The New Rules for OTC Derivatives
John Hull is an internationally recognized authority on derivatives and risk management and has many publications in this area; he is currently Maple Financial Professor Of Derivatives & Risk Management at Joseph L. Rotman School of Management at University Of Toronto. He will be discussing how to handle negative rates and P vs. Q measure issues at RiskMinds International.
The Leaders’ statement issued after the G-20 meetings in Pittsburgh in September 2009 included the following paragraph:
“All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements. We ask the FSB and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.”
Eight years on, it seems appropriate to review the changes that this has led to.
The key objective immediately following the crisis was to reduce systemic risk by requiring more collateral to be posted when financial institutions trade with each other. This objective has largely been achieved. Standard transactions between financial institutions are cleared through CCPs and attract both initial margin and variation margin. Non-standard transactions between financial institutions continue to be cleared bilaterally. But, following the 2011 G-20 meeting in Cannes, rules requiring initial and variation margin for these transactions are being implemented.
One result of these changes is that there has been a trend away from customized OTC derivatives toward more standard products. This should reduce systemic risk, but there are potential disadvantages. If dealers are less willing to customize transactions, end users may make less use of derivatives for hedging. One of the reasons that end users require non-standard derivative transactions is to make the transaction match some physical transaction so that the derivative and the physical transaction qualify for hedge accounting rules. The end user may not be willing to enter into a standard derivative if it does not qualify for hedge accounting. Also, there is a danger that the new rules will hinder financial innovation by dealers.
There has been a trend away from customized OTC derivatives toward more standard products. This should reduce systemic risk, but there are potential disadvantages.
There can be little doubt that reporting all OTC derivative transactions to trade repositories such as the Depository Trust and Clearing Corporation (DTCC) is desirable. It gives regulators the opportunity to recognize situations where unacceptable risks are being taken. It also creates more post-trade price transparency.
No doubt politicians and regulators were greatly influenced by the AIG fiasco. AIG Financial Products entered into many transactions where it guaranteed the AAA-rated securities created from the securitization and re-securitization of subprime mortgages. The performance of AIG Financial Products was guaranteed by its U.S. parent. It was not required to post collateral on its transactions providing AIG’s credit rating remained above AA. In mid-September, AIG’s credit rating fell below AA and it was unable to provide the required collateral. Only then did regulators become aware of the risks that had been taken. A massive bailout followed.
A situation similar to AIG should never happen again. First, trade repositories would allow regulators to be more aware of the one-sided risks being taken, making it possible for them to step in earlier. Second, a company entering into trades similar to those of AIG would be required to post so much initial margin and variation margin that its appetite for the trades would be greatly diminished.
The least important, and least defensible, of the new regulations for OTC derivatives is the requirement that standard transactions between financial institutions be traded on electronic platforms. The motivation for this seems to be that, if OTC derivatives are traded like exchange-traded derivatives, there will be more price transparency and problems such as those observed during the crisis will be avoided. In fact, the problems during the crisis were caused by non-standard derivatives and there is no requirement that these be traded on electronic platforms.
There is a danger in trying to trade OTC derivatives in the same way as exchange-traded derivatives... there are important differences between the two.
There was not a serious problem in the way OTC derivatives were traded pre-crisis. It is not clear that there was a lack of price transparency. Industry participants had access to reliable sources of price quotes. In any case, trade repositories should take care of any transparency issues. Trading OTC derivatives in the same way as exchange traded derivatives is therefore not necessary to achieve price transparency.
In addition, there is a danger in trying to trade OTC derivatives in the same way as exchange-traded derivatives. This is because there are important differences between the two. OTC derivatives trade intermittently whereas exchange-traded derivatives such as futures trade continuously. The size of a typical OTC derivative is much larger than that of a typical exchange-traded derivative. There are fewer market participants in the OTC market, but they are more sophisticated than the average participant in exchange-traded markets.
In addition, there is a danger in trying to trade OTC derivatives in the same way as exchange-traded derivatives. This is because there are important differences between the two. OTC derivatives trade intermittently whereas exchange-traded derivatives such as futures trade continuously. The size of a typical OTC derivative is much larger than that of a typical exchange-traded derivative. There are fewer market participants in the OTC market, but they are more sophisticated than the average participant in exchange-traded markets.
A final question is whether the effect of the new regulations is to move the too-big-to-fail problem from banks to CCPs. It is certainly true that CCPs are too big to fail. But arguably they are much easier to regulate than banks and therefore are much less likely to fail.
This article is an abbreviated version of an editorial that appeared in Journal of Risk Management and Financial Institutions, Autumn/Fall 2015