class="MsoNormal">We keep hearing that the risk in over-the-counter (OTC) derivatives can be dramatically reduced through centralized clearing facilities. But how would that work?
class="MsoNormal">Clearing facilities mitigate risk by netting out positions and putting collateral behind deals. But when we're talking about current numbers -- $700 trillion in notional values outstanding and $3.7 quadrillion of annual notional turnover in 2010 -- how much collateral is that in dollars?
class="MsoNormal">The World Federation of Exchanges wanted to know that, too, as well as the best way to implement the new rules affecting OTC derivatives. As the representative for regulated stock and derivative exchanges, the WFE could be viewed as looking to advance its own position. But the group's Deputy Secretary General, Peter Clifford, told Institutional Investor on a call from his office in Paris that, "We're not arguing against the OTC market in any way. It's just a question of making it safe." And safety is not a word associated with OTC lately.
class="MsoNormal">Ever since the WFE witnessed the effect that OTC markets had on the financial crisis in 2008, Clifford said, the group has been working on assessing the best policies for the markets and was frustrated in that effort by the lack of "reliable data." Despite the new rules, little has been implemented. "There is still quite a free lunch in the OTC market. They're not posting the collateral -- and getting away with it," Clifford said. Exchanges, on the other hand, have had to put in risk controls not necessarily in use in the OTC markets, he said, "even though during the crisis there was no problem pricing contracts and delivering derivative trades on exchanges."
class="MsoNormal">WFE hired the Tabb Group, an independent financial markets research and strategic advisory firm headquartered in NY to assess where the market is today, by drawing on global market data, but also brokers, banks, and the Bank for International Settlements (BIS), in order to see how some of the new rules should be implemented. "The US is slightly ahead of Europe in rules for financial regulation," Clifford said. "It's important for (the WFE) to see, as a global body and resource to the industry, some coordination and common understanding of the problems."
class="MsoNormal">The WFE assignment fell upon E. Paul Rowady, a senior Tabb analyst with 20 years of experience in capital markets, who produced some eye-popping numbers. "I had sticker shock at first," Clifford said, when he saw the Tabb Group's estimates for the collateral needed to centrally clear OTC derivatives. "But when you look at the overall size of the market you're looking at very big numbers.
"They've already come down on ICE futures," he noted."Speaking personally, I like being able to look at the report market by market to see the size and specifically how trading is organized," he said. "We can see what savings can be achieved through clearing." Tabb, Clifford said, has shown that clearing credit default swaps, for one, would take collateral requirements "down 12 times."
style="margin-bottom: 0pt;">"It's a big number," agreed Rowady. "There was a lot of internal debate about it." But he stands by the results, explaining that the numbers used were far from a snap shot of a point in time, but figured over a multitude of periods from 2004 through 2009. "I am confident in the total required margin at somewhere in the neighborhood of $3.5 trillion to $3.8 trillion at the high end. But it could be even higher than that. In any case, there are a number of factors that suggest that these figures may never be reached."
style="margin-bottom: 0pt;">In producing The Global Risk Transfer Market: Developments in OTC and Exchange-Traded Derivatives, Rowady used two benchmarks to estimate the margin requirements for the over the counter (OTC) derivative segment of the market. The main benchmark being the estimated collateral posted in the exchange-traded derivative (ETD) market using the US numbers posted at the CFTC and the OCC markets, for the year ending 2009.
style="margin-bottom: 0pt;">He divided the sum of the CFTC and OCC reported margin numbers by the proportion of global exchanged traded derivative open interest that is represented in the US. He was looking for the estimate of the global margin posted against exchange traded open interest. And that number came out to be roughly $450 billion. He divided that by $70 trillion, the open interest in global ETDs in 2009, and came up with an estimated margin of .6%, his ETD benchmark, or $450 billion in margin estimated globally.
style="margin-bottom: 0pt;">To check himself further, Rowady compared his findings to the gross credit exposure (GCE) in the OTC Derivative sector as determined by the BIS and found they were 99% correlated. "The high correlation of the ETD and GCE benchmarks is most likely due to similar risk models being used on similar combinations of exposures, he says. It is through the ETD and GCE benchmarks that Rowady arrives at the total required margin collateral range of $3.5 trillion to $3.8 trillion. He concluded: "With $1.6 trillion in collateral already posted in 2009, according to ISDA, the shortfall is $1.9 - $2.2 trillion."
style="margin-bottom: 0pt;">The startling number of $2 trillion is even more unsettling given that a senior economist with the IMF reached the same conclusion in April of this year. In his paper, "Collateral, Netting & Systemic Risk in the OTC Derivatives Market", Manmohan Singh also found the OTC derivatives market under collateralized by about $2 trillion.
style="margin-bottom: 0pt;">"Regulators should be cognizant that LCFIs (large complex financial institutions) active in OTC derivatives market under collateralize-relative to the risk they assume (there is an estimated shortfall of up to $2 trillion if measured by the derivative payables carried by the major market participants)," wrote Singh.
style="margin-bottom: 0pt;">And, Singh is not optimistic about the ability of central counterparties (CCPs), or a process of moving some eligible or standard contracts to them, to reduce the systemic risk. "Whatever collateral already posted is currently allowed to be rehypothecated (so collateral needs will be even more onerous if placed at CCPs)," he added. "Thus, offloading transactions to CCPs would make this gap obvious and require large increases in collateral." Consequently, the IMF favors a levy that might force LCFIs to offload a critical mass -- about two-thirds of contracts -- to CCPs.
class="MsoNormal">Meanwhile, the WFE's Clifford imagines a big job ahead. "We have to look at it as a lot of work out there left to be done in making the OTC markets safer, as Basel III approaches," he said. "A road map has been laid out."