2
Derivatives

2.1 INTRODUCTION

Derivatives transactions represent contractual agreements either to make payments or to buy or sell an underlying security at a time or times in the future. The times may range from a few weeks or months (for example, futures contracts) to many years (for example, long-dated swaps). The value of a derivative will change with the level of one or more underlying assets or indices and possibly decisions made by the parties to the contract. In many cases, the initial value of a traded derivative will be contractually configured to be zero for both parties at inception.

Derivatives are not a particularly new financial innovation; for example, in medieval times, forward contracts were popular in Europe. However, derivatives products and markets have become particularly large and complex in the last three decades. One of the advantages of derivatives is that they can provide very efficient hedging tools. For example, consider the following risks that an institution, such as a corporate, may experience:

• Interest rate risk. They need to manage liabilities such as transforming floating- into fixed-rate debt via an interest rate swap.
• Foreign exchange (FX) risk. Due to being paid in various currencies, there is a need to hedge cash inflow in these currencies, for example, using FX forwards.
• Commodity risk. The need to lock in commodity prices either due to consumption (e.g. airline fuel costs) or production (e.g. a mining company) via commodity futures or swaps.

In many ways, derivatives are no different from the underlying cash instruments. They simply allow one to take a very similar position in a synthetic way. For example, an airline wanting to reduce its exposure to a potential rise in oil price can buy oil futures, which are cash-settled and therefore represent a very simple way to go ‘long oil’ (with no storage or transport costs). An institution wanting to reduce its exposure to a certain asset can do so via a derivative contract (such as a total return swap), which means it does not have to sell the asset directly in the market.

There are many different users of derivatives such as sovereigns, central banks, regional/local authorities, hedge funds, asset managers, pension funds, insurance companies, and non-financial corporations. All use derivatives as part of their investment strategy or to hedge the risks they face from their business activities. Due to the particular hedging needs of institutions and related issues, such as accounting, many derivatives are relatively bespoke. For example, a corporation wanting to hedge the interest rate risk in a floating-rate loan will want an interest rate swap precisely matching the terms of the loan (e.g. maturity, payment frequency, and reference rate).

Financial institutions, mainly banks, provide derivative contracts to their end user clients and hedge their risks with one another. Whilst many financial institutions trade derivatives, many markets are dominated by a relatively small number of large counterparties (often known as ‘dealers’). Such dealers represent key nodes of the financial system. For example, there are currently around 35 globally-systemically-important banks (G-SIBs), which is a term loosely synonymous with ‘too big to fail’. G-SIB banks are subject to stricter rules, such as higher minimum capital requirements.

During the lifetime of a derivatives contract, the two counterparties have claims against each other, such as in the form of cash flows that evolve as a function of underlying assets and market conditions. Derivatives transactions create counterparty credit risk (counterparty risk) due to the risk of insolvency of one party. Counterparty risk refers to the possibility that a counterparty may not meet its contractual requirements under the contract when they become due.

Counterparty risk is managed over time through clearing; this can be performed bilaterally, where each counterparty manages the risk of the other, or centrally through a central counterparty (CCP). As the derivatives market has grown, so has the importance of counterparty risk. Furthermore, the lessons from events such as the bankruptcy of Lehman Brothers have highlighted the problems when a major player in the derivatives market defaults. This, in turn, has led to an increased focus on counterparty risk and related aspects.

2.2 THE DERIVATIVES MARKET

2.2.1 Exchange-traded and OTC Derivatives

Within the derivatives markets, many of the simplest products are traded through exchanges. A derivatives exchange is a financial centre (Figure 2.1) where parties can trade standardised contracts such as futures and options at a specified price. An exchange promotes market efficiency and enhances liquidity by centralising trading in a single place, thereby making it easier to enter and exit positions. Exchange-traded derivatives are standardised contracts (e.g. futures and options) and are actively traded. It is easy to buy a contract and sell the equivalent contract to terminate (‘close’) the position, which can be done via one or more derivative exchanges. Prices are transparent and accessible to a wide range of market participants.

Figure 2.1 Illustration of exchange-traded and bilaterally-traded derivatives.

Compared to exchange-traded derivatives, OTC derivatives tend to be less-standard structures and are typically traded bilaterally (i.e. between two parties). Since there is no third party involved, they are traditionally private contracts and are often not actively traded in any secondary market. However, their main advantage is their inherent flexibility, as they do not need to be standardised and, in theory, any transaction terms can be accommodated. For example, a customer wanting to hedge their production or use of an underlying asset at specific dates may do so through a customised OTC derivative. Such a hedge may not be available on an exchange, where the underlying contracts will only allow certain standard contractual terms (e.g. maturity dates) to be used. A customised OTC derivative may be considered more useful for risk management than an exchange-traded derivative, which would give rise to additional ‘basis risk’ (in this example, the mismatch of maturity dates). It has been reported that the majority of the largest companies in the world use derivatives in order to manage their financial risks.¹ Due to the bespoke hedging needs of such companies, OTC derivatives are commonly used instead of their exchange-traded equivalents.

Customised OTC derivatives are not without their disadvantages, of course. A customer wanting to unwind a transaction and avoid future counterparty risk must do it with the original counterparty, who may quote unfavourable terms due to their privileged position. Even assigning or ‘novating’ the transaction to another counterparty typically cannot be done without the permission of the original counterparty. This lack of fungibility in OTC transactions can also be problematic. This aside, there is nothing wrong with customising derivatives to the precise needs of clients, as long as this is the sole intention. However, providing a service to clients is not the only role of OTC derivatives: some are contracted for regulatory arbitrage or even (arguably) misleading a client. Such products are clearly not socially useful and generally fall into the (relatively small) category of exotic OTC derivatives which in turn generate much of the criticism of OTC derivatives in general.

OTC markets work very differently compared to exchange-traded ones, as outlined in Table 2.1. OTC derivatives are traditionally privately negotiated and traded directly between two parties without an exchange or other intermediary involved (between a dealer and end user or between two dealers). OTC markets did not historically include trade reporting, which is difficult because trades can occur in private, without the activity being visible in any way (such as to an exchange). Legal documentation is also bilaterally negotiated between the two parties, although certain standards have been developed.

Table 2.1 Comparison between exchange-traded and OTC derivatives.

	Exchange-traded	Over-the-counter (OTC)
Terms of contract	Standardised (maturity, size, strike, etc.)	Flexible and negotiable
Maturity	Standard maturities, typically at most a few months	Negotiable and non-standard Often many years
Liquidity	Very good	Limited and sometimes very poor for non-standard or complex products

2.2.2 Clearing

After a transaction is executed, and before it has been settled, there is the question of clearing (Figure 2.2). An OTC derivative contract legally obliges its counterparties to make certain payments over the life of the contract (or until an early termination of the contract). These payments are in relation to buying or selling certain underlying securities or exchanging cash flows in reference to underlying market variables. Settlement refers to the completion of all such legal obligations and can occur when all payments have been successfully made or alternatively when the contract is closed out (e.g. settled in some other way or offset against another position). ‘Clearing’ is the process by which payment obligations between two or more firms are computed (and often netted), and ‘settlement’ is the process by which those obligations are affected. The means by which payments on OTC derivatives are cleared and settled affect how the counterparty risk that is borne by counterparties in the transaction is managed. Broadly speaking, clearing represents the period between execution and settlement of a transaction. One of the key aspects of clearing is, therefore, counterparty risk that arises when a party fails to perform on contractual responsibilities.

The time period for classically-exchange-traded derivatives is often no more than a few days (e.g. a spot equity transaction) or at most a few months (e.g. a futures contract). A key feature of many OTC derivatives is that they are not settled for a long time since they generally have long maturities. This is in contrast to exchange-traded products, which often settle in days or, at the most, months. For OTC derivatives, the time horizon for the clearing process is more commonly years and often even decades (and the representation in Figure 2.2 is therefore misleading since it does not emphasise the long period of clearing). This is one reason why OTC clearing is of growing importance as more such products become subject to central clearing.

Broadly speaking, clearing can be either bilateral or central. In the latter case, a third party takes responsibility for managing counterparty risk and associated components (e.g. collateralisation). All derivatives exchanges now have an associated CCP that performs this clearing function. In the bilateral case, the two parties entering a trade take responsibility for the processes and risks during the clearing process. Historically, the OTC derivatives market has been bilaterally cleared, but more recently OTC derivatives have begun to become centrally cleared (Figure 2.3).

Figure 2.2 Illustration of the role of clearing in financial transactions.

Figure 2.3 Clearing in exchange-traded and OTC derivatives.

In bilateral clearing, risk management processes are dealt with bilaterally by the counterparties to each OTC contract, whereas for centrally cleared transactions, the risk management functions are typically carried out by the associated CCP.

Whilst an exchange provides efficient price discovery,² it also typically provides a means of mitigating counterparty risk. Since the mid-1980s, all exchanges have had such central clearing facilities. More recently, central clearing has been applied to OTC derivatives.

Central clearing can be seen as a natural extension of exchange-trading but, since it requires a certain amount of standardisation, not all OTC derivatives can be centrally cleared. Whilst the volume of centrally cleared OTC derivatives is increasing, there will always be a relatively significant portion of bilaterally cleared OTC derivatives. Other methods, such as multilateral compression (Section 6.2.4), can be used in bilateral markets and can be seen as utilising some of the functionality of central clearing.

2.2.3 Market Overview

In 1986, the total notional of OTC derivatives was slightly less than that of exchange-traded derivatives at $500 billion.³ Arguably, even at this point, OTC markets were more significant due to the fact that they are longer-dated (for example, a 10-year OTC swap is many times more risky than a three-month futures contract). Nevertheless, in the following two decades, the OTC derivatives market grew exponentially in size (Figure 2.4) in terms of notional. This was due to the use of OTC derivatives as customised hedging instruments and also investment vehicles. The OTC market has also seen the development of completely new products (for example, the credit default swap market increased by a factor of 10 between the end of 2003 and the end of 2008). The relative popularity of OTC products is due to the ability to tailor contracts more precisely to client needs. Exchange-traded products, by their very nature, do not offer customisation.

The curtailed growth towards the end of the history in Figure 2.4 can be clearly attributed to the global financial crisis (GFC), where banks have moved away from some derivatives (for example, due to high capital charges) and clients have been less interested in some derivatives (particularly as structured products). However, the reduction in recent years is also partially due to compression exercises that seek to reduce counterparty risk by removing offsetting and redundant positions (discussed in more detail in Section 6.2.4).

OTC derivatives include the following five broad classes of derivative securities: interest rate (and inflation) derivatives, foreign exchange derivatives, equity derivatives, commodity derivatives, and credit derivatives. The split of OTC derivatives by product type is shown in Figure 2.5. Interest rate products contribute the majority of the outstanding notional, with foreign exchange and credit default swaps (CDSs) seemingly less important. However, this gives a somewhat misleading view of the importance of counterparty risk in other asset classes, especially foreign exchange and CDSs. Whilst most foreign exchange products are short-dated, the long-dated nature and exchange of notional in cross-currency swaps mean they carry a lot of counterparty risk. CDSs not only have a large volatility component but also constitute significant ‘wrong-way risk’. Therefore, whilst interest rate products make up a significant proportion of the counterparty risk in the market, one must not underestimate the other important (and sometimes more subtle) contributions from other products.

Figure 2.4 Total outstanding notional of OTC and exchange-traded derivatives transactions. The figures cover interest rate, foreign exchange, equity, commodity, and credit derivative contracts. Note that notional amounts outstanding are not directly comparable to those for exchange-traded derivatives, which refer to open interest or net positions, whereas the amounts outstanding for OTC markets refer to gross positions (i.e. without netting). Centrally-cleared trades also increase the total notional outstanding due to a double-counting effect, since clearing involves booking two separate transactions. Source: Bank for International Settlements (BIS).

Looking at the notional of derivatives contracts can be misleading, even when doing so only on a relative basis. A key aspect of derivatives products is that their exposure is substantially smaller than that of an equivalent loan or bond. Consider an interest rate swap as an example: this contract involves the exchange of floating against fixed payments and has no principal risk because only cash flows are exchanged. Furthermore, even the cash flows are not fully at risk because, at cash flow payment dates, only the net difference in fixed and floating cash flows will be exchanged. If a counterparty fails to perform, then an institution will have no obligation to continue to make cash flow payments. Instead, the swap will be unwound based on some defined valuation. If the swap has a negative value for an institution, then they may stand to lose nothing if their counterparty defaults.⁴

Figure 2.5 Split of OTC derivative gross outstanding notional by product type as of June 2017. Note that centrally-cleared products are double-counted since a single trade is novated into two trades in a CCP. This is particularly relevant for interest rate products, for which a large outstanding notional is already centrally cleared. Source: BIS.

It should be clear that the market value of derivatives (Figure 2.6) is a more relevant measure of the risk than the gross notional outstanding since it reflects the maximum loss that parties would incur if they all fail to meet their contractual payments and the contracts are replaced at current market prices. There are also clear incentives to reduce the gross market value of derivatives as much as possible using methods such as central clearing.⁵ In recent years, central clearing has had a significant impact on OTC derivatives markets, with around 60% in notional amounts outstanding (mostly interest rate contracts) reported by dealers being centrally cleared.⁶

2.2.4 Market Participants and Collateralisation

It is useful to characterise the different players in the derivatives market and the way in which they transact. Whilst exchange-traded derivatives are effectively settled on a daily basis with margin, OTC derivatives are not usually settled in this way but may be collateralised.⁷ A significant number of OTC derivatives are collateralised with parties pledging cash and securities against the value of their derivative portfolio, with the aim of neutralising the net exposure between the counterparties. Collateralisation (or settlement) can reduce counterparty risk but introduces additional legal and operational risks. Furthermore, posting collateral to meet margin requirements introduces funding costs as it is necessary to source the cash or securities to deliver. It also leads to liquidity risks in case the required amount and type of collateral cannot be sourced in the required time frame.

Figure 2.6 Total outstanding notional and gross market value of OTC derivatives transactions. The figures cover interest rate, foreign exchange, equity, commodity, and credit derivative contracts. Source: BIS. www.bis.org.

Broadly, the market can be divided into three groups:

• Large player. This will be a large global bank, often known as a dealer. They will have a vast number of derivatives trades on their books and have many clients and other counterparties. They will usually trade across all asset classes (interest rates, foreign exchange, equities, commodities, credit derivatives) and will collateralise positions (as long as the counterparty will make the same commitment, and sometimes even if they do not). They will be a member of most or all exchanges and CCPs to facilitate trading on their own account and for their clients. The OTC derivatives market is highly concentrated, with the largest 14 dealers holding around four-fifths of the total notional outstanding.⁸ These dealers collectively provide the bulk of the market liquidity in most products.
• Medium-sized player. This will typically be a smaller bank or other financial institution that has significant OTC derivatives activities, including making markets in certain products. They will cover several asset classes, although they may not be active in all of them (they may, for example, not trade credit derivatives or commodities, and will probably not deal with more exotic derivatives). Even within an asset class, their coverage may also be restricted to a certain market (for example, a regional bank transacting in certain local currencies). They will have a smaller number of clients and counterparties but will also generally be willing to collateralise their positions. They will be a member of local exchanges and CCPs (where appropriate) and may be a member of a number of global ones.
• End user. Typically this will be a large corporate, sovereign, or smaller financial institution with derivatives requirements (for example, for hedging needs or investment). They will have a relatively small number of OTC derivatives transactions on their books and will trade with only a few different counterparties. They may only deal in a single asset class (for example, some corporates trade only foreign exchange products, a mining company may only trade commodity forwards, and a pension fund may only be active in interest rate and inflation products). Due to their needs, their overall position will be very directional (i.e. they will not execute offsetting transactions). Often, they may be unable or unwilling to commit to margining or posting collateral or will post illiquid collateral and/or post more infrequently. Many players in the OTC derivatives market do not have strong credit quality, nor are they able to margin or post collateral to reduce counterparty risk. This counterparty risk is, therefore, arguably, an unavoidable consequence of the derivatives market.

A special case in OTC derivatives end users has been certain counterparties of exceptionally high credit quality, such as sovereigns, supranational entities, or multilateral development banks. Such entities have historically had a favourable arrangement with banks where they receive, but do not post, collateral (potentially subject to rating triggers, meaning that they may be required to post collateral if they are downgraded). Such arrangements are seen as much more costly nowadays due to the associated funding and capital requirements.

Finally, there are many third parties in the OTC derivatives market. These may offer, for example, settlement/margining/collateral management, software, trade compression, and clearing services. They allow market participants to reduce counterparty risk and the risks associated with counterparty risk (such as legal), and improve overall operational efficiency with respect to these aspects.

Broadly speaking, derivatives can be classified into several different groups by the way in which they are transacted and collateralised. These groups, in order of increasing complexity and risk are:

• Exchange-traded. These are the most simple, liquid, and short-dated derivatives that are traded on an exchange. All derivatives exchanges now have central clearing functions where margin must be posted against losses on a daily basis, and the performance of all exchange members is guaranteed. Due to the lack of complexity, the short maturities, and central clearing function, this has often been viewed as the safest part of the derivatives market although recent events have called this into question (Section 10.1.3). Note that exchange-traded derivatives are typically settled on a daily basis with a cash payment which is usually known as variation margin.
• OTC centrally cleared. These are OTC derivatives that are not suitable for exchange-trading due to being relatively complex, illiquid, and non-standard but are centrally cleared. Indeed, incoming regulation is requiring central clearing of standardised OTC derivatives (Section 2.5.4). OTC CCPs usually require a daily collateralisation in cash which, although not settlement, is still known as variation margin.
• OTC collateralised. These are bilateral OTC derivatives that are not centrally cleared but where parties post collateral (which may be cash or securities) to one another in order to mitigate the counterparty risk.
• OTC uncollateralised. These are bilateral OTC derivatives where parties do not post collateral (or post less and/or lower quality collateral). This is typically the case because one of the parties involved in the contract (typically an end user such as a corporate) cannot commit to collateralisation. Since they have nothing to mitigate their counterparty risk, these derivatives generally receive the most attention in terms of their underlying risks.

The question is how significant each of the above categories is. Figure 2.7 gives a breakdown in terms of the total notional. Only about a tenth of the market is exchange-traded with the majority OTC. However, over half of the OTC market is already centrally cleared. Of the remainder, around four-fifths is collateralised, with only 20% remaining under collateralised. For this reason, it is this last category that is the most dangerous and the source of many of the problems in relation to counterparty risk, funding, and capital.

The majority of this book is about the seemingly small 7% (20% of the 40% of the 91% in Figure 2.7) of the market that is not well collateralised bilaterally or via a central clearing function. However, it is important to emphasise that this still represents tens of trillions of dollars of notional and is therefore extremely important from a counterparty risk perspective. Furthermore, it is also important to look beyond just counterparty risk and consider funding, capital, and collateral. This, in turn, makes all groups of derivatives in Figure 2.7 important.

2.2.5 Banks and End Users

Broadly speaking, there are two situations in which counterparty risk and related aspects such as funding, collateral, and capital arise. The most obvious (Figure 2.8) would apply to an end user transacting derivatives for hedging purposes. Their overall portfolio will typically be directional (but not completely so, as mentioned below) since the general aim will be to offset economic risk elsewhere. The result of this will be that the variation in the value of the derivatives, or mark-to-market (MTM) volatility, will be significant and any associated margin or collateral flows may vary substantially. Indeed, the fact that substantial collateral may be required over a short time horizon is one reason why many end users do not enter into collateral agreements. Another implication of directional portfolios is that there may be less netting benefit available. In practice, an end user will trade with a reasonable number of bank counterparties depending on the volume of their business and risk appetite.

Figure 2.7 Breakdown of different types of derivatives by total notional. Source: Eurex (2014). www.eurexclearing.com.

Figure 2.8 Illustration of the classic end user counterparty risk set-up.

Another important feature is that end users may hedge risks on a one-for-one basis – for example, the terms of an OTC swap may be linked directly to those of bonds issued rather than the interest rate exposure being hedged more generically on a macro basis. End users may find it problematic when unwinding transactions since the original counterparty will not necessarily quote favourable terms. Furthermore, if they do execute offsetting transactions (for example, certain parties may execute receiver interest rate swaps to hedge their lending,⁹ whilst also using payer interest rate swaps to hedge borrowing), the terms received will be less favourable than if they macro-hedged the overall risk. This is a consequence of hedging borrowing and lending on a one-to-one basis. For a similar reason, default situations will be problematic since an end user may want to replace transactions on a one-for-one basis rather than macro-hedging their exposure to the defaulted counterparty. This will likely be more time-consuming and costly.

It is also important to understand that the hedging needs of a client may lead to certain imbalances when using derivatives. A common example is when an institution borrows money via a loan where the interest rate payment will typically be based on a floating rate (Figure 2.9). If the institution wants to hedge their interest rate risk then they may use an interest rate swap matching the terms of the loan, where they will pay a fixed rate against receiving the floating rate. However, even if they transact both the loan and interest rate swap with the same bank, they may have different practices with respect to aspects such as accounting treatment and collateralisation. From the bank's perspective, the capital treatment for the two transactions will be separate as the loan will be part of the ‘banking book’, whereas the swap will be a ‘trading book’ item.

For a bank, the classic counterparty risk situation is rather different (Figure 2.10). Banks will typically aim to run a relatively flat (i.e. hedged) book from a market risk perspective. This means that a transaction with a client will be hedged, either on a macro basis or directly (‘back to back’) with another market participant. This will likely lead to a series of hedges through the interbank market, possibly ending with an offsetting position with another end user. In this situation, the bank may have little or no MTM volatility or market risk. However, they do have counterparty risk to both counterparties A and B since, if either were to default, this would leave exposure for the other party.

Figure 2.9 Illustration of an institution borrowing via a floating rate loan and using an interest rate swap to convert (hedge) the floating interest rate payments into fixed payments.

Figure 2.10 Illustration of the classic bank counterparty risk set-up.

Another important feature of this situation is that client transactions will often be uncollateralised, whereas the hedges will be bilaterally collateralised (or exchange-traded/centrally cleared). The counterparty risk problem exists mainly on the uncollateralised transactions (although there is often still a material risk on the hedges). Whilst the overall MTM is neutralised, this introduces an asymmetry in collateral flows which can be problematic. Dealers also suffer from the directional hedging needs of clients. For example, they may transact mainly receiver interest rate swaps with corporate clients. In a falling interest rate environment, the hedges of these swaps will require significant margin or collateral posting. Figure 2.10 is very important as a starting point for many different types of analysis and will be referred back to at several later points in this book.

2.2.6 ISDA Documentation

The rapid development of the OTC derivative market could not have occurred without the development of standard legal documentation to increase efficiency and reduce aspects such as counterparty risk. The International Swaps and Derivatives Association (ISDA) is a trade organisation for OTC derivatives practitioners. The market standard for OTC derivative documentation is the ISDA Master Agreement, which was first introduced in 1985 and is now used by the majority of market participants to document their OTC derivative transactions.

The ISDA Master Agreement is a bilateral framework which contains terms and conditions to govern OTC derivative transactions between parties. Multiple transactions will be covered under a general Master Agreement to form a single legal contract of an indefinite term, covering many or all of the transactions. The Master Agreement comprises a common core section and a schedule containing adjustable terms to be agreed by both parties. This specifies the contractual terms between parties with respect to aspects such as netting, collateral, termination events, the definition of default, and the close-out process. By doing this, it aims to remove legal uncertainties and to provide mechanisms for mitigating counterparty risk. The commercial terms of individual transactions are documented in a trade confirmation, which references the Master Agreement for the more general terms. Negotiation of the agreement can take considerable time, but once completed, trading tends to occur without the need to update or change any general aspects. Typically, English or New York law is applied, although other jurisdictions are sometimes used.

From a counterparty risk perspective, the ISDA Master Agreement has the following risk-mitigating features:

• the contractual terms regarding the posting of collateral (covered in detail in Chapter 3);
• events of default and termination;
• all transactions referenced are combined into a single net obligation; and
• the mechanics around the close-out process are defined.

In relation to counterparty risk, default events lead to the termination of transactions before their original maturity date and the initiation of a close-out process. Events of default covered in the ISDA Master Agreement are:

• failure to pay or deliver
• breach of agreement
• credit support default (collateral terms)
• misrepresentation
• default under the specified transaction
• cross-default (default on another obligation)
• bankruptcy
• merger without assumption.

The most common of the above is a failure to pay (subject to some defined threshold amount) and bankruptcy.

Recent years have highlighted the need for risk mitigants for OTC derivatives. For example, the Lehman Brothers bankruptcy led to extensive litigation in relation to the ability to offset different obligations and the valuation of OTC derivative assets or liabilities (for example, refer to Figure 2.11). This illustrates the importance of documentation in defining the processes that will occur in the event of a counterparty default.

2.2.7 Credit Derivatives

The credit derivatives market grew swiftly in the decade before the GFC due to the need to transfer credit risk efficiently. The core credit derivative instrument, the CDS, is simple and has transformed the trading of credit risk. However, CDSs themselves can prove highly toxic since, whilst they can be used to hedge counterparty risk in other products, there is counterparty risk embedded within the CDS contract itself. The market has recently become all too aware of the dangers of CDSs. Credit derivatives can, on the one hand, be very efficient at transferring credit risk but, if not used correctly, can be counterproductive and highly toxic. The growth of the credit derivatives market has stalled in recent years since the GFC.

One of the main drivers of the move towards the central clearing of standard OTC derivatives is the counterparty risk represented by the CDS market. Furthermore, as hedges for counterparty risk, CDSs seem to require the default remoteness that central clearing apparently gives them. However, the ability of central counterparties to deal with the CDS product, which is much more illiquid and risky than other cleared products, is crucial and not yet tested.

2.2.8 Financial Weapons of Mass Destruction

Derivatives can be extremely powerful and useful, have facilitated the growth of global financial markets, and have aided economic growth. For example, ISDA (2014b) notes that:

• derivatives are essential to global economic activity and growth;
• thousands of companies use OTC derivatives to manage the risks arising from their business and financial activities;
• derivative users are corporations, investment managers, governments, insurers, energy and commodities firms, international and regional banks, and financial institutions;
• derivatives are transacted around the world in more than 30 currencies; and
• most of the world's 500 largest companies use derivatives to manage risk.

Of course, not all derivatives transactions can be classified as ‘socially useful’. Some involve arbitraging regulatory capital amounts, tax requirements, or accounting rules. As the average person now knows, derivatives can be highly toxic and cause massive losses and financial catastrophes if misused. Some historical examples of this are Orange County (1994), Proctor and Gamble (1994), Barings Bank (1995), Long-Term Capital Management (1998), Enron (2001), and Société Générale (2008).¹⁰

A key feature of derivatives instruments is leverage. Since most derivatives are executed with only a small (with respect to the notional value of the contract) or no upfront payment made, they provide significant leverage. If an institution has the view that US interest rates will be going down, they may buy US treasury bonds. There is a natural limitation to the size of this trade, which is the cash that the institution can raise in order to invest in bonds.¹¹ However, entering into a receiver interest rate swap in US dollars will provide approximately the same exposure to interest rates but with no initial investment.¹² Hence, the size of the trade and the effective leverage must be limited by the institution itself, the counterparty in the transaction, or a regulator. Inevitably, the leverage will be significantly bigger than that in the previous case of buying bonds outright. Derivatives have repeatedly been shown to be capable of creating or catalysing major market disturbances.

As mentioned above, the OTC derivatives market is concentrated in the hands of a relatively small number of dealers. These dealers act as common counterparties to large numbers of end users of derivatives and actively trade with each other to manage their positions. Perversely, this used to be perceived by some as actually adding stability since prior to 2008 it was believed that none of these dealer counterparties would ever fail. Now this set-up is thought to create significant systemic risk: in financial terms, where the potential failure of one institution creates a domino effect and threatens the stability of the entire financial market. Systemic risk may not only be triggered by actual losses; just a heightened perception of losses can be problematic.

In 2002, the famous investor Warren Buffett described derivatives as ‘financial weapons of mass destruction’. His criticisms were generally based on the following points:¹³

• their value depends on the creditworthiness of the counterparty to the contract (i.e. there is counterparty risk);
• whilst derivatives valuations should be symmetric with respect to the two parties involved, this may not be true in practice, with reported earnings on derivatives being overstated, and there are large incentives to overstate the valuation (this is referred to as ‘mark-to-myth’ by Buffett);
• they often have (rating) downgrade triggers requiring greater collateralisation, imposing at just the worst time an unexpected demand for cash on a company that may create liquidity problems that may even create more downgrades and lead to a death spiral; and
• they create a daisy-chain risk, thwarting prudent counterparty diversification since large receivables from interconnected counterparties build up over time.

These points were insightful with respect to events from 2007 onwards, and some of the issues captured by post-GFC regulation were foreseen by Buffett.

Criticisms of derivatives such as the above are generally aimed towards OTC derivatives, given the size and relative complexity of this market. Whereas the process by which a financial contract becomes exchange-traded can be thought of as a long journey where a reasonable trading volume, standardisation, and liquidity must first develop, OTC derivatives markets are traditionally faster moving. This has fairly obvious advantages and disadvantages, such as promoting innovation but allowing the development of large, relatively toxic risks. Prior to 2007, OTC derivatives were, to a large extent, opaque and unregulated.

Derivatives have, in many cases, become more standardised over the years through industry initiatives. Nevertheless, OTC derivative markets remain decentralised and more heterogeneous and are consequently less transparent than their exchange-traded equivalents. This leads to potentially challenging counterparty risk problems which have historically been managed through the use of various risk mitigants (discussed in later chapters).

2.2.9 The Lehman Brothers Bankruptcy

The complexity of derivatives clearing leads to potential challenges in the event that a derivatives counterparty defaults. Such a default may be directly related to or at least catalysed by losses on derivatives themselves. Defaults of major derivatives counterparties have been relatively rare, with the aforementioned cases of Barings Bank and Long-Term Capital Management being examples. Since derivatives do not trade in secondary markets and do not have an objectively-defined valuation, dealing with a major ‘derivatives default’ is complex.

Figure 2.11 Management of derivative transactions by the Lehman Brothers estate. Source: Fleming and Sarkar (2014).

The bankruptcy of Lehman Brothers in 2008 provides a good example of the difficulty created by derivatives. Lehman had over 200 registered subsidiaries in 21 countries and around a million derivatives transactions. The insolvency laws of more than 80 jurisdictions were relevant.

In order to fully settle with a derivative counterparty, the following steps need to be taken:

• reconciliation of the universe of transactions;
• valuation of each underlying transaction; and
• agreement of a net settlement amount.

As shown in Figure 2.11, carrying out the above steps across many different counterparties and transactions has been a very time-consuming process, and the Lehman settlement of OTC derivatives has been a long and complex process lasting many years.

2.3 DERIVATIVE RISKS

An important concept is that financial risk is often not negated completely but is rather converted into different forms (for example, collateral can reduce counterparty risk but creates market, operational, legal, and liquidity risks). Sometimes these new forms of risk are more benign, but this is not guaranteed, and they may only appear so with significant hidden dangers. Furthermore, some financial risks can be seen as a combination of two or more underlying risks (for example, counterparty risk is primarily a combination of market and credit risk). Whilst this book is primarily about counterparty risk and related aspects such as funding, it is important to understand this in the context of other financial risks.

2.3.1 Market Risk

Market risk arises from the (short-term) movement of market variables. It can be a linear risk, arising from exposure to the movement of underlying quantities such as stock prices, interest rates, FX rates, commodity prices, or credit spreads. Alternatively, it may be a non-linear risk arising from the exposure to market volatility or basis risk, as might arise in a hedged position. Market risk has been the most studied financial risk over the past two decades, with quantitative risk management techniques widely applied in its measurement and management. This was catalysed by some serious market risk-related losses in the 1990s (e.g. Barings Bank), and the subsequent amendments to the Basel I capital accord in 1995 that allowed financial institutions to use proprietary mathematical models to compute their capital requirements for market risk. Indeed, market risk has mainly driven the development of the value-at-risk-type approaches to risk quantification (Section 2.6.1).

Market risk can be eliminated by entering into an offsetting contract. However, unless this is done with the same counterparty as the original position(s),¹⁴ then counterparty risk will be generated. If the counterparties to offsetting contracts differ, and either counterparty fails, then the position is no longer neutral (for example, see Figure 2.12). Market risk, therefore, forms a component of counterparty risk. Additionally, the imbalance of collateral agreements and central clearing arrangements across the market creates a funding imbalance and leads to funding costs.

Banks generally aim to be market risk neutral so as to minimise accounting volatility and capital requirements and to comply with the regulation. The depiction in Figure 2.12 is, therefore, a useful simple example to refer to with respect to counterparty risk and related aspects.

2.3.2 Credit Risk

Credit risk is the risk that a debtor may be unable or unwilling to make a payment or fulfil contractual obligations. This is often known generically as ‘default’, although this term has slightly different meanings and impact depending on the jurisdiction involved. To quantify credit risk, default probability must be characterised fully throughout the lifetime of the exposure and so too must the recovery value (or equivalently the loss given default).

Figure 2.12 Illustration of the hedging of a transaction with counterparty A with one executed with counterparty B. Whilst the market risk may be hedged, party X is exposed to the failure of either counterparty A or party B.

Although less severe than default, it may also be relevant to consider deterioration in credit quality, which will lead to a MTM loss (due to the increase in future default probability). Such deterioration can occur, for example, if a counterparty's credit rating is downgraded. In terms of counterparty risk, characterising the term structure of the counterparty's default probability is a key aspect. A greater chance of credit deterioration will lead to a higher future default probability.

The credit risk of debt instruments depends primarily on default probability and the associated recovery value since the exposure is deterministic (e.g. the par value of a bond or notional amount of a loan). However, for derivatives, the exposure is uncertain and driven by the underlying market risk of the transactions. Counterparty risk is therefore seen as a combination of credit and market risk.

2.3.3 Operational and Legal Risk

Operational risk arises from people, systems, and internal and external events. It includes human error (such as trade entry mistakes), failed processes (such as settlement of trades or posting collateral), model risk (inaccurate or inappropriately calibrated models), fraud (such as rogue traders), and legal risk (such as the inability to enforce legal agreements, for example those covering netting or collateral terms). Whilst some operational risk losses may be moderate and common (incorrectly booked trades, for example), the most significant losses are likely to be a result of highly improbable scenarios or even a ‘perfect storm’ combination of events. Operational risk is therefore extremely hard to quantify, although quantitative techniques are sometimes applied. Counterparty risk mitigation methods, such as collateralisation, inevitably give rise to operational risks, since collateral requires many operational processes in order for it to be passed from one party to another in a timely fashion.

Legal risk (often defined as a particular form of operational risk) is the risk of losses due to the assumed legal treatment not being upheld. This can be due to aspects such as incorrect documentation, counterparty fraud, mismanagement of contractual rights, or surprising decisions by courts – for example, if a party believes that they are owed a certain amount on derivatives transactions with a defaulted counterparty, but this subjective valuation is actually determined to be lower (a key component in much of the litigation with respect to the Lehman Brothers bankruptcy discussed in Section 2.2.9). Mitigating financial risk generally gives rise to legal risk due to the mitigants being challenged in some way at a point where they come into force. Defaults are particularly problematic from this point of view because they are relatively rare and so are not often tested, and they are also sensitive to the precise regional jurisdiction (sometimes courts in different countries have ruled differently on legal matters in this respect).

2.3.4 Liquidity Risk

Liquidity risk is normally characterised in two forms. Asset liquidity risk represents the risk that a transaction cannot be executed at market prices, perhaps due to the size of the position and/or relative illiquidity of the underlying market. This may lead to losses in the event that the asset is sold, with the extreme case of this being a ‘fire sale’. Non-cash collateral held against derivatives exposures is prone to this type of liquidity risk since it needs to be liquidated in the event of a default. This is one of the reasons why derivatives collateral is often in cash or high-quality securities, and ‘haircuts’ are often required to act as a buffer against potential liquidation losses.

Funding liquidity risk refers to the inability to fund – in a timely manner – contractual outflows such as cash flows, margin, or collateral payments. In turn, this may force an early liquidation of assets and crystallisation of losses due to asset liquidity risk. Since such losses may lead to further funding issues, funding liquidity risk can manifest itself via a death spiral caused by the negative feedback between losses and cash requirements.

In general, reducing counterparty risk via margining or collateralisation comes at the cost of increased funding liquidity risk since such payments must be made in a timely fashion, usually involving tight timescales (e.g. daily). This is one of the reasons why some derivatives end users do not agree to contractual collateral-posting in bilateral OTC markets, as discussed in Section 2.2.4. Note that this is probably not related to the amount (since all corporations have significant assets, for example) but more the type of collateral. All parties have access to illiquid non-financial collateral such as property, machinery, and equipment. However, derivatives collateral commonly requires liquid financial securities that would only be held in significant quantities by financial institutions such as asset managers or pension funds. Indeed, some OTC derivatives collateral is cash only, which is restrictive even for some financial institutions.

Not surprisingly, banks find it easier to post and receive cash as derivatives collateral. Furthermore, recent bank regulation in relation to liquidity risk (see Chapter 6) penalises less liquid forms of collateral and incentivises banks to receive cash. Hence, generally, banks – due to market access – prefer to receive more liquid collateral, whilst clients prefer to post less liquid collateral.

2.3.5 Integration of Risk Types

A particular weakness of financial risk management over the years has been the lack of focus on the integration of different risk types. This is especially relevant since it has been well known for many years that crises tend to involve a combination of different financial risks. Given the difficulty in quantifying and managing financial risks in isolation, it is not surprising that limited effort is given to integrating their treatment. As noted above, counterparty risk itself is already a combination of two different risk types, market and credit. Furthermore, the mitigation of counterparty risk can create other types of risk, such as liquidity and operational risk. It is important not to lose sight of counterparty risk as an intersection of many types of financial risk, and to remember that mitigating counterparty risk creates even more financial risks.

2.3.6 Counterparty Risk

Counterparty risk is traditionally thought of as credit risk between derivatives counterparties. In the event of the non-performance (default) of a counterparty to a transaction (Figure 2.12), there is potential exposure via the market value of the transactions in question. In turn, this market value is not fixed and varies through time and is also to some extent a subjective quantity (for example, it may be derived from a valuation model). Counterparty risk, therefore, contains elements of credit risk (the default of the party) and market risk (the value of the transactions at the default time). The interaction between these components – that is to say, the relationship between the default probability and potential exposure – is often termed ‘wrong-way risk’. Other aspects such as recovery value (or loss given default) and the impact of collateral are important considerations.

2.4 SYSTEMIC RISK OF DERIVATIVES

2.4.1 Overview

A major concern with respect to OTC derivatives is systemic risk, which generally refers to an uncontained crisis which may cause the failure of an entire financial system or market. Derivatives may increase systemic risk due to aspects such as their complexity, opacity, and overall volume. Derivatives may cause systemic risk episodes (for example, by a financial institution making large losses, as in the case of Barings Bank) or catalyse a crisis (as in the case of Lehman Brothers, discussed in Section 2.2.9).

Historically, the derivatives market focused on reducing the possibility of a systemic risk episode by minimising the risk of the default of a large, important market participant. However, there is clearly a balance between reduction of default risk and encouraging financial firms to grow and prosper. Derivatives markets have used processes such as netting and margining/collateralisation to minimise counterparty risk and, accordingly, systemic risk. However, such aspects create more complexity and may catalyse growth to a level that would never have otherwise been possible. Hence it can be argued that initiatives to reduce systemic risk may achieve precisely the opposite and create a source or catalyst (such as many large OTC derivative exposures supported by a complex web of collateralisation) for systemic risk.

It is useful to review some of the historical ways in which the derivatives market has sought to reduce systemic risk. Although some of these methods are somewhat obsolete, they provide a useful context for analysing more recent developments (such as central clearing).

2.4.2 Special Purpose Vehicles

A special purpose vehicle (SPV) or special purpose entity (SPE) is a legal entity (e.g. a company or limited partnership) created typically to isolate a firm from financial risk. SPVs have been used in the OTC derivatives market to isolate counterparty risk. A company will transfer assets to the SPV for management or use the SPV to finance a large project without putting the entire firm or a counterparty at risk. Jurisdictions may require that an SPV is not owned by the entity on whose behalf it is being set up.

SPVs aim essentially to change bankruptcy rules so that, if a derivative counterparty is insolvent, a client can still receive their full investment from the SPV prior to any other claims being paid out. SPVs are most commonly used in structured notes, where they use this mechanism to guarantee the counterparty risk on the principal of the note to a very high level (triple-A, typically), better than that of the issuer. The creditworthiness of the SPV is assessed by rating agencies, who look in detail at the mechanics and legal specifics before granting a rating.

SPVs aim to shift priorities so that, in a bankruptcy, certain parties can receive favourable treatment. Clearly such favourable treatment can only be achieved by imposing a less favourable environment on other parties. More generally, such a mechanism may then reduce risk in one area but increase it in another.

An SPV transforms counterparty risk into legal risk. The obvious legal risk is that of consolidation, which is the power of a bankruptcy court to combine the SPV assets with those of the originator. The basis of consolidation is that the SPV is essentially the same as the originator and this means that the isolation of the SPV becomes irrelevant. Consolidation may depend on many aspects, such as jurisdictions. US courts have a history of consolidation rulings, whereas UK courts have been less keen to do so, except in extreme cases such as fraud.

Another lesson is that legal documentation often evolves through experience, and the enforceability of the legal structure of SPVs was not tested for many years. When it was tested in the case of Lehman Brothers, there were problems (although this depended on the jurisdiction). Lehman essentially used SPVs to shield investors in complex and highly-rated transactions such as collateralised debt obligations (CDOs) from Lehman's own counterparty risk (in retrospect, a great idea).¹⁵ The key clause in the documents is referred to as the ‘flip’ provision, which essentially meant that if Lehman were bankrupt, then the investors would be first in line as creditors. However, the US Bankruptcy Court ruled that the flip clauses were unenforceable,¹⁶ putting them at loggerheads with the UK courts, which ruled that the flip clauses were enforceable. To add to the jurisdiction-specific question of whether a flip clause, and therefore an SPV, was a sound legal structure, many cases have been settled out of court.¹⁷

2.4.3 Derivatives Product Companies

Long before the GFC of 2007 onwards, whilst no major derivatives dealer had failed, the bilaterally-cleared dealer-dominated OTC market was perceived as being inherently more vulnerable to counterparty risk than the exchange-traded market. The derivatives product company (or corporation) evolved as a means for OTC derivative markets to mitigate counterparty risk (e.g. see Kroszner 1999). DPCs are generally triple-A-rated entities set up by one or more banks as a bankruptcy-remote subsidiary of a major dealer, which, unlike an SPV, is separately capitalised to obtain a triple-A credit rating.¹⁸ The DPC structure provides external counterparties with a degree of protection against counterparty risk by protecting against the failure of the DPC parent. Examples of some of the first DPCs include Merrill Lynch Derivative Products, Salomon Swapco, Morgan Stanley Derivative Products, and Lehman Brothers Financial Products.

The ability of a sponsor to create their own high-credit-quality derivatives counterparty via a DPC was partially a result of improvements in risk management models and the development of credit rating agencies. DPCs usually maintained a triple-A rating by a combination of capital, margin, and activity restrictions. Each DPC had its own quantitative risk assessment model to quantify their current credit risk. This was benchmarked against that required for a triple-A rating. Most DPCs used a dynamic capital allocation to keep within the triple-A credit risk requirements. The triple-A rating of a DPC typically depended on:

• Minimising market risk. In terms of market risk, DPCs attempted to be close to market risk neutral via trading offsetting contracts. Ideally, they would be on both sides of every trade, as these ‘mirror trades’ lead to an overall matched book. Normally the mirror trade exists with the DPC parent.
• Support from a parent. The DPC was supported by a parent, with the DPC being bankruptcy remote (like an SPV) with respect to the parent to achieve a better rating. If the parent were to default, then the DPC would either pass to another well-capitalised institution or be terminated, with trades settled at mid-market.
• Credit risk management and operational guidelines. Restrictions were also imposed on (external) counterparty credit quality and activities (position limits, margin, etc.). The management of counterparty risk was achieved by having daily MTM and margining/collateralisation.

Whilst being of very good credit quality, DPCs also aimed to give further security by defining an orderly workout process. A DPC defined what events would trigger its own failure (rating downgrade of parent company, for example) and how the resulting workout process would happen. The resulting ‘pre-packaged bankruptcy’ was therefore supposedly simpler (as well as less likely) than the standard bankruptcy of an OTC derivative counterparty. Broadly speaking, two bankruptcy approaches existed, namely a continuation and termination structure. In either case, a manager was responsible for managing and hedging existing positions (continuation structure) or terminating transactions (termination structure).

DPCs were created in the early stages of the OTC derivatives market to facilitate trading of long-dated derivatives by counterparties having less than triple-A credit quality. However, was such a triple-A entity of a double-A or worse bank really a better counterparty than the bank itself? The GFC essentially killed the already-declining world of DPCs. After their parent's decline and rescue, the Bear Stearns DPCs were wound down by J.P. Morgan, with clients compensated for novating trades. The voluntary filing for Chapter 11 bankruptcy protection by two Lehman Brothers DPCs, a strategic effort to protect the DPCs' assets, seems to link a DPC's fate inextricably with that of its parent. Not surprisingly, the perceived lack of autonomy of DPCs has led to a reaction from rating agencies, who have withdrawn ratings.¹⁹

As in the case of SPVs, it is clear that there are risks with DPCs. A DPC again illustrates that conversion of counterparty risk into other financial risks (in this case not only legal risk, as in the case of SPVs, but also market and operational risks) may be ineffective. The rating of the DPC should, therefore, be considered carefully in the context of that of the DPC parent. That said, some DPCs do still exist.²⁰

2.4.4 Monolines and CDPCs

As described above, the creation of DPCs was largely driven by the need for high-quality counterparties when trading OTC derivatives. However, this need was taken to another level by the birth and exponential growth of the credit derivatives market from around 1998 onwards. A credit derivative, such as a CDS, represents an unusual challenge since its value is driven by credit spread changes, whilst its payoff is linked solely to one or more credit events (e.g. default). The so-called wrong-way risk in CDSs (for example, when buying protection on a bank from another bank) meant that the credit quality of the counterparty became even more important than it would have been for other OTC derivatives. Beyond single-name CDSs, senior tranches of structured finance CDOs had even more wrong-way risk and created an even stronger need for a ‘default remote entity’.

Monoline insurance companies (and similar companies such as AIG)²¹ were financial guarantee companies with strong credit ratings that were utilised to provide ‘credit wraps’, which are financial guarantees. Monolines began providing credit wraps for other areas, but then entered the single-name CDS and structured finance arena to achieve diversification and better returns. Credit derivative product companies (CDPCs) were an extension of the DPC concept discussed in Section 2.4.3 that had business models similar to those of monolines.

In order to achieve good ratings (e.g. triple-A), monolines/CDPCs had capital requirements driven by the possible losses on the structures they provided protection on. Capital requirements were also dynamically related to the portfolio of assets they wrapped, which is similar to the workings of the DPC structure. Monolines and CDPCs typically did not have to post collateral (at least in normal times) against a decline in the market value of their contracts (due to their excellent credit rating).

When the GFC developed through 2007, monolines experienced major problems due to the MTM-based valuation losses on the insurance they had sold. Concerns started to rise over their triple-A ratings and whether they had sufficient capital to justify them. Critically, monolines had clauses whereby a rating downgrade (even below triple-A, in some cases) could trigger the need to post collateral. For example, in November 2007, ACA Financial Guarantee Corporation stated that a loss of its single-A credit rating would trigger a need to post collateral, which they would not be able to meet. Although rating agencies did not react immediately, once they began to downgrade monoline credit ratings their decline was swift, as the need to post collateral essentially sent them into default. Figure 2.13 illustrates the extremely rapid decline of the monolines AMBAC and MBIA.

From November 2007 onwards, a number of monolines (for example, XL Financial Assurance Ltd, AMBAC Insurance Corporation, and MBIA Insurance Corporation) essentially failed. In 2008, AIG was bailed out by the US Government to the tune of approximately $182bn. The reason why AIG was bailed out and the monoline insurers were not was the size of AIG's exposures and the timing of their problems close to the Lehman Brothers bankruptcy and Fannie Mae/Freddie Mac problems.²² These failures were due to a subtle combination of rating downgrades, required collateral posting, and MTM losses leading to a downward spiral. Many banks found themselves heavily exposed to the counterparty risk of monolines due to the massive increase in the value of the protection they had purchased. For example, as of June 2008, UBS was estimated to have $6.4bn at risk to monoline insurers, whilst the equivalent figures for Citigroup and Merrill Lynch were $4.8bn and $3bn respectively.²³

Figure 2.13 Share price (in dollars) of the monoline insurers AMBAC and MBIA (left axis) compared to the S&P 500 index (right axis).

The situation with AIG was more or less the same, from the joint result of a rating downgrade and AIG's positions moving against them rapidly, leading to the requirement to post large amounts of collateral. This essentially crystallised massive losses for AIG and led to potentially large losses for their counterparties if they were to fail (which is why AIG was bailed out).

CDPCs, like monolines, were highly leveraged and typically did not post collateral. They fared somewhat better during the GFC, but only for timing reasons. Many CDPCs were not fully operational until after the beginning of the GFC in July 2007; they therefore missed at least the first wave of losses suffered by any party selling credit protection (especially super senior).²⁴ Nevertheless, the fact that the CDPC business model is close to that of monolines has not been ignored. For example, in October 2008, Fitch Ratings withdrew ratings on the five CDPCs that it rated.²⁵

2.5 THE GLOBAL FINANCIAL CRISIS AND CENTRAL CLEARING OF OTC DERIVATIVES

2.5.1 OTC Derivatives and the Crisis

The causes of the GFC were complex and related to a mixture of macro-economic events, government policies, the relaxation of lending standards by financial institutions, and the failure of regulation. However, a significant amount of blame was attributed to OTC derivatives. In 2008, the global derivatives market reached a total notional of over $700 trillion (Figure 2.4). Around nine-tenths of this amount was OTC, dwarfing exchange-traded products. In hindsight, this has been viewed as having created a dangerous mix of complexity, leverage, and interconnectedness. This is perhaps epitomised by the rapid growth of credit derivatives during the period leading up to the GFC.

Another problem was that banks trading the majority of these OTC derivatives were very large as a result of a period of mergers and takeovers. Examples include Citigroup (Citicorp, Travellers Group, Smith Barney, Salomon Brothers), JPMorgan Chase & Co. (Chase Manhattan, Bank One), and Royal Bank of Scotland (ABN AMRO). Furthermore, other large financial firms, notably AIG, had effectively become very exposed to the OTC derivatives market. This market was large, complex, opaque, and only lightly regulated.

Over the course of the GFC, governments had no easy way to deal with financial institutions whose failure could trigger the collapse of other firms through channels such as the OTC derivatives market. Central banks such as the Federal Reserve and Bank of England were forced to manage the systemic risk posed by such institutions on an ad hoc and trial-and-error basis. To prevent cascading defaults, viewed as possibly leading to a breakdown of the entire financial system, governments facilitated the sale of some large financial institutions (e.g. Bear Stearns, HBOS) and injected capital into many others (e.g. Bank of America, Royal Bank of Scotland, AIG). Whilst such actions were undesirable, the aftermath of the bankruptcy of Lehman Brothers provided ample evidence as to the potential impact of not rescuing stricken large financial firms.

The problems governments faced were not just that large financial institutions were ‘too big to fail’ but also that they were ‘too interconnected to fail’. This interconnectedness was largely blamed on the OTC derivatives market. Regulators, therefore, believed that the GFC events demonstrated the obvious need to develop a clear regulatory framework to efficiently manage the systemic – or daisy-chain – risk posed by this market and its participants.

2.5.2 OTC Derivatives Clearing

From the late 1990s, several major CCPs began to provide clearing and settlement services for OTC derivatives and other non-exchange-traded products (such as repurchase agreements or ‘repos’). This was to help market participants reduce counterparty risk and benefit from the netting benefits and fungibility that central clearing creates. These OTC transactions are still negotiated privately and off-exchange, but are then novated into a CCP on a post-trade basis.

In 1999, LCH.Clearnet (now LCH Ltd) set up two OTC CCPs to clear and settle repos (RepoClear) and plain vanilla interest rate swaps (SwapClear). Commercial interest in OTC-cleared derivatives grew substantially in the energy derivatives market following the bankruptcy of Enron in late 2001. Intercontinental Exchange (ICE) responded to this demand by offering cleared OTC energy derivatives solutions beginning in 2002. ICE now offers OTC clearing for CDS contracts.

Although CCP clearing and settlement of OTC derivatives did develop in the years prior to the GFC, this was confined to certain products and markets. This suggests that there are both positives and negatives associated with using CCPs and, in some market situations, the positives may not outweigh the negatives.

As discussed in Section 2.2.2, clearing is the process that occurs after the execution of a trade in which a CCP may step in between counterparties to guarantee performance. The main function of a CCP is, therefore, to interpose itself directly or indirectly between counterparties to assume their rights and obligations by acting as the buyer to every seller and vice versa. This means that the original counterparty to a trade no longer represents a direct risk, as the CCP to all intents and purposes becomes the new counterparty. CCPs essentially reallocate default losses via a variety of methods including netting, margining, and loss mutualisation. Obviously, the intention is that the overall process will reduce counterparty and systemic risks.

CCPs provide a number of benefits. One is that they allow netting of all trades executed through them. In a bilateral market, an institution being long a contract with counterparty A and short the same contract with counterparty B has counterparty risk. However, if both contracts are centrally cleared, then the netted position has no risk. CCPs also manage margin requirements from their members to reduce the risk associated with the movement in the value of their underlying portfolios. All of these aspects can arguably be achieved in bilateral markets through mechanisms such as portfolio compression (Section 6.2.5) and increased collateralisation (Chapter 7).

In a centrally-cleared world, the failure of a counterparty, even one as large and interconnected as Lehman Brothers, is supposedly less dramatic. This is because the CCP absorbs the ‘domino effect’ by acting as a sort of financial shock absorber. In the event of default of one of its members, a CCP will aim to terminate swiftly all financial relations with that counterparty without suffering any losses. From the point of view of surviving members, the CCP guarantees the performance of their transactions. This will normally be achieved not by closing out transactions at their market value but rather by replacing the defaulted counterparty with one of the other clearing members for each transaction. This is typically achieved via the CCP auctioning the defaulted members' positions amongst the other members, which provides continuity for surviving members.

However, CCPs do introduce features beyond those seen in bilateral markets. One is loss mutualisation: one counterparty's losses are dispersed across all clearing members, rather than being transmitted directly to a smaller number of counterparties with potential adverse consequences. Moreover, CCPs can facilitate orderly close-outs by auctioning the defaulter's contractual obligations with multilateral netting, reducing the total positions that need to be replaced, which may minimise price impacts and market volatility. CCPs can also facilitate the orderly transfer of client positions from financially-distressed members.

The general role of a CCP is:

• to sets certain standards and rules for its clearing members (and to some extent their clients);
• to take responsibility for closing out all the positions of a defaulting clearing member;
• to support the above, to maintain financial resources to cover losses in the event of a clearing member default:
  • cash variation margin to closely track market movements;
  • initial margin to cover the worst-case liquidation or close-out costs above the variation margin; and
  • a default fund to mutualise losses in the event of a severe default; and
• to have a documented plan for the very extreme situation when all their financial resources (initial margin and the default fund)²⁶ are depleted – for example:
  • additional calls to the default fund;
  • variation margin haircutting;²⁷ and
  • selective tear-up of positions.²⁸

It is important to note that some banks and most end users of OTC derivatives (e.g. pension funds) will access CCPs through a clearing member and will not become members themselves. This will be due to the operational and liquidity requirements related to becoming a clearing member. In particular, participating in regular ‘fire drills’ and bidding in a CCP auction are the main reasons why an institution is unable to be or decides against being a clearing member at a given CCP.

2.5.3 CCPs in the Global Financial Crisis

It is important to emphasise that even before the GFC, some OTC derivatives were being centrally cleared (most notably, interest rate swaps). Despite OTC derivatives being at the centre of the financial chaos during the GFC, one area of this market did seem to be functioning well. Even the Lehman Brothers bankruptcy did not cause huge problems for CCPs such as LCH.Clearnet ($9trn notional Lehman portfolio) and Depository Trust and Clearing Corporation (DTCC; $500m notional Lehman portfolio). CCPs acted quickly (within hours) to suspend insolvent Lehman entities from trading and therefore prevented the build-up of more risk. On the other hand, solvent Lehman entities were also identified and continued trading. The CCPs also swiftly facilitated the transfer of solvent client accounts to other clearing members. In general, the response by CCPs was seen as providing stability and safety to Lehman counterparties and clients in cleared markets. In the CCP world, this mitigated potential knock-on or systemic effects due to the bankruptcy of a major OTC derivatives player.

The best and most commonly cited example of the benefits of CCPs for OTC derivatives is LCH.Clearnet's London-based SwapClear service, which provided interest rate swap central clearing for 20 large banks including Lehman. The total SwapClear portfolio exceeded $100trn notional across 14 currencies and represented close to half the global interest rate swap market at the time.²⁹ LCH.Clearnet had previously experienced defaults, such as Drexel Burnham Lambert (1990) and Barings (1995). However, the Lehman failure became the biggest default in CCP history.

At SwapClear, Lehman Brothers Special Financing Inc. (LBSF) was a big player, with a $9trn OTC portfolio comprising tens of thousands of trades, which was much larger than the exchange-traded portfolios of Lehman. On 15 September 2008, LBSF did not transfer margin payments and was therefore declared in default within hours. The goal now was for LCH.Clearnet to close out the large OTC portfolio (66,390 trades) as quickly as possible without creating large losses or knock-on effects. To help achieve this, LCH.Clearnet had a substantial amount (around $2bn) of initial margin from Lehman that was held precisely for such a situation.

The events at LCH.Clearnet's SwapClear clearing service in the aftermath of the Lehman default were as follows:

• As required by CCP rules, clearing members were obliged (on a rotational basis) to offer representatives to assist SwapClear in dealing with the defaulted member. LCH.Clearnet formed a default management group with senior traders from a total of six banks in order to assist in the close-out process.
• In the first couple of days, hedges were applied to neutralise the macro-level market risk in Lehman's portfolio. The risk positions were reviewed daily, and further hedges were executed in response to the changing portfolio and underlying market conditions.
• The majority of Lehman client positions were transferred to other solvent clearing members within the first week.
• Auctions were arranged to sell Lehman portfolios (together with their macro-hedges) to the remaining SwapClear members. Under the CCP's rules, members had to be involved in the auction. These auctions were arranged in each of the five relevant currencies between Wednesday 24 September and Friday 3 October. All auctions were deemed successful.

The events were hailed as a success by LCH.Clearnet³⁰ and required only around a third of the initial margin, with the rest being returned to the Lehman administrators. It should be noted that the Lehman close-out was not without its problems. In some cases, a client's margins were returned to the administrator and frozen for many months (this was partly related to poor record-keeping by Lehman and partly due to UK law, which did not have requirements regarding customer segregation that existed in the US). Indeed, even getting access to Lehman's offices was not immediately possible (Norman 2011).

Despite the general success of SwapClear with respect to the bankruptcy of Lehman, there were some negative implications involving other CCPs. The Chicago Mercantile Exchange (CME) cleared a combination of interest rate, equity, agriculture, energy, and FX positions for Lehman and had to rely on gains from three of these asset classes to offset losses on the two others (Pirrong 2014). Furthermore, there are suggestions that the three winning bidders in the CME auction for Lehman positions made a combined profit of $1.2bn on taking over the portfolios (see later discussion in Section 10.2.2).

Also regarding the Lehman bankruptcy, in December 2008, Hong Kong Exchanges and Clearing Ltd (HKEx) disclosed a loss of HK$157m in relation to the portfolio of Lehman Brothers Securities Asia (LBSA) being closed out by the Hong Kong Securities Clearing Company (HKSCC). As a result of this, HKSCC needed to draw on resources including their HK$394m default fund and call for additional default fund contributions from their most active members. As explained later, this means that the other CCP members suffered default losses.

2.5.4 The Clearing Mandate

Prior to the events of the GFC, there was no obvious requirement by regulators for central clearing of OTC derivatives. However, from the rescue of Bear Stearns onwards, calls for central clearing started to emerge from regulators globally. In the US, market participants and regulators agreed on an agenda for bringing about further improvements in the OTC derivatives market infrastructure, one of the points being ‘developing a central counterparty for credit default swaps that, with a robust risk management regime can help reduce systemic risk’.³¹ A statement from the European Commission described a CCP for CDSs as a ‘pressing need’.³² The Lehman events of September 2008 gave further weight to such viewpoints. The rationale behind the clearing requirement seemed to be that systemic risk in the GFC was exacerbated by counterparty risk concerns that could be mitigated by CCPs.

CCPs were being seen as a kind of OTC derivatives market ‘shock absorber’ in the event of the default of one or more market participants, as they would allow such an event to be managed with the least disruption. A key problem in such situations was the need to replace large numbers of defaulted positions within a short time in an illiquid market. Such a requirement can clearly lead to large price moves together with increased volatilities and dependencies. In turn, the price shocks arising from the rush to replace defaulted trades can impose substantial losses that can threaten the solvency of other market participants. CCPs became widely seen as the solution to such problems by providing greater transparency and reducing risk via their margining practices. CCPs could establish and enforce the ‘rules’ for the OTC derivatives market.

In 2009, the G20 leaders agreed in Pittsburgh to require:

• all standardised OTC derivatives to be traded on exchanges or electronic platforms;
• mandatory central clearing of standardised OTC derivatives;
• the reporting of OTC derivatives to trade repositories; and
• higher capital requirements for non-centrally cleared OTC derivatives.

Whilst much of the initial discussion and research on risks associated with OTC derivatives was focused on credit derivatives (via credit default swaps), the clearing mandate had now been broadened to cover the whole OTC derivatives market. This was perhaps not surprising since credit derivatives made up less than one-tenth of the overall notional OTC derivatives market.

Not all OTC derivatives can be centrally cleared as clearing requires a reasonable level of standardisation and liquidity. The clearing mandate is responsible for increasing the number of cleared OTC derivatives, though (Figure 2.14).

2.5.5 Bilateral Margin Requirements

Whilst clearing is mandatory, it can be avoided by trading contracts that are not sufficiently standardised to be cleared, for example. In order to give a strong incentive for market participants to move as many OTC derivatives to central clearing as possible, regulators introduced mandatory margin (collateral) rules for derivatives that would remain bilateral. Loosely speaking, this regulation can be seen as mimicking the margining requirements under central clearing (in reality, these rules may sometimes be more punitive, as discussed in Section 4.4.2) and thus reducing any incentive for avoiding central clearing.

Figure 2.14 Bilateral and centrally-cleared OTC derivatives. Source: Eurex (2014).

Following the previous 2009 agreements described in Section 2.5.4, in November 2011 in Cannes the G20 leaders agreed to add a mandate for margin requirements for non-centrally-cleared derivatives, stating:

We call on the Basel Committee on Banking Supervision (BCBS), the International Organization for Securities Commission (IOSCO) together with other relevant organizations to develop for consultation standards on margining for non-centrally cleared OTC derivatives by June 2012, and on the FSB [Financial Stability Board] to continue to report on progress towards meeting our commitments on OTC derivatives.

The BCBS and IOSCO accordingly produced a consultative paper (BCBS-IOSCO 2012) on the subject of bilateral margin requirements.

The Working Group on Margin Requirements (WGMR) was formed in October 2011 to develop the framework for margins. The WGMR is run jointly by the IOSCO, the BCBS, the Committee on Payment and Settlement Systems (CPSS), and the Committee on the Global Financial System (CGFS).

2.5.6 CCPs in Context

The aforementioned concepts of SPVs, DPCs, monolines, and CDPCs have all been shown to lead to certain issues. Indeed, it could be argued that as risk mitigation methods they all have fundamental flaws, which explains why there is little evidence of them in today's OTC derivatives market. At the same time, there is a clearing mandate that encourages the use of central counterparties as much as possible for clearing OTC derivatives.

A CCP aims to reduce systemic risk by having the means to manage periodic failures (of their clearing members) in a controlled manner. If there is a default of a key market participant, the CCP guarantees all the contracts that this counterparty has executed through them as a clearing member. This will mitigate concerns faced by institutions and prevent any extreme actions by those institutions that could worsen the crisis. Any unexpected losses³³ caused by the failure of one or more counterparties would be shared (‘loss mutualisation’) amongst all members of the CCP (just as insurance losses are essentially shared by all policyholders), rather than being concentrated within a smaller number of institutions that may be heavily exposed to the failing counterparty. Loss mutualisation is a key component as it mitigates systemic risk and prevents a domino effect.

The CCP concept is different to those discussed above but shares a key characteristic, which is that the reduction of counterparty risk relies on the CCP itself being of exceptional credit quality, since a CCP failure would almost certainly create (or catalyse) a systemic risk episode. It is important to ask to what extent the flaws of SPVs, DPCs, monolines, and CDPCs may also exist within a CCP, which does share certain characteristics of these structures.

Regarding SPVs and DPCs, two obvious questions emerge. The first is whether shifting priorities from one party to another really helps the system as a whole. CCPs will effectively give priority to OTC derivative counterparties and in doing so may reduce the risk in this market. However, this will make other parties (e.g. bondholders) worse off and may, therefore, increase risks in other markets (see Sections 6.4.4 and 10.3.5 for further detail). Second, a critical reliance on a precise sound legal framework creates exposure to any flaws in such a framework. This is especially important as in a large bankruptcy there will likely be parties who stand to make significant gains by challenging the priority of payments (as in the aforementioned SPV flip clause cases). Furthermore, the cross-border activities of CCPs also expose them to bankruptcy regimes and regulatory frameworks in multiple regions.

CCPs also share some similarities with monolines and CDPCs as strong credit quality entities set up to take and manage counterparty risk. However, two very important differences must be emphasised. First, CCPs have a ‘matched book’ and do not take any market risk (except when members default). This is a critical difference since monolines and CDPCs had very large, mostly one-way exposure to credit markets. Second, the related point is that CCPs require margining (variation and initial margin in all situations), whereas monolines and CDPCs would essentially post only limited collateral (variation margin) and would often only do this in extreme situations (e.g. in the event of their ratings being downgraded). Many monolines and CDPCs posted no margin or collateral at all at the inception of trades. Nevertheless, CCPs are similar to these entities in essentially insuring against systemic risk. However, the term ‘systemic risk insurance’ is a misnomer, as systemic risk cannot obviously be diversified.

Although CCPs do not suffer structurally from the flaws that caused the failure of monoline insurers or the bailout of AIG, there are clearly lessons to be learnt with respect to the centralisation of counterparty risk in a single large and potentially too-big-to-fail entity. One specific example is the destabilising relationship created by increases in margin requirements. Monolines and AIG failed due to a significant increase in collateral requirements during a crisis period. CCPs could conceivably create the same dynamic, which will be discussed later (Chapter 8).

Recent history has also highlighted some potential problems with central clearing, such as the default of a clearing member at the Nasdaq Nordic commodity exchange in September 2018 (see Section 10.1.3).

2.6 DERIVATIVES RISK MODELLING

2.6.1 Value-at-risk

Financial risk management of derivatives has changed over the last two decades. One significant aspect has been the implementation of more quantitative approaches, the most significant probably being value-at-risk (VAR). Initially designed as a metric for market risk, VAR has subsequently been used across many financial areas as a means for efficiently summarising risk via a single quantity. For example, the concept of potential future exposure (PFE), used to assess counterparty risk, is equivalent to the definition of VAR.

A VAR number has a simple and intuitive explanation as the worst loss over a target horizon to a certain specified confidence level. The VAR at the confidence level gives a value that will be exceeded with no more than a probability. An example of the computation of VAR is shown in Figure 2.15. The VAR at the 99% confidence level is −125 (i.e. a loss) since the probability that this will be exceeded is no more than 1% (it is actually 0.92% due to the discrete nature of the distribution).³⁴ To find the VAR, one finds the minimum value that will be exceeded with the specified probability.

Figure 2.15 Illustration of the value-at-risk (VAR) concept at the 99% confidence level. The VAR is 125 since the chance of a loss greater than this amount is no more than 1%.

Figure 2.16 Distribution with the same VAR as the distribution in Figure 2.15.

VAR is a very useful way in which to summarise the risk of an entire distribution in a single number that can be easily understood. It also makes no assumption as to the nature of the distribution itself, such as that it is a Gaussian.³⁵ It is, however, open to problems of misinterpretation since VAR says nothing at all about what lies beyond the defined threshold (1%, in the above example). To illustrate this, Figure 2.16 shows a slightly different distribution with the same VAR. In this case, the probability of losing 250 is 1%, and hence the 99% VAR is indeed 125 (since there is zero probability of other losses in between). We can see that changing the loss of 250 does not change the VAR since it is only the probability of this loss that is relevant. Hence, VAR does not give an indication of the possible loss outside the confidence level chosen. Over-reliance on VAR numbers can be counterproductive as it may lead to false confidence.

Another problem with VAR is that it is not a coherent risk measure (Artzner et al. 1999), which basically means that in certain (possibly rare) situations, it can exhibit non-intuitive properties. The most obvious of these is that VAR may not behave in a sub-additive fashion. Sub-additivity requires a combination of two portfolios to have no more risk than the sum of their individual risks (due to diversification).

A slight modification of the VAR metric is commonly known as expected shortfall (ES). Its definition is the average loss equal to or above the level defined by VAR. Equivalently, it is the average loss knowing that the loss is at least equal to the VAR. ES does not have quite as intuitive an explanation as VAR, but it has more desirable properties such as not ignoring completely the impact of large losses (the ES in Figure 2.16 is indeed greater than that in Figure 2.15) and is a coherent risk measure. For these reasons, the Fundamental Review of the Trading Book (BCBS 2013e) requires that banks use ES rather than VAR for measuring their market risk.

The most common implementation of VAR and ES approaches is using historical simulation. This takes a period (usually several years) of historical data containing risk factor behaviour across the entire portfolio in question. It then resimulates over many intervals within this period how the current portfolio would behave when subjected to the same historical evolution. For example, if four years of data were used, then it would be possible to compute around 1,000 different scenarios of daily movements for the portfolio. If a longer time horizon is of interest, then quite commonly the one-day result is simply extended using the ‘square root of time rule’. For example, in market risk VAR models used by banks, regulators allow the 10-day VAR to be defined as multiplied by the one-day VAR. VAR models can also be ‘backtested’ as a means to empirically check their predictive performance. Backtesting involves performing an ex post comparison of actual outcomes with those predicted by the model. VAR lends itself well to backtesting since a 99% VAR number should be exceeded once every 100 observations.

It is important to note that the use of historical simulation and backtesting are relatively straightforward to apply for VAR and ES due to the short time horizon (10 days) involved. For counterparty risk assessment (and xVA in general) much longer time horizons are involved, and quantification is therefore much more of a challenge.

2.6.2 Models

The use of metrics such as VAR relies on quantitative models in order to derive the distribution of returns from which such metrics can be calculated. The use of such models facilitates combining many complex market characteristics such as volatility and dependence into one or more simple numbers that can represent risk. Models can compare different trades and quantify which is better, at least according to certain pre-defined metrics. All of these things can be done in minutes or even seconds to allow institutions to make fast decisions in rapidly-moving financial markets.

However, the financial markets have a somewhat love/hate relationship with mathematical models. In good times, models tend to be regarded as invaluable, facilitating the growth in complex derivatives products and dynamic approaches to risk management adopted by many large financial institutions. The danger is that models tend to be viewed either as ‘good’ or ‘bad’ depending on the underlying market conditions, whereas in reality models can be good or bad depending on how they are used. An excellent description of the intricate relationship between models and financial markets can be found in MacKenzie (2006).

The modelling of counterparty risk is an inevitable requirement for financial institutions and regulators. This can be extremely useful, and measures such as PFE, the counterparty risk analogue of VAR, are important components of counterparty risk management. However, like VAR, the quantitative modelling of counterparty risk is complex and prone to misinterpretation and misuse. Furthermore, unlike VAR, counterparty risk involves looking years into the future rather than just a few days, which creates further complexity that is not to be underestimated. Not surprisingly, regulatory requirements over backtesting of counterparty risk models have been introduced to assess performance.³⁶ In addition, a greater emphasis has been placed on stress testing of counterparty risk, to highlight risks in excess of those defined by models. Methods to calculate xVA are, in general, under continuous scrutiny.

2.6.3 Correlation and Dependency

Probably the most difficult aspect in understanding and quantifying financial risk is that of dependency between different financial variables. It is well known that historically-estimated correlations may not be a good representation of future behaviour. This is especially true in a more volatile market environment, or crisis, where correlations have a tendency to become very large. Furthermore, the very notion of correlation (as used in financial markets) may be heavily restrictive in terms of its specification of dependency.

Counterparty risk takes difficulties with correlation to another level, for example, compared to traditional VAR models. Firstly, correlations are inherently unstable and can change significantly over time. This is important for counterparty risk assessment, which must be made over many years, compared to market risk VAR, which is measured over just a single day. Secondly, correlation is not the only way to represent dependency, and other statistical measures are possible. Particularly in the case of wrong-way risk (Section 17.6), the treatment of co-dependencies via measures other than correlation is important. In general, xVA calculations require a careful assessment of the co-dependencies between credit risk, market risk, funding, and collateral.

NOTES

1. 1 ISDA (2009). Over 94% of the World's Largest Companies Use Derivatives to Help Manage Their Risks, According to ISDA Survey. Press Release (23 April). www.isda.org.
2. 2 This is the process of determining the price of an asset in a marketplace through the interactions of buyers and sellers.
3. 3 ISDA (1986). Survey covering only OTC swaps.
4. 4 Assuming the swap can be replaced without any additional cost.
5. 5 There are other ways to reduce market values, such as restructuring transactions. Note that the use of collateral or margin (discussed in Section 2.2.4) is not shown in these figures.
6. 6 BIS (2018). OTC derivatives statistics at end-June 2016 (31 October). www.bis.org.
7. 7 The difference between margin and collateral will be explained in more detail in Chapter 7. The former is more associated with exchange-traded derivatives and the latter with OTC derivatives.
8. 8 ISDA (2010).
9. 9 This involves receiving the fixed rate and paying the floating rate.
10. 10 Hull (2015) discusses these and other examples in more detail.
11. 11 Although the use of a repurchase agreement (‘repo’) can resolve this and create leverage similar to the way in which a derivative does.
12. 12 Aside from initial margin requirements and bank capital requirements.
13. 13 Berkshire Hathaway Annual Report (2002).
14. 14 Or via a central counterparty, or later reduced via trade compression.
15. 15 For example, a bank may have issued a triple-A CDO which was problematic since the bank itself did not have a triple-A rating.
16. 16 Contiguglia, C. (2016). Flip clause ruling nets Lehman estate $3 billion. Risk (27 January). www.risk.net.
17. 17 Whittall, C. (2010). Lehman opts to settle over Dante flip-clause transactions. Risk (18 November). www.risk.net.
18. 18 Most DPCs derived their credit quality structurally via capital, but some simply did so from the sponsors' rating.
19. 19 Fitch withdraws Citi Swapco's ratings. Business Wire (10 June 2011). www.businesswire.com.
20. 20 Cameron, M. (2014). RBS sets up first Moody's-rated DPC in 14 years. Risk (14 May). www.risk.net.
21. 21 For the purposes of this analysis, we will categorise monoline insurers and AIG as the same type of entity, which, based on their activities in the credit derivatives market, is fair.
22. 22 Whilst the monolines together had approximately the same amount of credit derivatives exposure as AIG, their failures were at least partially spaced out.
23. 23 Van Duyn, A. and F. Guerrero (2008). Banks face $10bn monolines charges. Financial Times (10 June). www.ft.com.
24. 24 The widening in super senior (very-highly-rated tranches of structured credit securities) spreads was, on a relative basis, much greater than credit spreads in general during late 2007.
25. 25 Fitch withdraws CDPC ratings. Business Wire (17 October 2008). www.businesswire.com.
26. 26 Note that only the defaulter's initial margin can be used.
27. 27 See Elliott (2013) or Gregory (2014) for more details.
28. 28 See previous footnote.
29. 29 LCH.Clearnet Annual Report (2007). www.lch.com.
30. 30 LCH.Clearnet (2008). $9 trillion Lehman OTC interest rate swap default successfully resolved. Press release (8 October). www.lch.com.
31. 31 Federal Reserve Bank of New York (2008). Statement regarding June 9 meeting on over-the-counter derivatives (9 June). www.newyorkfed.org.
32. 32 European Commission (2008). Statement of Commissioner McGreevy on reviewing derivatives markets before the end of the year (17 October). ec.europa.eu.
33. 33 Meaning those above a certain level that will be discussed later.
34. 34 For a continuous distribution, VAR is simply a quantile (a quantile gives a value on a probability distribution where a given fraction of the probability falls below that level).
35. 35 Certain implementations of a VAR model (notably the so-called variance-covariance approach that forms the basis of the SIMM approach discussed in Section 9.4.4) may make normal distribution assumptions, but these are done for reasons of simplification and the VAR idea itself does not require them.
36. 36 Under the Basel III regulations.