting, in conjunction with CCP clearing,
leads to a redistribution of wealth among a defaulter’s creditors. This
redistribution depends inter alia on the insolvency scheme in force
and on the order of the claims and does not necessarily enhance
welfare.10 Moreover, by transferring counterparty risk to the CCP, the
bank or broker is assuming a new type of risk: mutualisation risk.
This refers to the possibility that in case of a default where the
defaulting member’s initial margin turns out to be insufficient, the

9
Initial margin is intended to cover potential future losses on open positions and is
calculated by taking the worst probable one or two-day loss that the position could
sustain. It can be paid in cash or collateral. Variation margin consists of funds to
cover losses on open positions and is calculated by the CCP using recent market
prices (Wendt, 2006).
10
This hypothesis is exemplified in Pirrong (2009). Under pro rata distribution of the
defaulter’s assets, netting effectively transfers wealth in a default from a defaulter’s
other creditors to its derivatives counterparties.

10 April 28, 2010

OTC derivatives
Risk mitigation and mutualisation of
losses
Positive effect on market liquidity
Increase in operational efficiency
Reduction of operational risk
Improved transparency
April 28, 2010
clearing house is forced to draw on its other members’ default fund
and in extremis to allocate contracts to its non-defaulting members.
Benefits for market participants and infrastructure providers
The benefits and advantages for users of introducing central
counterparty clearing are straightforward given the above discussion
of the limitations arising from bilateral collateralisation. Introducing
CCPs would firstly allow risk mitigation, which has a fundamental
qualitative difference to bilateral collateral provisioning. Risk
mitigation is guaranteed by multilateral netting, by novation/open
offer as well as by robust margining procedures and other risk
management controls performed by the CCP.
Secondly, the introduction of CCP clearing may have a positive
effect on market liquidity: the usage of a CCP for OTC derivatives
may allow a user (clearing member) to free capital for other
purposes, as less collateral should be required, thanks to
multilateral netting, payment netting and possible cross-margining
arrangements. Instead of collateralising with each individual
counterparty bilaterally, with a CCP as the central counterparty, each
clearing member will ideally need to post collateral with the clearing
house only. However, to what extent this advantage materialises will
depend on ex ante conditions: against the background of current
bilateral under-collateralisation and re-hypothecation (i.e. re-use) of
collateral, some maintain that even more collateral may be required
once a (mandatory) CCP starts to systematically and
comprehensively call for collateral to be posted.
A third benefit of CCP clearing is that its introduction may reduce
disruptive information problems by mitigating uncertainty, may
increase operational efficiency through centralisation and may allow
for regulatory capital savings since the CCP is considered a zero-
risk counterparty.
Last, but not least, the CCP model, by its very nature, catalyses and
enforces standardisation of processes and operations, resulting in
significant workflow reforms that provide the opportunity for a
substantial reduction of operational risk: while initially costly to set
up, standardisation brings the opportunity to drive down the potential
cost of errors made by the front office.11
Benefits for financial stability
Central counterparty clearing for derivatives may not only be
favourable for market participants and infrastructure providers, but
may also benefit financial stability in several ways: introducing CCPs
would improve transparency by allowing for central collection of
high-frequency, market-wide information on market activity,
transaction prices and counterparty exposures. The centralisation of
information in a CCP enables market participants, policymakers and
researchers to be provided with the information necessary to better
gauge developments in the positions of individual market
participants in the different market segments (BIS, 2009).
11
According to Dhall (2009), front office operations (especially trade capture /
booking) in OTC derivatives are highly error-prone. A large percentage of errors or
breaks are due to improper trade data and detail capture. Reasons include the
highly subjective nature of trades and the manual use of spreadsheets for booking
trades. Standardisation is likely to reduce operational risk by substantially reducing
the number of errors and thus the per-trade processing cost. Another industry-wide
problem has been the low level of confirmation rates, which are at present near
60%. In contrast, currently operating CCPs provide T+0 confirmations with a
success rate of 90%, which is further strong evidence of the benefits stemming
from the introduction of CCP clearing.
11

Level playing field
CCPs’ “lines of defence” provide
more financial resources to cover
losses from default
Reduction of systemic risk from
LCFIs
12
Current Issues
The introduction of central clearing would create a more level
playing field as identical, non-discriminatory admission to a CCP
would guarantee small banks the same opportunities for access as
large banks. In that sense, a centrally cleared world may lead to an
improved competitive environment for smaller institutions.
Equities CCPs in Europe and the US have typically installed several
“lines of defence” to protect themselves against the negative
consequences of a possible default of a clearing member. These
include membership criteria, daily marking-to-market, the calculation
of initial margin to cover potential future losses in “normal” market
conditions, and in extremis some form of post-default backing to
cover exceptional market events. CCP clearing would entail that
through participants’ margins and default fund contributions more
financial resources were available to cover potential losses in the
event of a participant’s default. Margins are called by the CCP and
posted by the participants to cover the losses incurred should a
participant default. If the margin deposited by the defaulting clearing
member appears to be insufficient to cover the loss of the closing
out of its positions under normal market circumstances, the CCP
can use the contribution to the clearing fund of this defaulting
clearing member to cover the losses in excess of these margins. If
this contribution appears to be insufficient, the CCP may use the
contributions from the non-defaulting clearing members. The final
line of defence comprises other financial resources, like the own
funds of the CCP or the CCP’s contingent claims on parent
organisations or insurers (Wendt, 2006, Bliss/Papathanassiou,
2006).
A dichotomous effect may be anticipated in terms of procyclicality:
on the one hand, more netting should result in less use of collateral,
which would tend to reduce procyclicality. A CCP may involve fewer
downgrade-induced jumps in collateral, as it would require collateral
to be posted by all counterparties, including those that are AAA-
rated; this feature may in turn reduce pressure on markets for the
securities used as collateral. On the other hand, though, because of
their higher frequency in a CCP, centralised and uniform margin
calls (compared with decentralised and less uniform collateral
practices in bilateral OTC markets) could aggravate procyclicality.
By lowering counterparty risk concerns in periods of market stress, a
CCP might help ensure that trading continues in situations in which
bilateral OTC markets might seize up. In addition, introducing CCPs
may reduce systemic risk from Large and Complex Financial
Institutions (LCFI) by partially transferring the risk to an entity, the
CCP, that is better able to bear it and tends to be more capable of
collateralising it and which is – from a regulatory aspect – easier to
monitor and to supervise. In the course of the financial crisis market
participants displayed an aversion to dealing with some LCFIs due
to their counterparty risk. LCFIs’ clients feared that their high-grade
collateral might get stuck in the LCFIs, while LCFIs themselves
locked up collateral in their balance sheets.12 This had negative
implications for global liquidity. With the existence of derivatives
12
Goldman Sachs, for instance, argued in terms of hoarding good quality collateral:
“Our most important liquidity policy is to pre-fund what we estimate will be our
likely cash needs during a liquidity crisis and hold such excess liquidity in the form
of unencumbered, highly liquid securities that may be sold or pledged to provide
same-day liquidity”. Across the entire market, these liquidity buffers amounted to
almost USD 5 trillion of risk capital and balance sheet capacity; considering the
velocity of collateral (which is greater than 1), the adverse impact on global
liquidity was even greater than USD 5 trillion (Singh, 2009).
April 28, 2010
OTC derivatives
One single CCP per derivative class
seems to be optimal …
… but regulators favour competition
April 28, 2010
CCPs, it is likely that systemic risk will be spread to about 10 to15
entities (LCFIs plus CCPs) instead of being borne by the present 6
to 10 LCFIs that currently dominate the OTC derivatives market
(IMF, 2009).
Reasons for little CCP usage
Considering the positive effects from a central clearing
infrastructure, the question arises why CCP usage has not hitherto
become more widespread in OTC derivatives markets. Most likely,
insufficient economic incentives are the main motive: existing rules
allowing firms to treat derivatives processed through a clearing
house as “zero risk” did not apparently provide enough motivation
for the market to introduce CCPs. Incomprehensive bilateral
collateralisation and the possibility to re-hypothecate collateral for
other purposes instead of dedicating and segregating it explicitly to
the purpose for which it was received were apparently stronger
incentives. Possible further reasons include:
— Regulatory requirements for CCPs (e.g. in France and Germany:
the obligation for CCPs to have banking licences; in Italy: the
constraint that prohibits participants in Italian settlement systems
from settling trades on behalf of clearing houses).
— Higher operational costs that arise from putting in place a
margining and collateral management process.
“Optimal” number of CCPs per market
An economically interesting question is the discussion of the
“optimal” number of CCPs per market or market segment: should
clearing be channelled via a single CCP or through multiple CCPs?
In their academic research, Duffie and Zhu (2009) find that
introducing a CCP for a particular asset class, such as credit
derivatives, improves the efficiency of counterparty risk mitigation
and collateral demands, relative to bilateral netting between pairs of
dealers. They show that adding a second CCP for one class of
derivatives such as CDSs can reduce netting efficiency and thereby
lead to an increase in collateral demands and in average exposure
to counterparty default. They therefore conclude that (from a purely
efficiency-based view) whenever it is efficient to introduce a CCP for
a certain class of derivatives, it cannot be efficient to introduce more
than one CCP for the same class of derivatives.
From the perspective of market participants, a single CCP would
make economic sense due to improved efficiency, firstly in terms of
reaping economies of scale and secondly in terms of risk mitigation
and collateral demands (collateral would need to be posted only with
that specific clearing house). However, the common problem of
monopolistic markets in terms of dynamic gains (innovation) arises.
From the perspective of regulators and supervisors, the efficiency
argument in favour of a centralised CCP clearing market structure
has to be aligned with the stability argument which favours a more
competitive, diverse and reliable structure. In times of crisis, a single
CCP would be the single point of failure, putting all market
participants at risk, which must be avoided from a regulatory and
supervisory perspective. If a CCP is successful in clearing a large
quantity of derivatives trades, the CCP is itself a systemically
important financial institution. The failure of a CCP could suddenly
expose many major market participants to losses (Federal Reserve
Bank, 2010).
13
 Current Issues

In order to effectively avoid a “race to the bottom” in terms of risk

management, the European Commission intends to include in its
legislative proposals rules to ensure that CCPs do not employ low
risk management standards (COM, 2009b).This will probably entail
that ESMA13 will be mandated to develop technical standards and
guidelines. Market participants will benefit from high standards to
the extent that compliance with them should result in the lowest
possible regulatory capital charge for counterparty credit risk of
centrally cleared contracts. In general, CCPs should not compete on
price (i.e. the amount of margin required for a particular position),
but rather on the quality of the service offered. An EU directive could
ensure a level playing field for all EU CCPs. Authorisation and
supervision to a specified level will give market participants
worldwide the confidence that such CCPs are robust and well run.
CCP supervision and regulators' Public discussion, though, does not currently seem to be focused on
access to trade data still the number of CCPs per market segment, but rather on the global
undetermined number of CCPs and in particular on the jurisdiction and supervision
under which they should fall. This latter question is of special
importance in the debate on which party might act as a possible
lender of last resort in case of a CCP’s failure (nature of public
support and possible access to central bank credit facilities; see
next paragraph). Access to market-wide OTC derivative contract
information held by CCPs is another issue still undetermined.
Information on OTC trades may be needed by different public and
private entities, depending on their nature and mandate; it may be
recorded by CCPs or specialised “trade repositories” (TRs). The
current debate focuses on the granularity of information (aggregated
vs. trade-level), to whom it should be provided (regulators, market
participants, and/or the general public) and on whether (foreign) TRs
should be mandated to provide trade data to any regulator that has
requested it.
CCP loss bearing and access to facilities of last resort
The public discussion has also focused on how and by whom
potential losses of a CCP should be borne in the case of a defaulting
member, if losses exceed collateral. A clear procedure is needed for
defining a default event, for valuation and for margining. In order to
avoid cross-border distortions, uniform application of standards is
needed across all CCPs handling derivatives. For this purpose, a
working group was set up in July 2009 to review the application of
the 2004 CPSS-IOSCO risk management recommendations for
central counterparties in order to reflect future clearing of OTC
derivatives. Proposals are expected for the first half of 2010,
addressing in particular five issues, namely: conduct of business
and governance, risk standards, legal protection to collateral and
positions, authorisation and recognition of third-country CCPs.
One important but as yet unresolved question is whether CCPs
should have access to central bank credit facilities and, if so, when.
Keeping a CCP liquid in the face of the failure of one or more
participants requires that liquidity be available somewhere.
Currently, however, access to central bank liquidity varies widely
across jurisdictions. The Association Française des marchés
financiers (AMAFI) urges that each CCP should have
intraday/overnight access to central bank money in the currency it
operates in to be in a position to rapidly and securely obtain the
necessary liquidity for it to limit systemic risk (AMAFI, 2009).

13
ESMA: European Securities Markets Authority.

14 April 28, 2010

OTC derivatives

Interoperability of multiple CCPs

Interoperability of CCPs is currently a
major unresolved issue
The European Code of Conduct for Clearing and Settlement, which
is a voluntary self-commitment by the undersigning organisations,
comprises, inter alia, the provision of clearing and CCP services by
clearing houses, CCPs and potentially also central securities
depositories (CSDs). All signatories of the Code must adhere to the
principle of interoperability, i.e. the creation of links between CCPs
to facilitate cross-border clearing and to give traders a choice over
where to send their deals for clearing, rather than being reliant upon
a single monopoly clearer.14 The Code specifically states that “CCPs
should be able to access other CCPs” (see FESE, EACH & ECSDA,
2006).
Pursuant to the Code of Conduct, there are three types of access
and interoperability between CCPs:
1. Standard access: one CCP becomes a normal participant
(member) in another CCP. This means that the market
infrastructure gaining access assumes all rights and obligations
associated with regular participation. However, this may be
inconsistent with the subordinate CCP’s status as a CCP with the
question arising whether it is “fully collateralised” for the
purposes of its users’ regulators for capital requirements
calculation.
2. Data feed access: a CCP accesses a continuous flow of data
from another CCP and/or trading venue that is necessary to
perform the function of a CCP in the market of the other CCP
and/or trading venue in question.
3. Interoperability: two or more CCPs enter into an arrangement
with one another on an equal basis (peer-to-peer relationship)
which involves cross-system execution of transfer orders. This
implies advanced forms of relationships where a CCP does not
generally connect to existing standard service offerings of the
other CCP but where they agree to establish mutual solutions.
Here, the problem lies in the asymmetry in inter-CCP
collateralisation; moreover, there are no internationally agreed
standards for inter-CCP risk management.
A number of issues unresolved up to now are currently preventing
access and interoperability between CCPs: in the wake of the
financial crisis, European regulators are concerned that the creation
of these links could be the source of another systemic crisis. The
worry is that the weakest link in the chain could bring others down if
it were involved in a default and was insufficiently capitalised to
meet margin calls (contagion risk). And even if covered by collateral,
inter-CCP exposures could give rise to liquidity risk, i.e. the risk that
a CCP cannot find the necessary liquidity to cover the collateral call.
Attempting to link together CCPs has proved complex enough in the
case of cash equities, and interoperability for derivatives would
exacerbate the difficulties.15 Besides, while the protection of financial

14
MiFID already gives some access rights in the post-trade area to regulated
markets and to investment firms, and this Code is not intended to contradict any of
those rights.
15
In October 2009, efforts to promote competition between clearing houses in
Europe were stalled by regulators concerned by the risks that such an
arrangement might pose to the wider financial system: The UK’s FSA and the
Dutch regulator AFM had blocked the plans of a three-way link between
LCH.Clearnet, EMCF, and SIX x-clear in light of concerns that such a link might
cause excessive systemic risk. Concerns were prompted by ambiguities about
how clearing houses handle margin and perform risk management between each
other in the event that one clearer fails.

April 28, 2010 15


Inter-CCP Risk Management
Standards
This document (by EACH) states that in a
CCP-to-CCP interoperability scenario (e.g. in
a link between CCPs) the receiving CCP
recognise the requesting CCP as having the
nature and regulatory status of a CCP, not a
risk-taking intermediary. In particular, the
Guideline requires that (i) The CCPs involved
have to arrange an adequate collateralisation
scheme to cover the exposure of potential
losses. (ii) No CCP is obliged to contribute to
the other CCP’s participants’ default fund or
other post-default backing schemes. (iii) A
default of a clearing member at one CCP
should not affect the other CCP unless the
first CCP itself is in default.
Source: EACH
Ownership structure provides
differing incentives for risk
monitoring and risk management
16
Current Issues
stability is the main central bank concern, interoperability is a
medium-term objective that should not be forced. Apart from that,
since the Code of Conduct came into effect it has become apparent
that commercial barriers exist, on account of which incumbent
operators have no interest in accepting link requests that would
jeopardise their established business models.
In July 2008, EACH16 published a documentation of “Inter-CCP Risk
Management Standards” (see EACH, 2008) based on the Code of
Conduct’s Access and Interoperability Guidelines (see box).
CCP ownership structure and governance
A last key topic is the question of the “optimal” ownership structure
and governance of a CCP. Theoretically, five key types of
governance models are feasible for a market infrastructure
institution: the non-profit, cooperative, for-profit, public utility, and
hybrid models (Lee, 2010). Given the potential CCPs have for
ensuring financial stability by reducing systemic risk, the key
question is which governance model best incentivises risk
monitoring and risk management. As the owners of a for-profit CCP
will typically not be its customers, they will not bear the direct costs
of a large-scale clearing failure. Shareholders may therefore not
have as strong an incentive to ensure the financial stability of such
an institution compared with user-owners. In contrast, a CCP under
user ownership and governance – i.e. governed by the underwriters
of the risk taken on by the CCP – has a stronger, reciprocal
incentive (and capability) to monitor and control risks incurred by its
members due to the mutualisation of losses through loss-sharing
rules. It would deliver higher risk and operational efficiency benefits,
setting margins and returns at the right level to reflect users' pricing
of mutual risk.
Majority exchange control or influence over a CCP and profit-
maximising financial models may also raise concerns about the fee
structure as they enable the extraction of supra-normal profits from
customers of the CCP. While acknowledging innovation, dynamic
product development and other benefits of competition provided by
the for-profit models, an exchange-owned CCP might possibly
create a monopoly through the de facto vertical integration with the
exchange’s trading platform where there is no fungibility with
contracts traded anywhere else. On the other hand, a business
strategy characterised by greater innovation and greater associated
commercial and operational risks, than cooperative, non-profit, or
other governance models can enhance a CCP’s risk management
process, for example by improving systems that accelerate
information flow, by establishing an early warning system, or by
implementing real-time risk management (Lee, 2010).
16
EACH: European Association of Central Counterparty Clearing Houses.
April 28, 2010
OTC derivatives

Non-user shareholder control can lead to inefficiencies and high

costs as the risk appetite of external shareholders is different to that
of users. In the case of a profit-maximising entity, this could
theoretically lead to margins being set at too high a level in order to
protect external shareholders from the effect of a failure of the CCP.
Yet, as the limited evidence we have so far shows, the
predominantly user-owned CCP, LCH.Clearnet’s SwapClear, is
much more conservative in the levels of margin it sets for interest
rate swaps than, for instance, the CME, a profit-maximising firm.
The following table illustrates the ownership structure, markets and
products eligible for clearing at selected European equity
clearinghouses.
Against the background of the competing objectives, it is rather
difficult to identify the optimal ownership model and governance of a
CCP. Ultimately, the decision will be taken by the institutions
themselves, in accordance with the regulatory framework that is
currently being drafted by the legislators. We do, however, think that
the underwriters of the risk taken on by the CCP, hence the parties
paying for the safe management of counterparty risk, should at least
have a say in governance and risk steering committees.
Furthermore, market participants should, in principle, be able to own
part of the clearing house.
Supervision of CCPs
The discussion of CCP supervision is another delicate issue. If a
CCP were located in Europe, it would be subject to European rules
and supervision. Supervisors would accordingly have undisputed
and unfettered access to the information held by CCPs. If the CCP
were located outside Europe, EU supervisors would have to rely on

Clearinghouse Ownership structure Markets served Products

86% Borsa Italiana SpA,

Securities, Exchange-traded
14% Unicredit,
CC&G Borsa Italiana markets Derivatives, Emissions
(with Borsa Italiana SpA fully owned subsidiary
Products
of London Stock Exchange Group)

50% Wiener Börse, Securities, Exchange-traded

CCP Austria Wiener Börse
50% OeKB Derivatives,
77% Fortis Bank Global Clearing N.V.,
EMCF 1% Fortis Bank (Nederland) N.V., 7 exchanges and MTFs Equities
22% OMX AB

Securities, Exchange-traded
50% Deutsche Börse AG, DBAG markets, EEX, Irish Derivatives, OTC Derivatives,
Eurex Clearing
50% SIX Swiss Exchange Stock Exchange Emissions Products, Bonds
and Repos

Turquoise, SmartPool, NYSE

EuroCCP 100% Depository Trust & Clearing Corporation Arca Europe, Pipeline Equities
Financial Group Limited
ICE OTC Energy, Energy Futures, OTC
ICE Credit Clear 100% IntercontinentalExchange, Inc.
ICE OTC Credit Derivatives

Securities, Exchange-traded
83% Users, 22 exchanges and other Derivatives, OTC Derivatives,
LCH.Clearnet
17% Exchanges (Euronext, LME, ICE Futures) trading platforms Emissions Products, Freight,
IRS, Bonds and Repos

MEFFClear 100% BME BME markets Securities, Repos

SIX Swiss Exchange,
SIX x-clear 100% SIX Group London Stock Exchange, Securities, Bonds
Liquidnet, NYFIX, Equiduct
Sources: Corporate websites, DB Research 7

April 28, 2010 17

 Current Issues

third country supervision. Currently, supervisory bodies seem to be

Mutual trust is currently still an issue
uncomfortable with third country regulators overseeing systemically
relevant financial infrastructures such as CCPs, especially in times
of market stress. In consequence, it is currently hardly imaginable
that a central bank would provide liquidity to institutions located
outside its currency area.
In order to build mutual trust, the objective of international regulators
should therefore be to establish reasonable structures for cross-
jurisdiction supervisory cooperation to the same extent as structures
for the supervision of cross-border financial institutions have evolved
over time in the past. Once an adequate level of cooperation with
sufficient access to and comfort with the supervising regulator has
been created, a CCP’s location should no longer be an issue. We do
recognise, however, that this will be a politically difficult process.
Clearing houses in Europe are currently regulated by the national
securities regulators in each country. Given the systemic importance
of clearing houses, the European Commission intends to give the
future ESMA (currently the Committee of European Securities
Regulators – CESR) powers to supervise CCPs. This is logical to
the extent that the CCPs in question serve more than one national
market, i.e. constitute a pan-European infrastructure. Even then,
however, the issue arises that, in the event of failure, a CCP may
ultimately fall back on the support of national authorities, as long as
there is no EU-level process for dealing with failed CCPs.
Interim conclusion
The introduction of CCPs alone is unlikely to be sufficient to ensure
that OTC derivatives markets operate efficiently and remain resilient
in the face of major shocks. It is important to complement the
introduction of CCPs with improvements in the trading and
settlement infrastructure. This includes the greater use of automated
trading, registration of all trades in central data depositories, and
enhanced risk management and disclosure requirements for market
participants themselves.
Whether or not to introduce CCPs for OTC derivatives can only be
answered per segment, not for the entire market. CCPs for
derivatives other than CDSs, such as interest rate swaps, have
been in place for a decade, and those for futures and options have,
in some cases, been around for more than a century17 (BIS, 2009).
In the case of FX derivatives, CCPs are not urgent as the most
important risk management function is performed within the CLS
system. This was affirmed by many of the respondents to the COM’s
consultation who pointed out that the FX market is different and that
CCPs are not needed as the main source of risk is the settlement
risk, not replacement risk, and the former is already adequately
covered.

5. Contract standardisation
As outlined throughout this report, the introduction of CCP clearing
for OTC derivatives would be an effective way to mitigate inherent
risks that became apparent in the course of the financial crisis and

17
The Minneapolis Chamber of Commerce established the first modern
clearinghouse for futures in 1891, and other futures exchanges in the United
States adopted clearing in the years between 1891 and 1925. One of the last
futures exchanges to adopt a CCP, the London Metal Exchange, did so only in
1986 (Pirrong, 2009).

18 April 28, 2010

OTC derivatives
Contractual standardisation is
welcomed by market participants …
... while product standardisation is
predominantly rejected
Contract specificities make it difficult
to introduce central trading of
derivatives …
April 28, 2010
in its aftermath. One of the prerequisites that must be met in order to
facilitate CCP clearing is contract standardisation and electronic
processing. The ongoing public debate, fuelled particularly by an
official statement18 from the G-20 Pittsburgh summit in September
2009, has highlighted the perceived importance of standardisation of
derivatives for the purpose of creating a more stable financial
market infrastructure. However, what it is exactly that should be
standardised needs to be specified.
Standardisation can be broken down into: (i) contract uniformity
(standard legal relationships, confirmation agreements,
documentation, market conventions on event handling); (ii) product
uniformity (standard valuations, payment structures, dates); and (iii)
process uniformity and automation (straight-through processing
(STP), matching, confirmation and settlement).
Contractual standardisation (as referred to by the European
regulators) has two dimensions, i.e. the standardisation of the legal
terms of the contracts (e.g. applicable law, dispute resolution
mechanism etc.) and the standardisation of the economic terms of
the contracts (e.g. in the case of CDSs the maturity of the contract,
the coupon to be paid etc.). Over the years, interest rate swaps and
foreign exchange derivatives have become highly standardised
through voluntary industry initiatives. For example, Master
Agreements developed by the ISDA represent the first type of
standardisation. The recent market agreement to use only a handful
of standardised coupon values for European-referenced CDSs is an
example of the second type of standardisation.
Product uniformity, as far as standardising the economic parameters
of the contract is concerned, is widely rejected by market
participants since it would limit hedging possibilities and might result
in a conflict with accounting rules. Technical standardisation, i.e. the
automation of processes, is widely seen as beneficial, but also
comes with set-up costs.
Standardisation – a prerequisite for central clearing and central
trading?
There are a number of practical implications to the desired outcome
of the G-20 Pittsburgh summit, i.e. the reduction of operational and
systemic risk within a meaningful timeframe. In general, we can
state that getting OTC derivatives to be traded on-exchange is
harder than getting them to be cleared centrally: any product traded
on an exchange can be cleared, but the opposite is not necessarily
true.
Regarding standardised derivative contracts, the difference between
how a clearing house can deal with standardised OTC derivatives
and how an exchange cannot do the same must be highlighted: for
instance, a 5-year interest rate swap – the most standard, liquid
OTC interest rate contract available in the market when transacted
today – is a different product tomorrow, when it becomes a 4-year
364 day interest rate swap. It is still the same standardised product
in the eyes of users and of a clearing house, in the sense that it is
simple to value and to risk manage. It is, however, not easy to
18
G-20 leaders had agreed at that meeting that “for improving over-the-counter
derivatives markets, all standardised 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".
19
 Current Issues

create an exchange or order-driven electronic trading platform that

... such that the value of electronic
trading platforms will remain limited
can accommodate this aspect of the OTC derivative markets.
There are an infinite number of interest rate swaps that would in the
eyes of users and according to the capabilities of a clearing house
be treated as standardised and homogenous, but because they
could differ in terms of maturity, coupon, upfront payment, reference
index, and many other terms, it is not possible to trade them or “list”
them on an electronic system or exchange as one would list or trade
an equity or a foreign exchange currency pair. Thus whilst they are
“standardised” and eligible for clearing, they are not suitable for
exchange trading. This same situation arises when considering any
of the OTC derivative asset classes used extensively in risk
management, e.g. interest rates, foreign exchange, commodities.
It is possible to use electronic platforms on a “request for quote”
basis for some products, wherein, using an electronic template, the
client specifies the terms of the structure he is seeking to trade and
then requests a price from one or more market participants.
Because of the nature of the OTC derivative market, where trades
are bespoke, and where bespoke should not be confused with being
complex, the use of such systems will always remain limited.
US regulators are attempting to encourage standardisation
wherever possible and will monitor any attempts at “spurious
customisation”. EACH, however, claims that standardisation itself
does not ensure CCP eligibility, while at the same time a lack of
standardisation does not necessarily dictate ineligibility. The
fundamental requirement for eligibility is that the CCP can manage
the default of a participant, through the implementation of both its
risk management and default management policies, in a way that
controls systemic risk. Some degree of standardisation contributes
to liquidity and price reliability (if there is sufficient demand for the
“standard” offering) but does not guarantee it.

Current level of market standardisation per market segment

Credit Derivatives contracts are governed by an ISDA Master Agreement; euro denominated CDSs are transacted for EUR 5m or 10m of
notional and 5 or 10 years of maturity. CDS on North American names trade with a fixed coupon of 100bp, 500bp or both and without
restructuring. CDSs on European names use fixed coupons of 25, 100, 500 and 1000bp for new trades and 300 and 750bp for
recouponing existing trades.
Interest Rate Derivatives are a mature market and the largest asset class of OTC derivatives, with interest rate swaps (IRS) having the
greatest market share. Due to sufficient standardisation under the ISDA master agreement, CCPs are in place for the interest rate OTC
market. LCH.Clearnet’s SwapClear is the dominant provider of CCP services for IRS, clearing 83-94% of eligible trades. Ineligible trades
are subject to bilateral collateralisation.
FX Derivatives are a large and mature market, which is concentrated in terms of products (top three currencies account for 80% of the
market), and characterised by large-sized trades. Though the FX market is standardised in terms of contract specifications, it is nearly
solely conducted OTC. To deal with cross-currency settlement risks, market participants predominately use CLS Bank’s Continuous Linked
Settlement system which multilaterally nets payments of gross value instructions; the remainder is settled bilaterally.
Equity Derivatives are one of the smallest derivatives segments. It is a relatively young market with very little standardisation. Contracts
are therefore not contractually fungible. As in contrast to CDSs the payout structure is continuous in nature, equity derivatives are easier to
value as observable and tradable market prices exist. CCP clearing exists for exchange-traded equity derivatives; for OTC-traded equity
derivatives, attempts to offer CCP clearing are hampered by various issues, e.g. different treatment of corporate actions by CCPs.
Commodity Derivatives are relatively non-standardised. Several master confirmation agreements and a multitude of market conventions
exist. The market structure is very diverse, with some segments being more standardised and subject to CCP clearing and others being
purely OTC. CCPs exist notably in energy commodities and for listed commodities. Ineligible trades are subject to bilateral
collateralisation.

20 April 28, 2010

OTC derivatives
Both US and EU plan to present their
regulatory strategies in the coming
months
EU policy options for exempting
corporate users:
1. Complete exemption: preferred by
corporate users, but associated with
“significant downsides” (e.g., regulatory
arbitrage);
2. Devising “thresholds” for the intervention
of regulators once “significant imbalances”
build up in the bilateral derivatives market;
3. Using accounting rules to determine
whether companies are speculating in
OTC derivatives.
Option 2 seems to be the most likely policy
outcome; discussion is currently focused on
whether non-financial institutions above a
defined investigation threshold (i) should
explain to the satisfaction of the relevant
supervisor the size, intent and objective of
their activity, (ii) could become subject to the
clearing obligation if their activity exceeds a
specific clearing threshold, or (iii) a
combination of both (i) and (ii).
Legislative proposals in the US:
In August 2009, the Obama Administration
released its proposal, entitled “OTC
Derivatives Markets Act” (DMA). In November
2009, the Senate Banking Committee, led by
Senator Christopher Dodd, introduced a
proposal called “Restoring American Financial
Stability Act” (revised in March 2010). And in
December 2009, the House of
Representatives passed the “Derivative
Markets Transparency and Accountability Act”
(DMTA) as part of the “Wall Street Reform and
Consumer Protection Act of 2009” (H.R.
4173).
April 28, 2010
6. Current regulatory initiatives in the EU
and the US
Against the background of the September 2009 G-20 agreement,
the European Commission's policy, set forth in its Communication
and underlined by the Council, is that the future proposal on post-
trading market infrastructures should focus on these four aspects:
— Ensuring that all CCP-eligible (“standardised”) derivatives
contracts are cleared via authorised (or, in case of third
countries, recognised) CCPs;
— Ensuring transparency via reporting obligations to trade
repositories (TRs) and access to relevant information held by
TRs;
— Ensuring safety and soundness of CCPs irrespective of the type
of financial instruments they process;
— Removing barriers preventing links between market
infrastructures and ensuring the appropriate management of
risks arising from these arrangements.
Initially, the Commission had also considered mandating the
migration of trading in standardised contracts onto organised trading
venues such as regulated markets (i.e. derivatives exchanges) or
multilateral trading facilities (MTFs). Taking into consideration that
this transfer to public trading venues, especially if mandatory, is not
supported by the majority of market participants (see COM, 2009c)
as this would add limited value to CCP clearing combined with the
introduction of TRs and could damage liquidity for some markets,
the Commission now favours a natural evolution over a mandatory
approach.
Current status in the EU: A Commission working group is
consulting with the member states over details of the clearing
obligation, organisational requirements and conduct of business
rules for CCPs, as well as links between CCPs. While it generally
seems agreed upon that all regulated financial institutions should be
subject to mandatory clearing, three options are currently under
consideration by the Commission for exempting non-financial users
(see box). At the same time, the European Parliament’s (EP)
Committee on Economic and Monetary Affairs is preparing a
Parliament Resolution on efficient, safe and sound derivatives
markets, which in its current state differs in certain respects from the
COM’s proposals, e.g. in terms of the obligation for central trading or
the governance of CCPs.
Current status in the US: In the US, where OTC derivatives are
considered to be a current gap in the regulatory system and existing
regulation to be too light or ineffective, three separate pieces of
legislation have been introduced in response to the financial crisis,
which all aim at overhauling the financial system (see box). All three
proposals aim to tighten regulation of the OTC derivatives market;
they have major items in common: subjecting OTC derivatives
transactions to mandatory clearing, mandating trades to be reported
to a TR, requiring derivatives dealers and "major swap participants"
to register with either the Commodity Futures Trading Commission
(CFTC) or the Securities and Exchange Commission (SEC), and
meeting capital and margin requirements such that non-centrally
cleared contracts will be subject to higher capital requirements than
centrally cleared ones. In comparison to the current EU proposals, it
is noteworthy that all proposals in the US maintain that products
21
 Current Issues

required to be cleared must also be executed on a regulated

exchange or an alternative swap execution facility (ASEF), which
includes electronic trade execution and voice brokerage facilities.
Yet, the devil is in the details; hence the three proposals differ in
certain respects, for example in their definition of “rulemaking
regulator” and "major swap participant" and the determination of
clearing and exchange trading, capital and margin requirements,
and position limits.
A number of amendments have been offered to the Dodd bill since
March. After weeks of dispute between Democrats and Republicans,
bipartisan agreement seems to be emerging. We expect the process
of reconciling these amendments into a final compromise bill to last
probably into May 2010. Once the Senate passes the bill (expected
for June / July), reconciliation with the House Bill will be the next
step (Dodd and House proposals differ, inter alia, in terms of pre-
emptive authority for the CFTC and SEC). Passing into law would
then be the last step. Despite various recesses and campaigning in
the run-up to the mid-term elections in November, a finalisation of
the financial refom bill in 2010 seems possible, if the bipartisan
consensus holds up.

7. Economic consequences of
standardisation, on-exchange trading
and centralised clearing
Current regulatory proposals – be they in the US or in Europe – are
likely to result in set-up costs for the industry, the size of which the
European Commission has up to now been incapable of quantifying.
In terms of the impact of current regulatory proposals on bid/ask
spreads, increases in standardisation and transparency can be
expected to lead to tightened spreads. However, concerns may be
justified that costs associated with creating and maintaining the
clearing system – the industry is already heavily building up
capacities to meet the expected resulting demand – will ultimately
be passed on to users.
As things stand today, it is unclear how the proposed regulatory
measure of centralised clearing would impact market liquidity and
functionality: it seems to be the corporate users who are predicting
that volumes will fall. Corporations in general appear much more
pessimistic about the impact of centralised clearing of derivatives on
costs, expecting higher transaction costs due to the requirements to
post margin along with less flexibility as a consequence of the newly
enforced contract standardisation.
“Cost of regulation” discussion in the US
The US non-partisan Congressional Budget Office (CBO) has
calculated that the proposed OTC derivatives reform legislation
approved by the House Financial Services Committee would cost
the US government USD 872 million to implement. The estimate,
based on additional regulatory costs, suggests that the CFTC alone
would have to boost its staffing by 40% to handle this legislation and
the SEC would have to grow by 13%. So far, no official parallel
estimate of the cost of the bill to the industry has been calculated
because too much depends on the precise contents of the final
proposed version of the legislation.

22 April 28, 2010

OTC derivatives

The European Commission announced that an economic impact

assessment will accompany any future policy actions.
Cost-benefit analysis for the industry
While the implementation of the new regulations will lead to costs for
the public sector as discussed above, a severe impact on revenues,
profits and on risk weighted assets (RWAs) of the infrastructure
users (banks) can also be expected.
While the impact on revenues and profits is mainly driven by
expected margin compression and operational costs respectively,
impact on risk weighted assets can be assessed on the basis of
counterparty credit risk being included in the credit risk component
of the bank’s RWA:
Total RWA = Credit Risk + Market Risk + Operational Risk
According to both EU and US legislators’ plans (which are, however,
not yet finalised) it is very likely that (i) less capital will be required
for centrally cleared OTC derivatives while there will be (ii)
increased capital requirements for non-CCP cleared derivatives.
In the first case (if centrally cleared), banks will benefit from lower
RWAs and from a capital relief for those OTC derivatives that are
centrally cleared as there will be no need to hold capital for
counterparty risk. In consequence, higher ROEs should result, and
for the largest banks with high OTC derivative dealer volumes, the
benefit would be significant, so that a minimal direct P&L benefit can
be expected.
In the second case (bilaterally cleared OTC derivatives), higher
RWAs, higher capital requirements, and hence lower ROEs should
result. The higher capital requirements for non-CCP cleared OTC
derivatives may more than offset the capital relief benefits to banks
of centrally cleared derivatives. As regulators and the Basel
Committee have not yet indicated how high the new capital charges
will be, it is not yet ultimately foreseeable how high the incremental
capital charges will be. New capital charges are, however, expected
to be sharply higher in order to create incentives for the migration
toward centralised clearing and the reduction of systemic risk.

8. Conclusions and policy implications

In the aftermath of the recent financial crisis, the enormous growth
rates in OTC derivatives volumes that could be observed over the
past years have increasingly brought the systemic relevance of
these markets to the collective consciousness.
While originally derivatives were thought to have predominantly
been used by financial institutions, a current ISDA survey reveals
that demand for derivatives exists in all industries: a vast majority of
Fortune 500 firms use derivatives to manage business and macro-
economic risks. In this context, foreign exchange and interest rate
derivatives are the most heavily traded instruments.
We illustrated that OTC derivatives market characteristics differ
substantially from those of equity markets. Most significantly, trading
partners are exposed to substantial counterparty risk, i.e. the risk
that one counterparty may not honour its obligation or may default
during the lifetime of the contract. In contrast to equity markets,
counterparty risk in derivatives is much more difficult to measure
and thus to mitigate. This peculiarity is based on the fact that
contracts are more often than not bespoke and that their payout

April 28, 2010 23

 Current Issues

structure in conjunction with the often extensive duration regularly

makes them difficult to value as no observable and tradable market
prices exist. This is why OTC derivatives markets are often referred
to as opaque and intransparent. Trading partners typically mitigate
counterparty risk by means of bilateral collateralisation, a method
that in the past proved to be associated with a number of
weaknesses.
Central counterparty clearing seems to be an effective and efficient
means to address these limitations. EU and US regulators – in
accordance with G-20 leaders – are therefore pushing for increased
usage of CCPs in derivatives markets; both intend to present their
regulatory strategies in the coming months. Rules on eligibility of
contracts for central clearing, interoperability of CCPs and
ownership of the market infrastructure are issues set to shape the
industry, but are undetermined at the moment.
In order to prevent regulatory arbitrage between jurisdictions, we
think that a uniform pan-European regulatory framework should be
developed for CCPs, including high standards for risk management.
This framework and its risk management standards should be
consistent with global standards, in particular with the US. CCPs
should not compete on those standards (i.e. the amount of margin
required for a particular position), but rather on the quality of the
service offered.
Central clearing should not be mandatory for all standardised
derivatives. Certain counterparties (e.g. non-financials) that do not
pose a systemic risk and for whom use of CCPs would introduce
new risks that they are ill-equipped to manage (e.g. management of
liquidity risk), should be exempted. Bilateral risk management
techniques can address risk for these and all non-cleared
derivatives. Generally, eligibility of products for central clearing
should be determined by the members of the CCP who are
mutualising the risk, having considered key characteristics of the
product class in question, the capability of the CCP, and the ability of
major market participants to support the default process.
Market participants should be able to own part of the clearing house.
As the underwriters of the risk taken on by the CCP, they are
strongly incentivised to ensure a CCP is soundly risk managed.
Users have long experience in the risk management of derivatives;
this should be deployed by involving them in governance and risk
committees. Paying for the safe management of counterparty risk by
the CCP (margin, default funds etc.), clearing members have an
incentive to maximise use of central clearing on a safe basis.
The introduction of trade repositories – as proposed by the G-20
leaders – may be a useful measure to provide transparency to
regulators on the market activity in each OTC derivative asset class.
To satisfy the needs of global regulators in the most efficient and
lowest cost manner, regulators should work together to determine a
consistent global legal framework that allows a limited number of
trade repositories to be built (one per asset class) but enables all
regulators to have unfettered access.
Electronic and/or centralised trading does not appear to be
necessary to lower systemic risks in OTC derivative markets. While
recent regulatory proposals in the EU seem to have moved away
from mandating central trading and now target a natural evolution
over a mandatory approach, current US plans are still in line with the
original G-20 recommendation. Admittedly, the advantages of
electronic trading are significant. It improves price transparency,

24 April 28, 2010

OTC derivatives

trade capture, trade affirmation and confirmation and makes it much

easier for the regulators to track and for the participants to ensure
that they are complying with the regulations.
Centrally cleared OTC derivatives could be traded on an electronic
trading platform, either on a single dealer basis or on a multi-dealer
Request-for-Quote basis, but this should not be at the expense of
stopping clients continuing to use voice execution should they so
choose. Reduction of operational risk is achieved by using electronic
confirmation and affirmation tools and Straight Through Processing,
rather than via electronic trading.
Product standardisation, too, is not a pre-requisite for operational
and systemic risk reduction. The goal of electronic
affirmation/confirmation and lifecycle management for substantially
all contracts can be achieved without product standardisation.
Given the level of complexity, the European Commission needs to
take the most appropriate path based on full consultation with the
industry and end users, and ensure that legislation drafted is
appropriate to the risks faced. While US and EU regulators alike are
still sorting out the details of legislative reform, the future of the
industry will critically hinge not so much on market forces but on the
outcome of the regulatory process.
Michael Chlistalla (+49 69 910-31732, michael.chlistalla@db.com)

April 28, 2010 25

 Current Issues

Literature
AMAFI – Assocation Française des marchés financiers (2009).
French Market Position towards the “Draft Recommendations
for CCPs revised for CCPs clearing OTC derivatives”. April
2009.
BIS – Bank for International Settlements (2009). Central
counterparties for over-the-counter derivatives. BIS Quarterly
Review. September 2009.
Bliss, R. and C. Papathanassiou (2006). Derivatives clearing,
central counterparties and novation: The economic implications.
CFTC – Commodity Futures Trading Commission (2009). Remarks
of Chairman Gary Gensler before the Managed Funds
Association. Chicago, Illinois. June 24, 2009.
City of London (2009). Current Issues Affecting the OTC Derivatives
Market and its Importance to London. April 2009.
COM – European Commission (2009a).Commission Staff Working
Paper Accompanying the Commission Communication
“Ensuring efficient, safe and sound derivatives markets”.
SEC(2009) 905 final.
COM – European Commission (2009b). Communication from the
Commission to the European Parliament, the Council, the
European Economic and Social Committee, the Committee of
the Regions and the European Central Bank ”Ensuring efficient,
safe and sound derivatives markets: Future policy actions”.
COM(2009) 563 final.
COM – European Commission (2009c). Summary of the
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Dodd, R. (2002). The Structure of OTC Derivatives Markets. The
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Federal Reserve Bank (2010). Policy Perspectives on OTC
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26 April 28, 2010

OTC derivatives

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Frankfurt am Main.

April 28, 2010 27

 Current Issues
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