Risk Management – Over the Counter (OTC) Derivatives

Banks hold the loans and mortgages once they are originated.  Banks now handle billions and billions of money in derivative products. The growing volume of derivative markets across the globe and also the introduction of new products everyday more risk like counterparty credit risk, liquidity risk, operational risk etc to the investment banks/financial institutions/investors. Especially after 2008 Lehmann crash, as an IT person in bank I am able to see lot of regulatory projects like Dodd Frank, EMIR, CVA etc and this post is to understand the risk in derivatives and the role of Central Counter-parties in handling the risk.

Post trade activities in financial world is always associated with huge risk and I can say this is the heart of the trading infrastructure. Post trade activities means clearing and settlement. Clearing involves various post trade activities related to risk like netting, collateral and margin requirements. Exchange traded derivatives also possess risk like Over the Counter (OTC)  products but exchange traded always follows strict margin/collateral requirements and also cleared through Clearing house (Central Counterparty – CCP).

Almost 90% of the derivative products are traded in Over the Counter (OTC) and now it clearly shows why regulators are more concerned about this market. Just think one defaults in this markets and it will have huge impact on everyone. After Lehman crash, regulators in US and Europe are emphasizing that the OTC trades should be reported to repositories like DTCC and clearing must happen through clearing house(CCP) and non-cleared products should follow high margin requirements.

Clearing house – Central Counterparty (CCP)

A clearing house acts as a central counterparty for both buyers and sellers. In other words it will become seller to the buyer and buyer to the seller. It will solve the problem of counterpart default risk and CCP will bear the default risk of buyer and seller.

Usually settlement can happen in two ways namely

Bilateral settlement

Central clearing settlement

Bilateral settlement:

In bilateral settlement model, each members are exposed to default risk and if anyone fails it leads to serious issue. Look at the below diagram, just assume if Bank A goes default means rest of the banks will get impacted because almost everyone has open positions with Bank A. Because of this reason only all the regulators are worrying about OTC derivative market and imposing strict regulation policies.

Central Clearing model:

In central clearing model, CCP will own the risk of the clearing member and it will reduces the default and operational risk. But CCP imposes strict margin and collateral requirements. By moving towards CCP, derivatives trade becomes more transparent and reduces complexity. CCP will not be exposed to any market risk but in turn it is exposed to credit risk which is handled by strict risk functions such as margin and collaterals.

Counterparty risk management functions like netting, collateralization and DVP will be carried out in clearing house.

Let us take one derivate contract as an example (Interest Rate Swap – my favourite one) so that we can understand the CCP functions.

Consider a 5 year IRS with a notional value of $10 million and a fixed rate of 5 percent against a reference rate of six-month London Interbank Offer Rate (LIBOR), with semi-annual payments in arrears. It will have 10 Observation periods and by taking the difference between the prevailing six month LIBOR and 5 percent and then multiplying that number by $10 million.

Clearing and settling this swap involves the following:

Confirming the terms of the contract at T day.

Determining the payment obligation at the beginning of each six-month interval.

Settling payments due at the end of each six-month interval.

Maintaining the following records: terms of contract, payments made/received by the counterparties, and names, addresses, and account numbers of the counterparties.

Valuing the swap for purposes of determining collateral requirements.

Monitoring counterparty creditworthiness.

Determining collateral requirements

Valuation and monitoring of securities posted as collateral.

Let me continue on this later by tomorrow.