22 January 2012

VoxEU: The fallacy of moving the OTC market to central counterparties

This article argues that current proposals for centralised counterparties are misguided. Instead of reducing risk in the notorious over-the-counter derivatives markets, they may simply shift it around. It calls for tax on the derivative liabilities of large banks to tackle the problem at its source.

Big moves are afoot when it comes to regulating derivatives trade. G20 leaders, among others, were unhappy with the lack of transparency in the massive customised derivatives market (these are known as ‘over-the-counter’ or OTC derivatives – a name that evokes the distinction between over-the-counter drugs and those that require a doctor’s prescription). OTC derivatives are typically a contract struck bilaterally between a financial intermediary (banks, etc.) and a particular investor. Perhaps the leading reform is a drive to move OTC derivatives on to more market-like settings with a central counterparty.

It is important to note that post-Lehman, little progress has been made on crisis resolution frameworks for unwinding large banks, let alone large non-banks and infrastructures like central counterparties. All this means that the underlying economics of having more ‘too-big-to-fail’ entities needs to be thought through correctly if the move is to improve things.

The proposed regulations

A single, central counterparty with an adequate, multicurrency, central-bank liquidity backstop that would be well regulated and spans the broadest range of derivatives would have been an ideal “first-best” solution.

• In view of the political realities (and subtleties of market organisation), a “second-best” solution from an exposure, netting, and collateral standpoint would limit regulations to a few central counterparties rather than a proliferation of central counterparties.
• Recent developments suggest a significant departure from the envisaged first-best solution.

In fact, there will be a plethora of central counterparties since many jurisdictions, such as Australia, Canada, etc., do not want to lose oversight of their local currency derivative products to an offshore central counterparty.

• Furthermore, the proposed regulations are likely to exempt end-users.

They may also exempt foreign-exchange swaps from moving to central counterparties. Large banks are likely to keep some non-standard OTC derivatives on their books due to netting benefits across products and also because central counterparties may not be in a position to clear all OTC derivatives. Such exemptions will not only dilute the intended objectives of moving all or most OTC derivatives to central counterparties, but will increase the overall collateral requirements due to fragmented netting in the market.

We are not moving the status quo of 10-15 large banks (or “pockets” of risk) to one global “pocket” (which would maximise netting); we are moving towards something like 20-30 “pockets” of risk that include large banks and CCPs.

Alternative proposal

Present market practices result in residual derivatives liabilities and residual derivative assets because (aside from large banks), sovereigns, AAA insurers, large corporate, multilateral institutions (e.g. EBRD), Fannie, Freddie, and the ‘Berkshire Hathaway’ types of firms do not post their full share of collateral. They are viewed by large banks as privileged and (presumably) safe clients. The authors thus suggest a tax, or a levy on residual derivative liabilities to be a more transparent approach than moving OTC derivatives to central counterparties, especially if the costs of bailing out central counterparties are to be funded by taxpayers. If a levy is punitive enough, then large banks will strive to make derivative liabilities reach zero; as a result, there will be no systemic risk via the OTC derivatives markets if a large bank fails.

Furthermore, as a by-product of the above levy, the authors would also address the residual derivative assets (that have also averaged $100 billion per large bank in recent years). This will happen since the large banks typically have matched books (i.e. the size of the derivative liability and asset positions at each bank is, on average, roughly the same).

Since, at the time of inception of the OTC derivative contract, it is not known if the contract will be in-the-money (asset) or out-of-the money (liability), the levy on liabilities will force receiving/paying collateral with every client (i.e. no free riding for anyone). Thus, derivative assets will also go to zero. From a risk-management angle, large banks need to hedge their ‘in-the-money’ positions, or derivative receivables, when there is a likelihood that these positions may not be paid in full. For example, hedging derivative receivables due from a sovereign pushes up the credit default swap (CDS) spreads on the sovereign, as seen in peripheral Europe in the past year or so. This, in turn, inflates the sovereign’s debt issuance costs (since CDS spreads impact the spreads of the underlying bonds). Thus, addressing the under-collateralisation issues results in other synergies that are not being considered in the central counterparty CCP discussions.

Conclusions

In summary, placing a levy on derivative payables would be a better alternative, as it addresses the ‘original sin’ (i.e. some derivative users not posting their share of collateral) and also lower CDS spreads from spiralling during distress.

Full article

© VoxEU.org