10 October 2013

New Regulations and Collateral Requirements – Implications for the OTC Derivatives Market

The paper provides a snapshot of the changing collateral space and how this will impact the regulatory push to move over-the-counter (OTC) derivatives to CCPs. With continued quantitative easing (QE) by some central banks, price signals from the repo market indicate a shortage of good collateral. This paper focuses on the collateral demand in the OTC derivatives market as they move to central counterparties (CCPs) and suggests alternatives on how to reduce risk in this market.

There needs to be justification for creating new systemically important financial institutions (SIFIs) like CCPs, since it is not (yet) clear if SIFIs can be unwound. The proposed regulations disregard the existing netting bundles prevalent in this market which then leads to sizable collateral requirements—although many academic/consulting papers use simulations to show otherwise. Furthermore, some key exempted users (like the sovereigns) will keep afloat the sovereign/bank nexus that sow the seeds of moral hazard for a taxpayer bailout of CCPs. Some recent initiatives on the CCP resolution/recovery front may offset the likely burden on taxpayers, but has drawbacks too. Yet, under the rubric of transparency, a piece-meal compromise has taken off without global consensus on several key issues.

In summary, the proposed route of removing OTC derivatives from banks books creates new SIFIs, destroys the economics of netting on the books of the banks, silo(s) collateral and decreases collateral velocity, and increases the interconnectedness of the financial system. Alternately, if every user of OTC derivatives contributed their share of margin(s) when using OTC derivatives (relative to the proposed bifurcated “clearing” and “non-cleared” worlds including legacy trades that will not clear), the risk from derivatives at SIFIs would be eliminated. There would be no need for CCPs.

by Manmohan Singh

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