Making Markets Safe: The Role of Central Clearing
The financial crisis of 2007-09 prompted two distinct types of regulatory reforms. The first uses capital and liquidity requirements to make financial institutions resilient in the face of severe macroeconomic events. The second concerns market infrastructure and the ability to trade securities and derivatives or to use them as collateral. Here, the emphasis is on both information collection through trade reporting—who is buying or selling what to whom--and on shifting transactions from over-the-counter (OTC) markets to central clearing.
This post examines central clearing of OTC derivatives and highlights its importance for financial stability.
Let’s start by noting the enormous size of the OTC derivatives market. The chart below shows the gross notional amounts outstanding, along with an estimate of the credit exposure these represent. The numbers in the chart are in trillions of US dollars. So, for example, at the end of 2013, the gross notional amount peaked at more than $710 trillion. Since then, it has fallen substantially so that, as of mid-2015 (the last data available), the level was just over $550 trillion. To put this number in perspective, it remains more than six times the capitalization of global stock markets.
Gross Notional Value of OTC Derivatives Outstanding and Gross Credit Exposure (semiannual, trillions of U.S. dollars), 1998-June 2015
In acknowledgment of the role that this enormous market played in the 2007-2009 financial crisis, at their summit in September 2009, the leaders of the G-20 agreed that:
“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.”
This commitment to infrastructure change is a big deal. What does it mean?
Start with a simple example in which someone wishes to purchase 100 shares of Apple stock. At current prices, this will cost you something like $105,000. Implementing this transaction—which means transferring the payment from the buyer to the seller and the ownership of shares from the seller to the buyer—will involve a set of intermediaries that includes a bank, a securities firm, a clearinghouse and a few others. This settlement system works because the buyer and seller are confident that they will each quickly receive what they expect: the buyer, the Apple shares, and the seller, the cash.
Now consider a derivatives transaction—one involving a futures contract, an option, a swap or something more complicated. Unlike the stock purchase, where the payment is exchanged for equity in a few business days, the derivative contract entails promised payments on some future (possibly quite distant) date. How can each side of the transaction ensure that the other side will be able to deliver what they promised when the time comes?
To contain this risk in OTC derivatives trading prior to the financial crisis, buyers and sellers made bilateral arrangements based on previously negotiated terms specified in an ISDA master agreement (ISDA stands for International Swaps and Derivatives Association). These agreements specify things like how much collateral each party is required to provide to ensure ability to pay, as well as what happens should one of the parties go bankrupt prior to the contractual due date. Nevertheless, the fragility of these arrangements during the crisis led the G-20 leaders to advocate that central clearing replace bilateral OTC trading.
A central clearing party (CCP) sits between the buyer and seller of an asset. In the case of derivatives, the CCP buys the contract from the seller and sells an identical contract to the buyer. Critically, neither the buyer nor the seller need to worry about the ability of the other to make good on the contract. That problem has been handed over to the CCP. To ensure itself against the possibility of default, the CCP demands collateral to clear each trade. And, to handle the possibility of residual losses, it will hold capital and have a loss-sharing agreement with its trading members.
Three episodes over the past 20 years highlight the rationale for moving to central clearing: Long-Term Capital Management (LTCM), AIG and Amaranth Advisors. Starting with the last of these, in September 2006, Amaranth Advisors, a U.S.-based hedge fund specializing in trading energy futures, lost roughly $6 billion of its $9 billion in assets under management and was liquidated with little market-wide disruption. By contrast, eight years earlier, the impending collapse of LTCM threatened a financial crisis; financiers sprang into action to work out its debt without bankruptcy. Importantly, whereas Amaranth was engaged in trading futures on an organized exchange (a special form of a CCP), LTCM had entered into thousands of bilateral OTC swaps.
The AIG case focused everyone’s attention on the systemic risks arising from OTC trading. By end-June 2008, AIG had London-based Financial Products Group taken on $446 billion in notional credit risk exposure as a seller of credit risk protection via credit default swaps (CDS). These positions, which were largely unhedged and uncollateralized, concentrated credit risk in a financial institution that did not have the cash to meet crisis-related margin calls. Because the transactions were bilateral and OTC, no single counterparty could observe the aggregate risk concentration and charge an appropriate risk premium (say, in the form of a heightened collateral requirement). Unlike LTCM, where the private sector provided the funds needed to resolve the crisis, with AIG, it was the Federal Reserve that had to step in with an $85 billion loan.
Central clearing is the key difference between Amaranth Advisors on the one hand, and LTCM and AIG on the other. CCPs provide two important functions. The first is about collateralization and information. Would AIG have been able to write nearly half a trillion dollars face-value of insurance if they had been forced to post cash or other collateral commensurate with this risk concentration? Almost surely not.
The second is about reducing the fragility arising from complex networks of bilateral OTC transactions. A CCP can simplify this network, thereby reducing systemic risk.
To see how a CCP reduces complexity, imagine a set of three institutions engaged in OTC activities, arranged in a circle (see figure below). And, assume that each has a long position with the firm to their right and a short position in the exact same contract with the firm to their left. At this stage, everyone in this circle is perfectly hedged with a zero net position. But what happens if one firm goes bankrupt and breaks the circle? The other two firms are now exposed: one long and the other short. Expand the number around the circle to 10 or 20 firms and the problem does not essentially change, except that their interconnections are far more complex and opaque (through their counterparties’ counterparties’ counterparties… and so on).
Bilateral Transactions: Gross Exposures vs. Net Exposure
This example is not hypothetical. Financial intermediaries typically offset a derivative position not by buying back the original contract from the original counterparty (called “tearing up”), but rather by entering into a new contract for an offsetting payoff with another party. As a result, any serious deterioration in the creditworthiness of a large player in the market (a dealer, a bank, a hedge fund, or whatever), with the resulting flight to quality by its counterparties, creates open exposures and a surge of demand for new derivative positions with other counterparties.
Central clearing can reduce this risk through a combination of collateralization and, especially, multilateral netting. Netting eliminates the circles like the one in the chart, where only gross exposures exist. That is, if the CCP is counterparty to all trades, it can cancel those offsetting trades that merely move risk around a ring. Also known as trade compression, netting can reduce gross notional amounts significantly. While private trade compression services are available in the OTC market, it is more straightforward for a CCP that can directly observe complex netting opportunities to arrange to tear up the contracts.
Shifting transactions to CCPs improves the resilience of the financial system in three important ways. First, it diminishes the linkages among intermediaries, so that a single default (aside from that of the CCP itself) is less likely to harm others. Second, it facilitates the enforcement of collateral standards. Third, it makes risk concentrations transparent, thereby fostering appropriate risk premia and incentives. (A recent study of the 2007-09 crisis period concludes that the larger the portion of transactions in a particular jurisdiction that were centrally cleared, the less the damage to banks operating there.)
Importantly, there has been notable progress in recent years in improving derivatives market infrastructure. In their 10th semi-annual progress report, the Financial Stability Board (FSB) reports that roughly 80% all interest rate and credit derivatives in the United States are now centrally cleared. This is consistent with the recent evidence in an industry report that, from 2007 to 2014, the fraction of interest rate derivatives that were being centrally cleared globally rose from 16% to 69% (see also here). Note that interest rate derivatives have accounted for roughly three-quarters of outstanding OTC contracts over the past decade.
This recent expansion of central clearing has reduced systemic risk in at least two ways. First, there is the trade compression. Estimates here are that nearly $200 trillion in gross notional value has been eliminated. Second, as a result of netting, the need for collateral has been reduced. This is important when other regulatory changes—like the liquidity coverage ratio and margin requirements for OTC trades—have prompted concerns about a shortage of high-quality liquid assets.
Moreover, the data we have (see the first chart) understate the extent of progress. When OTC trades shift to a CCP, double-counting artificially boosts the gross notional value of contracts outstanding. The reason is that what used to be a single bilateral contract is now two contracts with a CCP. Adjusting for this measurement problem means that the outstanding level of interest rate swaps, for example, has plunged from about $450 trillion in mid-2011 to around $260 trillion by the middle of last year.
Of course, central clearing is not a panacea. The most obvious pitfall is that CCPs can become too big to fail. Second, there is the problem that multiple, for-profit CCPs may be pressured by competitive forces to underprice risks (say, by trimming collateral requirements) in a race to the bottom. And third, there is a risk that national authorities will buckle to pressures to each have their own CCP, undermining the benefits from netting and effective information aggregation. (For a detailed discussion of CCP-related risks, see here.)
The solution to these risks—too big to fail, underpricing of risk, and fragmentation—is to organize CCPs as financial market utilities acting in the public interest, not just domestically but also across borders. So, while we are fans of central clearing, we can reap the potentially substantial benefits only if we do it right.
(We thank Mark Chambers of the Financial Stability Board Secretariat for directing us to much of the material that forms the basis for this post.)