target="_blank" rel="nofollow" href="#n7" type="note">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”.
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.
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
Source: ISDA survey, 1986, covering only swaps.
