The credit crunch of 2008 exposed weaknesses within the
Over-the-counter (OTC) derivatives market: the lack of
transparency, counterparty credit risk and operational risk.
The resultant potential of one counterparty default cascading
into defaults for other parties was graphically illustrated with
the US Sub-prime problems that developed into a global financial
This series of blog posts looks at the changes coming to the
world of OTC derivatives and how the key players will be
Changes are coming
OTC derivatives account for almost 95% of the derivatives
Considering the catastrophe of 2008 and its far reaching
consequences, it was clear that something needed to be done to
stabilise this market to guard against the inherent risk element
attached to it.
In September 2009, at the G-20 Pittsburgh Summit, the leaders of
the world's 19 biggest economies reacted by agreeing that
"All standard derivative
contracts should be traded on exchanges or electronic trading
platforms…and cleared through central counterparties by end 2012 at
But why is it so volatile?
Let's start by looking at the current way of doing things.
OTC derivative contracts aren't traded on an exchange such as
the CME; they are privately negotiated between two counterparties.
These contractual relationships can last from a few days to several
decades and can involve counterparty credit risk as each builds up
claims against the other.
This counterpart credit risk can be managed over time through
clearing: either bilaterally or via central clearing.
Bilateral clearing is commonplace for OTC derivatives.
During this process collateral is used as insurance against
excessive credit exposure and the trade is negotiated privately
between the dealer and the client. All processing during its
lifetime is the responsibility of these two parties.
Throughout that time, OTC derivatives need a lot of manual
intervention and, as we've seen countless times before, this often
leads to high levels of operational risk.
The result is a web of counterparty exposures between different
participants with complex movements and the risk of a potential
domino effect if one dealer, for example C as shown in figure 1,
Overcoming the issues
It therefore became apparent that a different approach was
needed to avoid (or at least reduce) this risk element.
thinking lead to the idea of a Central Clearing Counterparty (CCP),
which would facilitate the clearing of OTC derivative trades.
The trade is negotiated between dealer and client and then
handed over to the CCP for clearing. By sitting between the two
counterparties, the CCP will help manage the risk present in
The way ahead
Earlier we mentioned the agreement reached at the G-20 Summit.
This has been filtered into the Dodd-Frank Act in the US and the
European Market Infrastructure Regulation (EMIR).
But before this can be implemented (this will be explored in the
third post in this series), five key stakeholders are required to
ensure the system works.
Our next post will look at the roles played by these
stakeholders in standardized and non-standardized OTC