After completing this reading, you should be able to:
- Describe how exchanges can be used to alleviate counterparty risk.
- Explain the developments in clearing that reduce risk.
- Describe netting and describe a netting process.
- Describe the implementation of a margining process and explain the determinants of initial and variation margin requirements.
- Compare exchange-traded and OTC markets and describe their uses.
- Identify the classes of derivative securities and explain the risk associated with them.
- Identify risks associated with OTC markets and explain how these risks can be mitigated.
- Describe the role of collateralization in the over-the-counter market and compare it to the margining system.
- Explain the use of special purpose vehicles (SPVs) in the OTC derivatives market.
How Exchanges Alleviate Counterparty Risk
An exchange is a central financial location where traders can trade (exchange) standardized financial instruments such as futures contracts.
A major risk when trading derivatives is counterparty risk. A counterparty refers to the opposite side of a financial transaction. For example, if company \(A\) enters interest rate swap to give fixed rate payments in exchange for floating rate payments from company \(B\) pegged on the six-month LIBOR, \(A\) and \(B\) are said to be counterparties. If large moves in the floating rate occur, \(B\) could default, resulting in a financial loss for \(A\).
Organized exchanges use several mechanisms to alleviate counterparty risk. These include:
- Standardization: In exchange contracts, the choice of expiry dates is limited, and trades have fixed sizes. This standardization paves the way for an active secondary market where trades can be executed. However, perhaps the most pronounced benefit is increased liquidity. Thus, a participant who finds themselves in pressure with respect to a position can easily liquidate it and use the proceeds to avoid default in another position.
- Margins: Daily settlements may not provide a buffer strong enough to avoid future losses. For this reason, each party is required to post collateral that can be seized in the event of default. The initial margin must be posted when initiating the contract. If the equity in the account falls below the maintenance margin, the relevant party receives a margin call – a requirement to provide additional funds to restore the margin account to the initial level.
- Clearinghouse: The clearinghouse is an interposed party between the buyer and the seller which ensures the performance of the contract. In essence, futures contracts have no credit risk. Each exchange has a clearinghouse. The clearinghouse splits each trade and acts as the opposite side of each position. It’s the buyer to every seller and seller to every buyer. In other words, there is no direct contact between the short and long parties. It’s the clearinghouse that makes margin calls whenever the need arises. In OTC markets, clearinghouses play a similar role.
- Marking to market: Since the clearinghouse must monitor the credit risk between the buyer and the seller, it performs daily marking to market. This is the settlement of the gains and losses on the contract on a daily basis. It avoids the accumulation of large losses over time, something that can lead to a default by one of the parties.
- Position limits: The number of contracts that a speculator can hold is capped at a certain value by the exchange. Besides avoiding situations where a party engages in multiple positions that could strain its resources, position limits prevent speculators from having an undue influence in the market.
A History Lesson in Clearing Trades
Over the years, the clearing process of exchanges has slowly evolved.
- Direct clearing: This simply refers to the bilateral reconciliation of commitments between the original two counterparties.
- Clearing rigs: Clearing rings simplify the dependencies of a member’s open positions and allow them to close out contracts more easily, increasing liquidity. Note that clearing rings do not completely eliminate the counterparty risk.
- Complete clearing: All exchange-traded contracts nowadays are using to central clearing. The CCP function may either be operated by the exchange or provided to the exchange as a service by an independent company.
Over-the-counter Trading vs. Exchange Trading
The over-the-counter market is a decentralized trading platform, without a central physical location, where market participants use a host of communication channels to trade with one another without a formal set of regulations. The communication channels commonly used include telephone, email, and computers. OTC trading is facilitated by a derivatives dealer who usually is a major financial institution specialized in derivatives.
In an OTC market, it’s possible for two participants to exchange products/securities privately without others being aware of the terms, including the price. OTC markets are much less transparent than exchange trading.
Stocks traded in an OTC market could belong to a small company that’s yet to satisfy the conditions for listing on the exchange. The OTC market is also popular for large trades.
Advantages of OTC markets over exchanges include:
- There are fewer restrictions and regulations on trades
- The participants have the freedom to negotiate deals
- It’s cost-effective for corporates as service costs lower
- There’s better information flow between a market maker and the customer thanks to one-on-one contact
Disadvantages of OTC markets compared to exchanges include:
- There’s increased credit risk associated with each OTC trade
- Less transparency
Risks Associated with OTC Markets
Systemic risk refers to a market-wide event that would originate from an initial park only to trigger a chain reaction that could devastate the financial markets. Such a spark could be the failure of a player considered “too big to fail.”
According to Ben Bernanke, an American economist, a too-big-to-fail firm is one whose size, complexity, interconnectedness, and critical functions are such that, should the firm go unexpectedly into liquidation, the rest of the financial system and the economy would face severe adverse consequences.
As we’ve seen before, counterparty risk is the risk that a counterparty in a derivatives contract will, either, willingly or unintentionally default on contractual obligations.
Some of the measures taken to mitigate these risks in OTC markets include:
- Margining: Each party is required to post collateral – usually in the form of risk-free bonds – that can be seized in the event of default.
- Netting: This refers to the offsetting of positions between counterparties due to the fungibility of the contracts. Suppose, for instance, that Bank \(X\) bought \($50\quad million\) worth of euros from \(Y\). At the same time, it sold an otherwise identical contract to Bank \(A\) in the amount of \($40\quad million\). If the two trades had gone through the same clearinghouse, the net exposure of Bank \(X\) would be \($10\quad million\) only.
- Special Purpose Vehicles: A special purpose vehicle is a legal entity created for the sole purpose of isolating a firm from financial risks. After the SPV is officially registered, the parent company typically transfers some assets to the SPV for management. The parent can also use the SPV to take on large finance projects, without threatening the financial stability of the entire firm. If a derivative counterparty defaults, the SPV ensures that the client whose funds are at risk can still receive their full investment prior to payment of any other outstanding claims. In fact, some legal jurisdictions do not allow firms to create SPVs using equity capital.
- Derivative Product Companies: A derivative product company, DPC, is generally an AAA-rated entity set up by one or more banks to serve as a bankruptcy-remote subsidiary of a major dealer. It differs from SPVs in that it’s separately capitalized to obtain an AAA-rating. The DPC shields external counterparties from the knock-on effects that may play out in the event the DCP parent fails.DCPs offer flexibility and decentralization, while still allowing counterparties to enjoy benefits associated with exchange-based trading.
- Monoline insurance companies: A monoline insurer is a company with strong credit ratings which it utilizes to provide financial guarantees called “credit wraps.”
- Credit Derivative Product Company: A CDPC is a special purpose entity that sells credit protection under credit default swaps or certain approved forms of insurance policies. In some cases, they can also buy credit protection.
In direct clearing, if Party A owes Party B $1 million and Party B owes Party C $500,000, then Party A will pay Party C:
- $1 million
- $1.5 million
The correct answer is C.
In direct clearing, there are no clearing rings, so Party A will only be responsible for paying Party B.