ETD vs. OTCD: Counterparty Risk and Capital Requirements for Exchange Traded Derivatives

Abstract

It is common belief that Exchange Traded Derivatives (ETDs), e.g. Futures and Futures Options, are collateralized plain vanilla financial instruments carrying low counterparty risk and capital requirements with respect to corresponding Over The Counter Derivatives (OTCDs). In this paper we discuss techniques to compute counterparty risk exposures for ETD portfolios, both computationally efficient and compliant with regulatory requirements. We compare a number of sample ETDs and OTCDs, and we show how the different collateralisation rules may lead to high exposure spikes. We also find that ETDs exposures may be, in some cases, larger than the corresponding OTCDs exposures. Finally, we show that the capital requirements generated by ETDs under the Internal Model Method (IMM) may be larger than those under Current Exposure Method (CEM). These findings may have important consequences for financial institutions holding large ETDs portfolios.