A central counterparty for OTC credit derivatives – are we over estimating the importance?
Part 1 of a series of 3 papers on central counter parties, bilateral margin agreements, OTC derivatives, weather forecasting, and a global risk research model written by Bill Hodgson of Adsatis.
In the current market conditions politicians, regulators and the public (of course) want to see action taken to repair the current crisis, and prevent such events happening in the future. One of the solutions being given high priority by regulators is the creation of a Central Counter Party (CCP) for OTC Credit Derivative contracts. It is worth understanding how and why a CCP works, and what difference this would make if such a service had existed prior to Autumn 2008.
CCPs
A CCP mutualises risk by becoming the legal party to cleared trades, and then applying complex risk models to mitigate the effects of the default of a member. Most CCPs have three main layers of protection, usually called Variation Margin, Initial Margin, and a Default Fund.
The Variation Margin is simply the change in the value of each contract, up or down, profit or loss, on a daily basis. Rather than wait until a contract matures the CCP will collect the losses up front and credit them to the party profiting, on a daily basis. Whilst this means a firm is guaranteed to receive profits up to the day a firm defaults, it doesn’t allow for major market movements which could create far bigger profit and loss swings.
The next layer is Initial Margin, intended to collect additional collateral to protect against much larger market movements. Initial Margin protects against volatility in the market, and is calculated using a number of methods, a common algorithm being SPAN developed by the CME for exchange traded products, another being PAIRS for Interest Rate Swaps within SwapClear developed by LCH.Clearnet. In both these cases the algorithm is attempting to predict the behaviour of the portfolio under a range of theoretical but realistic (or actual historical) market conditions. Each member must pay their Initial Margin amount to the CCP and is recalculated daily.
The final layer of protection is a Default Fund, a pot of money held on behalf of all the members of the CCP as a final resource to draw on in the event of losses in the defaulters portfolio. The Default Fund is calculated using even more market scenarios, but this time using extreme stress scenarios designed to explore low probability but extreme market events. At some CCPs the Default Fund is held as a single amount across all cleared markets, with members in each market making a proportional contribution to the fund depending on the risk within their own portfolios. Other CCPs hold Default Funds against specific cleared markets and do not mutualise this pool.
Figure 1 – Layers of protection around a CCP
The inner two layers, Insurance and the Capital of the CCP would only be drawn down on in a ‘doomsday’ scenario where the losses of the defaulting firm were so large that all the previous three layers were exhausted.
As a result of these layers of protection, a CCP is regarded as a triple A rated entity, where the chance of the CCP itself becoming bankrupt is remote. The CCP must also avoid a provider of the insurance policy, that isn’t also exposed to market losses and remains sound, without which the insurance is worthless. Although not the case, imagine if this were provided by a certain large American Insurance Giant.
Benefits of a CCP to a member
From a members point of view the CCP has many benefits:
A) Release of credit line usage. Any trade novated to the CCP becomes a credit exposure to the CCP and not to the original bilateral counterparty. This is crucial for many traders as it means they can do an almost unlimited amount of trades with their counterparties which then get absorbed into the CCP.
B) Release of regulatory capital. Most CCPs are modelled as having a credit rating equivalent to AAA, although not all will apply for such a rating formally. The rules on regulatory capital (including Basle II) allow a firm to zero weight trades held via a CCP, releasing capital for other uses.
CC) More efficient back office processing: Processing and settling trades via a CCP is more efficient, as the settlement rules and procedures are more tightly defined, plus all the trades are multi-laterally net settled, meaning a single payment per currency per day.
Firms using a CCP must hold collateral to cover the Variation and Initial Margin requirements in the firm of cash or securities. An interesting question is to compare the CCP margin requirements with the regulatory capital requirements within Basle II for the same trades, given that they are both held as protection against losses.
Figure 2 – The CCP transforms Capital Holdings into Margin Holdings
One downside of having OTC contracts via a CCP is the exclusion of these trades from the existing ISDA based margin agreement between a pair of firms. With a large number of trades being novated to the CCP, this can potentially reduce the effect of exposure netting, and increase the amount of margin required in the bilateral relationship.
Benefits of a CCP to a regulator
For a regulators they provide a single viewing “window” into the risk exposures of the members of the CCP, giving them an automatic and convenient way to monitor the risk levels of each member and their portfolio. The only CCP for OTC products is SwapClear at LCH.Clearnet, and given the global nature of OTC products, is solely regulated by the UK FSA. Other markets such as exchange traded products, equities and bonds have oversight from a number of national bodies.
Regulators also have comfort from their oversight of a CCP that someone independent is monitoring and setting risk parameters in addition to the firms themselves, giving an extra level of comfort in that market.
Benefits of a CCP to the operator
The operator of the CCP is in it for the business – given the level of protection, the return on capital will be good and the level of risk minimised. Global competition in the exchange traded markets takes place in the US and Europe between DTCC, LCH.Clearnet (soon to be one organisation), and Eurex the German trading and clearing house. Many countries with a stock exchange have an embedded clearing house within the exchange. Provided the risk models at each CCP are successful, you could argue that a CCP makes money whether volumes go up or down, and that the financial risks to the CCP are minimal, who wouldn’t want to be in such a business?
In addition a debate has continued on whether clearing should be horizontally aligned, meaning freedom of choice to clear trades at whichever platform you prefer, or vertically with trading activity linked directly to one and only one clearing house. In the current competition for an OTC clearer, each firm must hope they can use the CCP as a step to moving OTC credit derivatives onto their own trading platform and scoop up a generous source of income for the foreseeable future.
Current CCP plans
The current proposals put forward by the four firms competing to clear OTC Credit products are all focused on the “vanilla” Credit Default Swap contracts where the underlying is either a single legal entity, or one of the two current credit indices being the CDX and iTRAXX from Markit. None of the competitors (ICE, CME, Eurex and NYSE Euronext / BClear) are considering including structured credit products such as CDOs within the clearing service, as they are too difficult to price and risk manage for a CCP.
What if the CCP existed 5 years ago?
Had a CCP existed traders would see the majority of their inter-dealer CDS trades absorbed into the clearing house, minimising credit line usage, in return for zero regulatory capital, with the various margin holdings (for VM, IM and Default Fund) on deposit at the CCP. Given the freedom from credit line limits, traders may have been able to execute even more CDS business, provided the costs of collateral remained reasonable.
Given the recent run of defaults triggering protection payouts on the CDS contracts, you would expect the CCP to have an efficient automated procedure to calculate and settle the relevant payout amounts. The industry has already automated this process within the DTCC Trade Information Warehouse, although there is no obligation to use this facility.
Finally you would have expected the CCP to provide trade netting on a periodic basis, to reduce the number of open trade contracts, lowering processing costs for all concerned. In the past few years firms like TriOptima have provided this service to great effect.
What about structured products?
CDOs or SIVs would be excluded from the CCP, even if vanilla CDS trades are used to hedge tranches of the CDO. This means the systemic effects of the CDOs and the factors that caused the drop in asset values recently would not be changed by the existence of a CCP.
Firms such as AIG who had exposure to these structured products, would not have seen any benefits from the CCP and would still be holding those same positions and losses even now.
So why the rush for a CCP?
The arrival of a CCP for OTC credit contracts will transform what was a bilateral credit risk, into a mutualised central risk, albeit protected using an established methodology. Traders will see more freedom to execute credit trades given the absence of bilateral risk, but, the credit risk officer has to look at a bilateral relationships across all products so may still limit trading to allow for risks in other product areas.
Some of the public dialogue on a CCP for credit mention reduction in the “systemic risk” in counterparty exposures. If your definition of systemic means the whole capital market, then given the narrow scope of the OTC credit CCP, this benefit doesn’t seem justified given the wide range of other business transacted by the major firms.
Other commentators on the OTC credit market state a lack of “transparency” on trades and risk exposures, but to whom? OTC contracts are executed between consenting professional parties, who wouldn’t normally disclose details of a private contract nor their aggregate amount of business in public. Until recently the DTCC Trade Information Warehouse was little known outside its’ professional customers and users. This service developed with the support of the entire OTC industry now processes nearly 100% of the vanilla CDS trades executed in the market, and is publishing aggregate data on market activity via their website to address this desire for some public view into this market.
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Before CCP
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After CCP
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Transparency of trade positions
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Available within the DTCC Trade Information Warehouse (TIW) (but no regulator has a right to this data currently)
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Visible within the CCP, and possibly also within the DTCC TIW
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Transparency of risk exposures
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Available within each firm
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Available centrally within the CCP
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Margin protection
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Bilaterally via the ISDA Credit Support Annex, Variation Margin only
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As described above, with VM, IM, Default Fund etc.
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Processing efficiency
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Highest level of automation in the OTC markets via DTCC
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Additional complexity but still highly automated
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In a default
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Collateral held via your ISDA CSA provides the equivalent of Variation Margin
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Much greater protection with VM, IM, DF, Insurance and Capital layers
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Our view is that the last item on the table above, protection in a default, is far better via a CCP than otherwise, in all other aspects, the arrival of a CCP will make little net difference to the current world banking crisis.
Conclusions
There are two potential reasons why the politicians would like to see a CCP for OTC Credit products; 1) so it looks like something has been done and 2) they believe they will have better insight into the OTC credit derivatives market in future.
A CCP is a small scope model for a specific region of the capital markets. No single CCP will give anyone a complete view of a firms risk, nor the risk of an entire market, in fact, there is no existing global system within which someone could view the risk of a firm, nor the systemic effects of the risk between firms, and in the context of the world economy.
The CCP won’t make any difference to the probability of a firm going bust, only make the outcome less damaging. What it will do is link trading activity to margin levels using a layered risk model, rather than to regulatory capital using the Basle II calculations, and does that mean we feel safer?
The existence of a credit CCP won’t prevent a future crisis and will be a footnote to any history of this period. If anything this is a tactical step which will be forgotten once launched as we continue to see the after effects of the crisis. And a final note, given the scale of losses in the market so far, can a single CCP absorb such losses bringing concentration of risk into a single entity?
Follow ups
Both sell side and buy-side firms need to be prepared for the arrival of a CCP in the OTC Credit markets, it is likely the solution will be required to accept trades from almost everyone in the OTC Credit Market, using the traditional direct and indirect clearing model.
Adsatis can offer help and advice to firms facing the prospect of implementing the new CCP within their Operations. Advice includes background on the proposed operational model, the technology required, the underlying concepts described above and help deploying any new infrastructure required.
Coming Soon – Part 2
Part 2 of this series compares the ISDA bilateral exposure management model with a CCP and comments on the adequacies (or not) of that approach.
