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The Weakness Within OTC Derivatives Markets


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 crisis.

This series of blog posts looks at the changes coming to the world of OTC derivatives and how the key players will be affected.

Changes are coming

OTC derivatives account for almost 95% of the derivatives market.

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 the latest."

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

Bilateral clearing is commonplace for OTC derivatives.

Figure 1 OTC clearing

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, defaults.

 Overcoming the issues

It therefore became apparent that a different approach was needed to avoid (or at least reduce) this risk element.

Figure 2 OTC clearingThis 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 bilateral clearing.

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 derivatives.

Posted at 12:26

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