Risk by definition is the uncertainty in any transaction. The Risk may manifest itself in multiple forms including market risk, credit risk, operational risk, legal & compliance risk, etc. While a few of these types are quantitative risks, others tend to have a more qualitative interpretation. Over the years, banks and financial institutions have become risk aware which is evident from the increased investment towards strengthening of their enterprise risk infrastructure. Further, following the 2008-meltdown, market participants are preferring vanilla products over the more exotic structured varieties. Despite the additional checks and balances that market participants and regulators have put in place, credit risk continues to be a major concern for everyone. Thus, credit risk analysis has become significant in the financial market.
As commonly understood, credit risk explains the probability of loss on a trade due to the counterparty’s non-fulfillment of a contractual obligation. For example, assume two parties namely A and B have entered into a derivative swap transaction. Let’s assume party B has run into financial difficulties and is unable to meet its obligations, then there may either be a part OR full default on its payments that are due to party A. Thus, party A is exposed to the risk of losing potential cash flows under the contract. This is a simple example of credit risk. To overcome these risks, the financial institutions have a team for credit risk management.
Let’s extend this analysis to the Over the Counter (OTC) market, where notional exposures worth trillions of dollars are currently outstanding on the books of market participants. In the absence of a Central Counterparty (CCP), the onus of clearing and settlement of trades lies with the parties involved in the transaction. Post the lessons learned during 2008, there has been a shift in the way OTC trades are getting cleared and settled. During the meltdown, the market witnessed that no one was “too big to fail”. With the view to avoid repeating the issues that marred the market in 2008, market participants are increasingly using the CCP platform for their trades. With the ongoing risks in the market, one can mitigate the risks by adapting several capital market risk management techniques.
Bi-lateral netting is a popular technique used in the clearing and settlement of OTC market trades. This technique involves the counterparties to a trade performing daily valuation of their positions and exchanging cash collateral with each other under what is called a Credit Support Annex (CSA) agreement. Banks have in place such CSA agreements with their major trading counterparty banks. Daily collateral exchange ensures that banks are able to manage the potential credit risk in a better way. The Advantage of bilateral netting is that trades ranging from vanilla to highly exotic nature can be handled via this approach.
CCPs are organizations whose main purpose is to facilitate the clearing and settlement of trades. Every Exchange has a CCP to support trades happening on that Exchange. In this article, however, we will focus on the role of CCPs in OTC derivatives markets. The size of the OTC market is many times bigger than the Exchange market, resulting in a greater demand for CCPs to support trades in that market. Three main activities done by a CCP include namely:
Clearing: The process of clearing of trades begins at trade initiation and will continue until the maturity date of a derivatives trade (this may last up to a few years to a decade for OTC derivatives).
Settlement: Settlement of trade happens at the trade maturity/expiry.
Collateral Management: Collateral management involves asking transacting counterparties to post cash or cash equivalents as collateral. In case of member defaults, the collateral posted by the members is used to make up for the loss from default. Related concepts like pricing of trades by CCPs and margining are explained in the subsequent portions of this article.
The above activities are necessary to complete any trade’s life cycle. CCPs provide a guarantee of clearing and settlement of trades thereby helping market participants mitigate credit risk inherent in OTC transactions with the help of ccps risk management.
In the absence of CCPs parties have to depend on the technique of bilateral netting in order to mitigate the credit risk in the transaction. However, the onus of credit risk mitigation then lies with the transacting counterparties under their bilateral netting agreements.
In the presence of CCPs, the CCP becomes a seller to every buyer and a buyer to every seller. In other words, parties see CCP as their counterparty. CCPs perform this action through a technique called Novation. One can imagine novation to be similar to a transaction wherein CCP breaks the original trade between parties A and B, and creates or novates trades between itself and the respective counterparties which is exactly equivalent to the original trade between A and B.
The presence of CCPs enhances the confidence of transacting counterparties as well because they know that the CCP is there to ensure clearing and settlement of their trades and thus their credit risk has been taken care of to a considerable extent by ccps risk management techniques.
CCPs are a private organization who themselves also carry some risk of defaulting on their commitments. Although the probability of them defaulting may be rare, it is still a possibility. However, CCPs use the following funding arrangements in order to ensure that they continue to support the market participants for clearing and settlement of their trades:
Initial Margin (IM): This is the initial amount that is to be posted by the transacting counterparties with the CCP at the time of entering into the trade. Without posting IM at the start, CCPs won’t allow parties to use the CCP platform for their trades.
Variation Margin (VM): This is similar to the daily MTM mechanism observed on Exchange-traded futures, whereas, the trading counterparties are required to post margin payments depending on whether they are in the money or out of the money on that particular day. VM is done on a daily basis. For computing, the VM, CCPs use their pricing models to arrive at trade MTMs
Default fund: Every member of the CCP is expected to contribute a specific amount of funds that are classified as the default fund of that member. The default fund is used for protecting against losses that may not be covered by the margins posted by members.
Member’s equity: Members purchase the equity of the CCP. This is done to provide an additional layer of protection to cover for defaults.
To understand how member default is handled: assume a member has defaulted on its commitment, then the initial margin will absorb the initial credit losses, if that is not enough then variation margin is consumed. Assuming both the margins are not enough to meet the credit losses, the defaulting member’s default fund amount gets used. Further, in the event of a complete default by a certain member, CCP may resort to measures like trade auction of defaulted trade and loss mutualization.
The idea behind member’s equity in CCP is to discourage members from defaulting, as in the event of that member defaulting, they stand to lose their equity too.
The point to be noted is CCPs are not eliminating the credit risk from the system, rather they are re-distributing this risk to its network of members. Through efficient management of collateral and ample amount of margining coupled with default fund provisions, CCPs are expected to contain systemic risks that may build up.
In response to the 2008 meltdown which saw a cascading effect of one dealer default resulting in default by multiple dealers downstream, the G-20 came up with a set of recommendations to enhance market confidence and to avoid the repeat of events that unfolded in 2008. A few major regulations that G20 suggested included:
- CCPs should clear all vanilla swaps and CDS products with the view of eliminating the risk of default from bilateral transactions
- Trades done on OTC markets should be reported to repositories so that regulators will have better access to such information in an otherwise opaque OTC market
- Suggested greater capital requirements for OTC transactions that are not done on a CCP
In India, Clearing Corporation of India Limited (CCIL) plays a major role in clearing and settlement of trades in the OTC market primarily fixed income, OIS swaps, FX, and there is NSE’s Clearing Corporation (NSCCL) acting as CCPs on behalf of trades on Exchange. Further, India’s central bank The Reserve Bank of India (RBI) regulates the banking industry and also plays a pivotal role in shielding the Indian economy to a considerable extent from global economic shocks.
Banks have already begun benefitting from certain actions including periodic trade compression performed by CCIL. Further, banks are moving a greater number of their OTC trades onto CCIL platforms thereby helping banks reduce their counterparty exposures and as a result free up a certain portion of their capital. Globally as well, it is expected that the volume of transactions on CCPs will continue to see an uptrend. Market demands that CCPs continue to function as entities that can limit the impact of systemic risk thereby improving market confidence and supporting further growth of the market.
Article by: Mr. Ameya Abhyankar – Founder, FinQuest Institute, IRM India Affiliate Exam Coach