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3.1.1 Derivatives

Derivatives contracts represent 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 (such as long-dated swaps). The value of a derivative will change with the level of one of more underlying rates, 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:

• IR risk. They need to manage liabilities such as transforming floating- into fixed-rate debt via an interest rate swap.

• FX risk. Due to being paid in various currencies, there is a need to hedge cash inflow or outflow in these currencies via FX forwards.

• Commodity. 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.

There are many different users of derivatives, such as sovereigns, central banks, regional/local authorities, hedge funds, asset managers, pension funds, insurance companies and corporates. All use derivatives as part of their investment strategy or to hedge the risks they face from their business activities.

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 their exposure to a potential rise in aviation fuel 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 their exposure to a certain asset can do so via a derivative contract, which means they do not have to sell the asset directly in the market.

The credit risk of derivatives contracts is usually called counterparty risk. As the derivatives market has grown, so has the importance of counterparty risk. Furthermore, the lessons from events such as the failure of Long-Term Capital Management and Lehman Brothers (as discussed in the last chapter) 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.

3.1.2 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 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 easy to enter and exit positions.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. Whilst an exchange provides efficient price discovery,7 it also typically provides a means of mitigating counterparty risk. Modern-day exchanges have a central counterparty clearing function to guarantee performance and therefore reduce counterparty risk. Since the mid-1980s, all exchanges have had such central clearing facilities.

Compared to exchange-traded derivatives, OTC derivatives tend to be less standard structures and are typically traded bilaterally, i.e., between two parties. They are private contracts, traditionally not reported or part of any customer asset protection programme. Hence, each party takes counterparty risk with respect to the other party. Many players in the OTC derivatives market do not have strong credit quality, nor are they able to post collateral to reduce counterparty risk. This counterparty risk is therefore an unavoidable consequence of the OTC derivatives market. A relatively small number of banks are fairly dominant in OTC derivatives: generally these are large and highly interconnected, and are generally viewed as being “too big to fail”.

3.1.3 Market size

In 1986, the total notional of OTC derivatives was slightly less than that of exchange traded derivatives at $500 billion.8 Arguably, even at this point OTC markets were more significant due to the fact that they are longer-dated (for example, a ten-year OTC interest rate swap is many times more risky than a three-month interest rate futures contract).

Figure 3.1 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.

Source: BIS.

Nevertheless, in the following two decades, the OTC derivatives market grew exponentially in size (Figure 3.1). 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 ten between the end of 2003 and the end of 2008). The relative popularity of OTC products arises from the ability to tailor contracts more precisely to client needs, for example, by offering a particular maturity date. Exchange-traded products, by their very nature, do not offer customisation.

The total notional amount of all derivatives outstanding was $601 trillion at 2010 year-end. The curtailed growth towards the end of the history can be clearly attributed to the global financial crisis, where banks have reduced balance sheets and reallocated capital, and clients have been less interested in derivatives, particularly as investments. However, the reduction in recent years is also partially due to compression exercises that seek to reduce counterpart risk via removing offsetting and redundant positions (discussed in more detail in Section 5.3).

A significant amount of OTC derivatives are collateralised: parties pledge cash and securities against the mark-to-market (MTM) of their derivative portfolio with the aim of neutralising the net exposure between the counterparties. Collateral can reduce counterparty risk but introduces additional legal and operational risks. Furthermore, posting collateral 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 timeframe.

Since the late 1990s, there has also been a growing trend to centrally clear some OTC derivatives, primarily aimed at reducing counterparty risk. Centrally cleared derivatives retain some OTC features (such as being transacted bilaterally) but use the central clearing function developed for exchange-traded derivatives. This is discussed in more detail in Chapter 9. It is possible to centrally clear an OTC derivative that is not liquid enough to trade on an exchange. However, central clearing does still require an OTC derivative to have a certain level of standardisation and liquidity, and to not be too complex. This means that many types of OTC derivatives may never be suitable for central clearing.

Broadly speaking, derivatives can be classified into several different groups by the way in which they are transacted and collateralised. These groups, in 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 whereby collateral must be posted and the performance of all exchange members is guaranteed. Due to the lack of complexity, the short maturities and central clearing function, this is probably therefore the safest part of the derivatives market.

• 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 9.3.1).

• OTC collateralised. These are bilateral OTC derivatives that are not centrally cleared but where parties post collateral 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 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 and costs.

The question, of course, is how significant each of the above categories is. Figure 3.2 gives a breakdown in terms of the total notional. Only about a tenth of the market is exchange-traded with the majority being OTC. However, more than half of the OTC market is already centrally cleared. Of the remainder, 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 3.2) 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 3.2 important.

3.1.4 Market participants

The range of institutions that take significant counterparty risk has changed dramatically over recent years – or, more to the point, institutions now fully appreciate the extent of counterparty risk they may face. It is useful to characterise the different players in the OTC derivatives market. Broadly, the market can be divided into three groups:

Figure 3.2 Breakdown of different types of derivatives by total notional.

Source: Eurex (2014).

• Large players. This will be a large global bank, often known as a dealer. They will have a vast number of OTC derivatives trades on their books and have many clients and other counterparties. They will usually trade across all asset classes (interest rate, foreign exchange, equity, commodities, credit derivatives) and will post collateral against positions (as long as the counterparty will make the same commitment and sometimes even if they do not).

• 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 may not be active in all of them (they may, for example, not trade credit derivatives or commodities, and will probably not deal with the more exotic derivatives). Even within an asset class, their coverage may also be restricted to 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 post collateral against their positions.

• 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 smaller 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 trade only commodity forwards; or 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 posting collateral or will post illiquid collateral and/or post more infrequently.

The OTC derivatives market is highly concentrated with the largest 14 dealers holding around four-fifths of the total notional outstanding.9 These dealers collectively provide the bulk of the market liquidity in most products. Historically, these large derivatives players have had stronger credit quality than the other participants and were not viewed by the rest of the market as giving rise to counterparty risk. (The credit spreads of large, highly rated, financial institutions prior to 2007 amounted to just a few basis points per annum.10) The default of Lehman Brothers illustrated how wrong this assumption had been. Furthermore, some smaller players, such as sovereigns and insurance companies, have had very strong (triple-A) credit quality. Indeed, for this reason such entities have often obtained very favourable terms such as one-way collateral agreements as they were viewed as being practically risk-free. The failure of monoline insurance companies and near-failure of AIG illustrated the naivety of this assumption. Historically, a large amount of counterparty risk has therefore been ignored simply because large derivatives players or entities with the best credit ratings were assumed to be risk-free. Market practice, regulation and accounting standards have changed dramatically over recent years in reaction to these aspects.

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

3.1.5 Credit derivatives

The credit derivatives market grew swiftly in the decade before the global financial crisis due to the need to transfer credit risk efficiently. The core credit derivative instrument, the credit default swap (CDS), is simple and has transformed the trading of credit risk. However, CDSs themselves can prove highly toxic: whilst they can be used to hedge counterparty risk in other products, there is counterparty risk embedded within the CDS itself. The market has recently become all too aware of the dangers of CDSs and their usage has partly declined in line with this realisation. 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 crisis.

One of the main drivers of the move towards central clearing of standard OTC derivatives is the wrong-way 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 complex, illiquid and risky than other cleared products, is crucial and not yet tested.

3.1.6 The dangers of derivatives

Derivatives can be extremely powerful and useful. They have facilitated the growth of global financial markets and have aided economic growth. Of course, not all derivatives transactions can be classified as “socially useful”. Some involve arbitraging regulatory capital amounts, tax requirements or accounting rules. As almost every average person now knows, derivatives can be highly toxic and cause massive losses and financial catastrophes if misused.

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. 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.11 Hence, the size of the trade, and the effective leverage, must be limited by the institution themselves, the counterparty in the transaction or a regulator. Inevitably, it will be significantly bigger than that in the previous case of buying bonds outright. Derivatives have been repeatedly shown to be capable of creating or catalysing major market disturbances with their inherent leverage being the general cause.

As mentioned above, the OTC derivatives market is concentrated in the hands of a relatively small number of dealers who trade extensively with one another. 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 – after all, surely none of these big counterparties would ever fail? Now it is thought of as creating significant systemic risk: where the potential failure in financial terms of one institution creates a domino effect and threatens the stability of the entire financial markets. Systemic risk may not only be triggered by actual losses; just a heightened perception of losses can be problematic.

3.1.7 The Lehman experience

The bankruptcy of Lehman Brothers in 2008 provides a good example of the difficulty created by derivatives. Lehman had more than 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 3.3, carrying out the above steps across many different counterparties and transactions has been a very time-consuming process. The Lehman settlement of OTC derivatives has been a long and complex process lasting many years.

Figure 3.3 Management of derivative transactions by the Lehman Brothers estate.

Source: Fleming and Sarkar (2014).