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.
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.
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.
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).
3.2 Derivative risks
An important concept is that financial risk is generally not reduced per se but is instead converted into different forms; for example, collateral can reduce counterparty risk but creates market, operational and legal risks. Often these forms are more benign, but this is not guaranteed. Furthermore, some financial risks can be seen as a combination of two or more underlying risks (for example, counterparty risk is primarily a combination of market and credit risk). Whilst this book is primarily about counterparty risk and related aspects such as funding, it is important to understand this in the context of
Source: ISDA market survey, 2010.
Meaning that the market priced their debt as being of very high quality and practically risk-free.
Aside from initial margin requirements and capital requirements.
