La metodología para el mejoramiento, ciclo PHVA

OTC derivatives are bilateral agreements to hedge risks or bet on prices. They are taylor- made and there was little regulation in the past. This lead also to lack of transparency about the counter parties. Since these markets grew heavily in the near past the lack of information led to uncertainty about the risks of these markets for the counter parties

but also for the whole financial system, see Figure 1.25 for the size of the markets. If

one assumes a notional amount of about 600 trillion USD in the OTC markets and if one compares this figure with the world wide GDP of about 55 trillion USD one might wonder about the rationale why for each dollar GDP there exist 11 dollars of protection transactions. 0 100 200 300 400 500 600 700 800

Jun 98 Jun 99 Jun 00 Jun 01 Jun 02 Jun 03 Jun 04 Jun 05 Jun 06 Jun 07 Jun 08 Jun 09 Jun 10

Other contracts Interest rate contracts Credit default swaps

Figure 1.25: The size of the OTC derivatives market in terms of notional amount outstanding

(USD trillion).Source: BIS (2011)

The size in these markets is a poor risk figure since several risk mitigating meth- ods exist. The most prominent are the Master Agreement and Credit Support Annex (ISDA). These agreements reduce counter party risk in the bilateral trades. Major in- struments in doing these are netting agreements and collateralization. Although this is effective on a bilateral level due to the privacy of the trades (i) it is not transparent from a system point of view and (ii) it does not provides a global view on the whole network of interlinked counter parties. Due to this lack of reporting and supervision a problem of undercollateralization can occur. A prominent example was AIG which served as pro-

tection seller for many investment banks, i.e. AIG obtained a premium from the banks in exchange of credit protection by AIG if the reference entities default. AIG faced a liquidity crisis due to a downgrade of its rating. Such a downgrade forced AIG to post additional collateral with its trading counter parties. Furthermore the credit protection sold lost in value since the market for CDOs (Collateralized Debt Obligations) were quasi evaporating. This led to a first bailout by the FED. There were others to follow with a total amount of 182 Billion USD. The first of bailout is an example of risk structuring and risk transfer. The FED created an 85 billion credit facility in exchange for the issuance of a stock warrant to the Federal Reserve Bank for 79.9% of the equity of AIG. Hence, the FED exchanged credit and market risk. It took the credit risk of AIG in exchange for a future participation in the firm value.

A main requirement to reduce some the mentioned risks in OTC transactions is to

clearthe contracts via acentral counter party (CCP). The idea is that the contracts are no longer between say two investment banks but between each investment bank and

a clearing house. This has the following consequences:36

• Standardized OTC derivatives (interest and credit derivatives, the clearing of FX

contracts is an open issue) are traded on exchanges or electronic platforms.

• The contracts are cleared, i.e. the clearing house applies the margin process. Figure

1.26shows the logic of client clearing.

This means that on a daily basis difference in value of the contracts are settled. Using such a procedure it is not possible that positive or negative value accumulate over time. From a risk perspective OTC trades are only partially secured. In the future trades will be overcollateralized and all clearing members are liable to a certain extend if clearing members default. More precisely, the ’risk waterfall’ method applies. A CCP has a multi-layer capital structure to protect itself and its members from losses due to member defaults. The following types of collateral will be held (we follow Arnsdorf (2011), Pirrong (2009) and ZKB (2012) in the sequel):

– Variation Margin: Variation margin is charged or credited daily to clearing

member accounts to cover any portfolio mark-to-market (MtM) changes.

– Initial Margin: Initial margin is posted by clearing members to the CCP.

This is to cover any losses incurred in the unwinding of a defaulting member’s portfolio. Typically the margin is set to cover all losses up to a pre-defined confidence level in normal market conditions.

– CCP Equity: A CCP will have an equity buffer provided by shareholders.

36

The consequences meet the statement of the G20 in their Pittsburgh Summit 2009: ’All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appro- priate, and cleared through central counter parties 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.’

Client Bank

Client Clearing Broker

(Bank)

Execution Broker

ISDA CSA

Client Clearing Agreement: Clearing ISDA, - CSA

Deed of Assignment

Execution Agreement

Figure 1.26: Client clearing under the existing ISDA and CSA setup and under the new clearing

– Default Fund (funded): Every member contributes to the clearing house de- fault fund. This acts as a form of collective insurance for uncollateralised losses.

– Default Fund (unfunded): Each clearing member is usually committed to

providing further funds if necessary. The maximum amount of additional

funds that can be called upon depends on the CCP. In some cases the liability is uncapped.

• Clearing the OTC contracts via a clearing house changes the bilateral random

network topology of all contracts to a star shaped one.

Participants in the OTC markets have three options: They can do nothing which means that they will stop to use say interest rate swaps. They can evaluate a clearing broker. This requires to invest into updating collateral risk management, accounting workflows and the redefinition of backoffice post trade workflows. The third alternative is to become a member of a clearing house. This allows for large flexibility to offer client clearing. Be- sides investment costs to change workflows one has also to consider the amounts payable into the default fund. To understand the alternatives, we consider them in an example regarding capital requirements. This example is an extension of an example developed by ZKB, 2012. The regulatory capital charge for OTC derivatives increases since bilateral OTC derivative contracts have to satisfy the Credit Value Adjustment (CVA) require- ments and the risk weights of cleared OTC derivatives increase from 0% to 2% . Cleared transactions will receive lower risk weights and can abstain from CVA if portability is given with a high probability. It is not yet defined what ’high probability’ means. We consider the following portfolio of CHF-IRS.

Notional TtM Add On NPV EAD

500 9m 0% 5.03 5.03

700 4y 0.5% -20 -16.5

400 10y 1.5% 40 46

The currency figures are in million CHF. The EAD is calculated using the standard- ized approach, i.e.

EAD=Notional x Add On + NPV .

The portfolio has a credit equivalent after netting is 32 Mio. CHF. With a rating of AAA to AA- this gives the 8% capital charge of 512’000 CHF. A lower rating of A+ to BBB- gives in the standardized approach the amount of 1.28 Mio.CHF. The nominal weighted TtM is 4.5 years. For a rating of AAA to AA the CVA capital is 2.3 Mio. CHF and 2.7 Mio. for a A rating.

If one clears the portfolio collaterization applies. The clearing client pays an initial margin of 4 Mio. CHF and receives a variation margin of 25.03 Mio. CHF. The capital requirements ...

• using two clearing brokers is 17’500 CHF by applying the risk weight of 2 percent.

• using a single AAA clearing broker is 175’000 CHF by applying the risk weight of

20 percent and the minimal CVA capital requirements are 510’000.

• using a single A clearing broker is 440’000 CHF by applying a risk weight of 50

percent and the minimal capital requirements for the CVA are 582’000 CHF.

This calculation shows the trade off between capital costs and costs for a second clearing broker. CVA should be part of the trade valuation but calculated separately because of portfolio effects. If one uses cleared OTC the risk weights increase from zero to 2 percent.

Pirrong (2009) shows the following effects of CCPs:

• In conditions of complete information, a CCP can improve welfare by allocating

default losses more efficiently than in a bilateral network. A CCP can reduce the frequency and severity of default losses that hedgers suffer in these high marginal utility states, thereby improving welfare. The formation of a CCP also affects equilibrium prices, quantities, and profits.

• ’A CCP affects the distribution of default losses among market participants. Net-

ting effectively gives derivatives counter parting a priority claim on assets of an in- solvent counter party, and therefore transfers wealth from other creditors to deriva- tives counter parties. Moreover, CCPs insure non-members against losses arising from a dealer default, thereby effectively transferring the burden of these losses from non-members to the financial institutions that are members of CCPs.’

• ’Due to the distributive effects of clearing, and its effect on the pricing of de-

fault risk, it is not necessarily true that formation of a CCP reduces systemic risk. Indeed, it can increase systemic risk under some circumstances.’

These results are all based on an economic model. Other approaches such as Duffie and Zhu (2011) show that there is ambiguity to which extend CCPs reduce systemic risk.

OTC regulation applies to banks, insurance companies, asset managers and cor- poartes with large OTC sizes. Pension funds are so far not included. Clearing houses are London Clearing House for interest rate swaps, ICE or CME for credit default swaps. The platforms where OTC trades are executed are so called multibank platforms.

Although bilateral counter party risk is reduced and overall transparency is gained with this initiative some issues are still open. First, the yet scarce resource of collateral will become more expensive due to the overcollateralization. This will make some OTC contracts less attractive.