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Futures Markets and Central Counterparties 33
traditionally been a feature of OTC derivatives markets. Consider two companies, A and
B, that have entered into a number of derivatives transactions. If A defaults when the net
value of the outstanding transactions to B is positive, a loss is likely to be taken by B.
Similarly, if B defaults when the net value of outstanding transactions to A is positive, a
loss is likely to be taken by company A. In an attempt to reduce credit risk, the OTC
market has borrowed some ideas from exchange-traded markets. We now discuss this.
Central Counterparties
We briefly mentioned CCPs in Section 1.2. These are clearing houses for standard OTC
transactions that perform much the same role as exchange clearing houses. Members of
the CCP, similarly to members of an exchange clearing house, have to provide both
initial margin and daily variation margin. Like members of an exchange clearing house,
they are also required to contribute to a guaranty fund.
Once an OTC derivative transaction has been agreed between two parties A and B, it
can be presented to a CCP. Assuming the CCP accepts the transaction, it becomes the
counterparty to both A and B. (This is similar to the way the clearing house for a
futures exchange becomes the counterparty to the two sides of a futures trade.) For
example, if the transaction is a forward contract where A has agreed to buy an asset
from B in one year for a certain price, the clearing house agrees to
1. Buy the asset from B in one year for the agreed price, and
2. Sell the asset to A in one year for the agreed price.
It takes on the credit risk of both A and B.
All members of the CCP are required to provide initial margin to the CCP.
Transactions are valued daily and there are daily variation margin payments to or
from the member. If an OTC market participant is not itself a member of a CCP, it can
arrange to clear its trades through a CCP member. It will then have to provide margin
to the CCP member. Its relationship with the CCP member is similar to the relationship
between a broker and a futures exchange clearing house member.
Following the credit crisis that started in 2007, regulators have become more con-
cerned about systemic risk (see Business Snapshot 1.2). One result of this, mentioned in
Section 1.2, has been legislation requiring that most standard OTC transactions between
financial institutions be handled by CCPs.
Bilateral Clearing
Those OTC transactions that are not cleared through CCPs are cleared bilaterally. In
the bilaterally cleared OTC market, two companies A and B usually enter into a master
agreement covering all their trades.3 This agreement usually includes an annex, referred
to as the credit support annex or CSA, requiring A or B, or both, to provide collateral.
The collateral is similar to the margin required by exchange clearing houses or CCPs
from their members.
Collateral agreements in CSAs usually require transactions to be valued each day. A
simple two-way agreement between companies A and B might work as follows. If, from
one day to the next, the transactions between A and B increase in value to A by X (and
3
The most common such agreement is an International Swaps and Derivatives Association (ISDA) Master
Agreement.
34 CHAPTER 2
Business Snapshot 2.2 Long-Term Capital Management’s Big Loss
Long-Term Capital Management (LTCM), a hedge fund formed in the mid-1990s,
always collateralized its bilaterally cleared transactions. The hedge fund’s investment
strategy was known as convergence arbitrage. A very simple example of what it might
do is the following. It would find two bonds, X and Y, issued by the same company
that promised the same payoffs, with X being less liquid (i.e., less actively traded)
than Y. The market places a value on liquidity. As a result the price of X would be
less than the price of Y. LTCM would buy X, short Y, and wait, expecting the prices
of the two bonds to converge at some future time.
When interest rates increased, the company expected both bonds to move down in
price by about the same amount, so that the collateral it paid on bond X would be
about the same as the collateral it received on bond Y. Similarly, when interest rates
decreased, LTCM expected both bonds to move up in price by about the same
amount, so that the collateral it received on bond X would be about the same as the
collateral it paid on bond Y. It therefore expected that there would be no significant
outflow of funds as a result of its collateralization agreements.
In August 1998, Russia defaulted on its debt and this led to what is termed a
‘‘flight to quality’’ in capital markets. One result was that investors valued liquid
instruments more highly than usual and the spreads between the prices of the liquid
and illiquid instruments in LTCM’s portfolio increased dramatically. The prices of
the bonds LTCM had bought went down and the prices of those it had shorted
increased. It was required to post collateral on both. The company experienced
difficulties because it was highly leveraged. Positions had to be closed out and LTCM
lost about $4 billion. If the company had been less highly leveraged, it would
probably have been able to survive the flight to quality and could have waited for
the prices of the liquid and illiquid bonds to move back closer to each other.
therefore decrease in value to B by X), B is required to provide collateral worth X to A.
If the reverse happens and the transactions increase in value to B by X (and decrease in
value to A by X), A is required to provide collateral worth X to B. (To use the
terminology of exchange-traded markets, X is the variation margin provided.) Collateral
agreements and the way counterparty credit risk is assessed for bilaterally cleared
transactions is discussed further in Chapter 24.
It has traditionally been relatively rare for a CSA to require initial margin. This is
changing. From 2016, regulations require both initial margin and variation margin to be
provided for bilaterally cleared transactions between financial institutions.4 The initial
margin is posted with a third party and calculated on a gross basis (no netting).
Collateral significantly reduces credit risk in the bilaterally cleared OTC market (and so
the use of CCPs for standard transactions between financial institutions and regulations
requiring initial margin for transactions between financial institutions should reduce
risks for the financial system). Collateral agreements were used by hedge fund Long-Term
Capital Management (LTCM) for its bilaterally cleared derivatives in the 1990s. The
4
For both this regulation and the regulation requiring standard transactions between financial institutions to
be cleared through CCPs, ‘‘financial institutions’’ include banks, insurance companies, pension funds, and
hedge funds. Transactions with most nonfinancial corporations and some foreign exchange transactions are
exempt from the regulations.
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