Over-the-counter Derivatives Research Articles

Unintended Consequences of the Global Derivatives Market Reform

Abstract Following the early implementation of the global over-the-counter (OTC) derivatives market reform in the USA and the associated increase in trading costs, US banks shifted up to 60% of their OTC derivatives activity abroad, particularly toward less regulated jurisdictions. Consistent with a cost saving incentive of regulatory arbitrage, we find that this flight abroad is driven by costlier blocks of the reform and subsequently causes a narrowing of swap spreads. We further show that this regulatory arbitrage causes an increase in financial risk as more activity is shifted to more lenient jurisdictions.

Dealer networks, client sophistication and pricing in OTC derivatives

Using a novel regulatory transaction-level dataset, we analyze determinants of pricing in both dealer-to-dealer (D2D) and dealer-to-client (D2C) segments of over-the-counter (OTC) currency derivatives market enabling us to provide new empirical insights into frictions driving pricing in both segments separately and interplay of these frictions jointly. The interdealer network exhibits a core-periphery structure with core dealers charging centrality premia in both D2D and D2C segments. By acting as principal and prearranging fewer trades, they provide execution immediacy besides receiving the opportunity to internalize flows. In D2C segment, sophisticated clients experience a reduction in centrality premium alluding to an interplay of client bargaining power and dealer centrality in pricing.

Using RMB bonds as collateral for OTC derivatives

Using Renminbi (RMB) bonds, especially Chinese Government bonds (CGB), as collateral for both onshore and cross-border over-the-counter (OTC) derivatives is a hot topic following China switching to a netting jurisdiction in August 2022. Since then, Chinese financial institutions are required to exchange initial margin and variation margin with offshore counterparties for dealing cross-border derivatives. As the market infrastructure for using RMB bonds as collateral for cross-border OTC derivatives transactions is not well established and RMB bonds are not extensively accepted by foreign counterparties as eligible collateral, Chinese financial institutions are unable to utilise their huge RMB bond holdings. At the same time, many foreign investors are allowed to access China’s onshore RMB bond market with RMB bond holding up to RMB 3.4tr, but are unable to use those inventories as collateral for their onshore and cross-border derivatives trading and other financial transactions. Using RMB bonds as collateral is also an initiative of RMB internationalisation. The purpose of this paper is to give an extensive explanation of the status of using RMB bonds as collateral in the Chinese market, point out challenges faced by market participants and provide suggestions to promote using RMB bonds as collateral for both onshore and cross-border derivatives transactions. This paper provides the full picture of China’s onshore RMB bond investment and bond collateral management along with the latest data. It also provides extensive analysis for deficiencies in respect of the RMB bond collateralisation. It concludes with suggestions for the future development of the Chinese market to use RMB bonds as collateral for both onshore and cross-border OTC derivatives.

MiFID II and the Regulation of Multilateral Trading in OTC Derivatives: Is the OTF Fit for Purpose?

Abstract This article identifies barriers to the complete implementation of the organized trading facility (OTF) as a new category of trading venue under the Markets in Financial Instruments Directive (Directive 2014/65/EU) (MiFID II). It argues that attempts to reconcile the competing claims of incumbent regulated markets and dealer banks operating broker crossing networks in the cash securities markets led to a market design that is not suitable for the over-the-counter (OTC) derivatives markets. The result has been that multilateral trading in the wholesale secondary markets has not been incorporated in trading venues, as was intended, and that changes that are better aligned to market requirements are needed. These include reform of requirements transposed from the cash securities markets, such as standardized fee structures, and relaxation of restrictions on interactions between an OTF and other OTFs or systematic internalizers.

Trust, Confidence, and Automation: The ISDA Master Agreement as a Smart Contract

The International Swaps and Derivatives Association (ISDA) Master Agreement (MA) is the prevailing contract in the Over-the-Counter (OTC) derivatives market. Its efficacy derives from, inter alia, the network effect. As the OTC derivatives market expanded so did users of the MA. During and after the MA’s creation, the market underwent extensive deregulation and the standard-form agreement soon filled the lacuna left by retreating regulation. Its ubiquity in the market has created a level of trust and confidence, not only in the terms of the MA itself but between parties which may not have otherwise entered into a business relationship. With the impending introduction by ISDA of a smart contract version, this article investigates whether automation will harmonize or disrupt trust and confidence in the MA. ISDA, derivatives, standard-form, trust, confidence, smart legal contracts

Valuation of initial margin using bootstrap method

PurposeThe purpose of this paper is to propose the parametric bootstrap method for valuation of over-the-counter derivative (OTCD) initial margin (IM) in the financial market with low outstanding notional amounts. That is, an aggregate outstanding gross notional amount of OTC derivative instruments not exceeding R20bn.Design/methodology/approachThe OTCD market is assumed to have a Gaussian probability distribution with the mean and standard deviation parameters. The bootstrap value at risk model is applied as a risk measure that generates bootstrap initial margins (BIM).FindingsThe proposed parametric bootstrap method is in favour of the BIM amounts for the simulated and real data sets. These BIM amounts are reasonably exceeding the IM amounts whenever the significance level increases.Research limitations/implicationsThis paper only assumed that the OTCD returns only come from a normal probability distribution.Practical implicationsThe OTCD IM requirement in respect to transactions done by counterparties may affect the entire financial market participants under uncleared OTCD, while reducing systemic risk. Thus, reducing spillover effects by ensuring that collateral (IM) is available to offset losses caused by the default of a OTCDs counterparty.Originality/valueThis paper contributes to the literature by presenting a valuation of IM for the financial market with low outstanding notional amounts by using the parametric bootstrap method.

Issues Involving 'Close-out Netting' and 'Collateral' for OTC Derivatives Transactions

Issues Involving 'Close-out Netting' and 'Collateral' for OTC Derivatives Transactions

From bombs to boons: changing views of risk and regulation in the pre-crisis OTC derivatives market

At the core of the 2008 financial crisis was a massive, un-publicly regulated market of complex financial products, which transmitted losses in the US residential mortgage market throughout the global financial system. How did the market for over-the-counter (OTC) derivatives grow so large and so risky with so little public supervision and regulation? At the heart of the matter, I contend, are changes in how both derivatives and risk have been understood as objects of governance. This article focuses on the decade preceding the passage of the 2000 Commodity Futures Modernization Act to demonstrate how competing and ultimately shifting understandings of both derivatives and financial risk put in place the conditions of possibility for the definitive deregulation of this market. Through a detailed interpretive analysis of regulatory documents, I show that changes in OTC derivatives regulation have been driven by changes in how regulators interpret derivatives themselves in a context of changing beliefs about risk and its management. Although regulators were acutely aware of OTC derivatives’ contribution to systemic risk as early as the early 1990s, they ultimately concluded that derivatives’ ability to serve as tools of risk management and generators of financial profits was consistent with their goal of promoting deep and liquid financial markets and thus took a decisively hands-off approach to regulation. The article concludes with a discussion of what shifts in interpretation and regulation of derivatives can tell us about the limits and potential for lasting post-crisis changes in financial governance.

Too much, too young: improving the client clearing mandate

The policy of clearing standardized over-the-counter (OTC) derivatives contracts through central counterparties (CCPs) was introduced after the 2008 crisis, and it has had a major impact. It has been implemented in major jurisdictions via “clearing mandates” that apply to the clearing members of CCPs and their clients. Since the policy was implemented, OTC derivatives markets have changed in ways that reduce the benefit of central clearing for clients. As policy makers are currently reviewing clearing mandates, considering how to improve them is apposite. Against this background, we present new evidence of the distribution of risk in client portfolios and use this to motivate clearing policy improvements. We recommend that the mandate to clear should be phrased in terms of initial margin. We present evidence of the concentration in client clearing service provision and suggest that regulatory barriers to increased competition should be lifted. Finally, we discuss two innovations that would increase the likelihood of clients moving between clearing members. This process, known as porting, is an important potential benefit of clearing. These innovations are the creation of a special-purpose clearing member for porting, and the development of access models for larger clients that will reduce their dependence on clearing members.

Incomplete Clearinghouse Mandates

In the 2007–08 financial crisis, over‐the‐counter (OTC) derivatives triggered the collapse of colossal financial institutions. In response, global policy makers instituted clearinghouse mandates. As a result, all standardized OTC derivatives must now use clearinghouses, and global financial market stability now depends upon these institutions. Yet certain underlying legal and regulatory structures threaten to undermine clearinghouse stability, particularly were a significant clearinghouse to become distressed. This article argues that the clearinghouse mandates are incomplete in that they fail to reform these problematic arrangements.As with electric utilities, the lights at the financial market infrastructures known as clearinghouses must always be on. Yet the legal frameworks for handling a distressed clearinghouse, the problem of clearinghouse recovery, and resolution, remain uncertain. This article advances debate on this issue. It argues that recovery, a private market restructuring process, can be conceptualized as a bargaining game dependent upon time‐critical cooperation between a clearinghouse and members. This article uses transaction cost economics to demonstrate, however, that certain underlying legal and regulatory structures could work at cross‐purposes to this necessary cooperation, and actually increase its cost. Based upon this analysis, it proposes reforms designed to ensure that parties’ incentives promote efficient recovery. In the absence of efficient recovery frameworks, the path of a distressed, significant clearinghouse is likely to resemble that of the government‐backed mortgage lenders whose fate more than ten years after their entry into conservatorship remains uncertain. This article aims to help avoid a repeat of this history.

Mandatory clearing: the infrastructural authority of central counterparty clearing houses in the OTC derivatives market

This study examines the role of central counterparty clearing houses (CCPs) in the over-the-counter (OTC) derivatives market. To achieve this goal, this paper introduces the notion of infrastructural authority. The notion of infrastructure, borrowed from Science and Technology Studies, is employed to locate a form of private authority stemming from how power and legitimacy are exercised by enabling the performance of specific functions in financial markets. As OTC derivatives had become widely discredited after the crisis, regulators had come under strong pressure to reform what had grown to be a systematically important segment of the global financial system. G20 leaders thus responded in 2009 by pledging to make the central clearing of standardized OTC derivatives mandatory to improve financial stability. Therefore, this study argues that the infrastructural authority of CCPs is politically contingent, originating from the statutory requirement of mandatory clearing in the OTC market. However, by reviewing specific moments in financial history, this study concludes that the infrastructural authority of CCPs may actually destabilize financial markets, undermining the G20’s original intent to strengthen systemic stability. More generally, the research conducted in this study provides evidence of the changing nature of authority in financial markets following the 2007–2008 financial crisis.

Physiology of the Over-The-Counter (OTC) Derivatives Market and Post-Crisis Reform

The recent financial crisis had a strong impact on the worldwide economy, particularly the crisis of 2007 known as the Global Financial Crisis GFC. What started as a US financial market crash resulted in a truly global crisis, impacting both financial and non-financial sectors. One of the markets involved was the derivatives market. As a result, both regulators and regulated firms are aware of the risks and uncertainties manufactured in the derivatives market, in particular in the OTCDM. In order to understand the role of risk and risk-based regulation in the context of the OTCDM and CCPs regime, this paper explores the rationale of derivatives as tools of distribution of risks. Following the notion of ‘manufactured risks’ of the risk society theory, it explains in detail why the OTCDM is a centre of production of risks. It also considers the post-GFC regulatory reforms and the move towards the use of CCPs. It puts forward the argument that the inclusion of CCPs in the OTCDM and the increase in mandatory central clearing adds complexity to the market, and thereby might become a source of new ‘manufactured risks’. This paper provides the framework of the OTC derivatives market. It is devoted to explain the physiology of Financial Derivatives. To this end, the work is divided into two parts. The first part addresses the fundamental questions of how financial derivatives work, with a critical overview of the uses of these transactions, and the traditional process of trading. Then, it highlights the differences between the exchange and the over-the-counter (OTC) markets, and how the post-crisis regulatory reforms have modified the structure and functioning of the OTCDM. Since the focus of this research is the OTCDM, the second part addresses the questions regarding the role that the OTC derivatives market played in the Global Financial Crisis, and the market failures that motivated current changes for more formal regulation and supervision. Such post-crisis regulatory reforms frame the object of study of this research, which is the major transformation of regulation and supervision of the OTC derivatives in the United Kingdom - as the biggest market of the world - and the consequent move towards the regulation of Central Counterparties CCPs, as new intermediaries of the market. The discussion of this paper concerning the decision to regulate CCPs in the OTCDM, as a means to enhance the stability of the market, is central to the analysis of this research. The aim is to explain the decision of UK regulators to regulate CCPs as a means of identifying, assessing and controlling the risks of the OTCDM collectively. This is instead of supervising individual firms that raise high risks.

Who pays? Who gains? Central counterparty resource provision in the post-Pittsburgh world

At the Pittsburgh Summit in 2009, G20 leaders agreed to wide-reaching reforms to over-the-counter (OTC) derivatives markets. One of these reforms required the clearing of standardized OTC derivatives through central counterparties (CCPs). Since then, CCPs have become increasingly important. There has been an extensive programme of regulatory change affecting CCPs, OTC derivatives markets and their participants. As OTC clearing has grown, tension has increased between different classes of market participants over the traditional CCP model of resource provision through loss mutualization. We argue that most of this tension can be explained by a misalignment between the policy goal of enhancing financial stability and the delivery of that goal by mandating clearing through CCPs as they are currently organized. Specifically, the traditional model for resource provision makes most CCPs suitable for managing “club goods”, whereas financial stability is a “public good”. The key differences between these two types of goods, driven by the wedge between those who pay for them and those who derive the benefits, create the observed tensions. Based on this analysis, we propose a framework to analyze the functional elements of a CCP and examine whether an alternative clearing model might be more effective. We conclude that incentives would be better aligned if the functions of CCPs were unbundled and the ownership and funding structures that best suit their individual characteristics were selected. Functions that are critical for the provision of financial stability might suggest some form of public sector involvement, whereas other services might lend themselves to a for-profit or traditional club model.

Regulation, economies of scale and credit Ratings: A puzzle of declining market concentration in the OTC derivatives market

We explore what impact regulatory change had on the over-the-counter (OTC) derivatives market dynamics. We find that despite the increase in regulatory burden and the associated costs of derivative business for broker/dealers, there is no evidence suggesting that the competition in the OTC derivatives business among banks declined, nor that it caused an increase in concentration of market share. In fact, the opposite appears to be the case. We suggest that this can be explained by derivative end-users having to spread their OTC derivative business among a larger number of banks for risk-management reasons.

Global financial regulatory reforms and sovereign’s exemption

PurposeThe purpose of this paper is to underline the (hidden) risks posed after the crisis by the exemption of non-financial operators, especially sovereigns, from the regulatory reforms of over the counter (OTC) derivatives undertaken by G20 countries in the absence of accounting data on trading.Design/methodology/approachRecent financial regulatory improvements are reported to underline that the trading of OTC derivatives by sovereigns and local administrations does not take place under the new regulatory umbrella, because of the relative size of the institution, the lack of incentives to adhere to Centralized Counterparty Systems (CCPs) and most of all, the absence of proper accounting rules. Sovereigns and local administrations have the potential to undermine global financial stability.FindingsThe limited availability of accounting data on derivatives’ use by public administrations constitutes a barrier towards a full comprehension of risks involved. Sovereigns should be compelled to adhere to the CCPs and the collateralized system of trading; the short-term costs of adhering to CCPs are worth $20bn.Research limitations/implicationsThe new regulatory system failed to explicitly consider the trading of sovereigns and this can reduce the effectiveness of regulation itself and can have negative impact on financial stability; in fact, omitting sovereigns from these regulations represent a significant risk oversight because they are systemically important players, although with a special political power.Originality/valueDespite progress made in improving the transparency and resilience of OTC derivative markets after the subprime crisis, sovereigns and public administrations are exempted from the new regulation, posing severe risks to financial stability.

An equilibrium pricing for OTC derivatives with non-cash collateralisation

In this study, we propose an equilibrium pricing rule for contingent claims traded in over-the-counter (OTC) markets with non-cash collateralisation. Owing to counterparty risks in OTC markets, collateral is required to create a derivative contract. In 2017, Osaka Exchange decided to expand the type of collateral asset, while cash has always been used as a collateral. In this study, we consider a market model in which the required collateral is not cash, and is instead assets with a senior credit class, such as a US Government bond. We further assume that market participants source collateral from the repurchase market (SC repo), where investors can borrow assets. Therefore, we provide an equilibrium pricing model that includes the repo market under counterparty risk. Our pricing rule also determines an equilibrium volume for the derivative contract. This enables us to examine the effects of the repo market on the price and volume for OTC derivative transactions.

The Impact of Regulation on Corporate Hedging Activities and the Response of Corporates – A Preliminary Conceptual Framework

Following the financial crisis of 2007/2008 regulators intensified the regulation of financial derivatives through (i) the implementation of the European Markets Infrastructure Directive (EMIR) to increase transparency of over-the-counter (OTC) derivatives and (ii) the implementation of Basel III to increase capital underpinning. Non-financial corporates, who mainly hedge with OTC derivatives, are seeing tendencies of increasing costs and decreasing availability of required OTC derivatives but fail to have a full concept of the impact and possible responses to manage the impact. Also, theoretical research did not consider reguation as an influencing factor and thus does not offer theories to analyse the impact of regulation on corporate hedging activities (defined as the willingness and ability of NFCs to conduct hedging in an optimal way). Given this gap, this paper reviews existing theories and based on that pre-conceptualises a model that helps to analyse the impact of regulation on corporate hedging activities and provides a preliminary conceptual framework that includes corporate responses to manage the regulatory impact.

OTC derivatives: The G20 and New Risks Ahead

Over-the-counter (OTC) derivatives played an important role in the build-up of systemic risk in financial markets before 2007 and in spreading volatility throughout global financial markets during the crisis. In recognition of the financial and economic benefits of derivatives products, the Group of Twenty (G20), under the auspices of the Financial Stability Board (FSB), moved to regulate the use of OTC derivatives. Although a number of scholars have drawn attention to the detrimental effects of the United States and European Union (EU) to coordinate OTC reform, this overlooks an important aspect of the post-crisis process: the exemption of non-financial operators from OTC derivative regulatory requirements, especially Sovereigns. Critically, they remain exempt under existing legislation regardless of the risks they continue to pose through unreported trades and counterparty risks to financial firms; there is still uncertainty around the pricing of derivative (i.e., model risk) for non-financial operators that could pose a risk to the financial system. These, and similar inconsistencies in financial regulation pose risks of conflict and fragmentation that should be soon addressed by the G20.

Bilateral vs. Central Counterparty Clearing in OTC Markets: Counterparty Exposures, Allocation Efficiency, and Applications

I construct a model of over-the-counter (OTC) trading to study equilibrium allocation properties under bilateral clearing (BC) and central counterparty (CCP) clearing of OTC derivatives. I show how CCP mutualizes individual counterparty exposures and prevents massive equilibrium defaults. I define allocation efficiency, show inefficient allocation under BC, and that CCP may improve efficiency. I also apply the model to produce different levels of equilibrium collateral requirement under CCP and to illustrate an aggregate risk-induced systemic CCP default.

Liberating the World from LIBOR: Implications for Non-Cleared Derivatives

Historically, the use of benchmarks, including LIBOR, in non-cleared over-the-counter transactions has been unrestrained. This lack of regulatory consideration is misaligned with the dominance of LIBOR in the over-the counter derivatives trading, as well as with a massive use of non-centrally cleared derivatives for hedging and speculation. Concerns over unprecedented use of LIBOR reached its peak when the benchmark manipulation became a centerpiece of several litigations involving high-profile financiers. In response to the pitfalls of the scandal-ridden LIBOR, in June this year the Alternative Reference Rates Committee recommended that market participants replace LIBOR with the broad Treasuries repo financing rate. The recommendation to gradually transition to a new risk-free rate was the first attempt to resolve problems surrounding the tainted benchmark on the national level in the US. This article discusses legal implications and risks around replacement of LIBOR in derivatives’ space. In particular, it contends that an abrupt switch from LIBOR to its risk-free alternative would result in a need to renegotiate a new benchmark, as well as remediate (or “repaper”) and collateralize millions of derivatives trades, which altogether may pose a significant threat to the industry. The article also voices concerns over calls to abandon LIBOR in a relatively short timeline, concluding that a halt to LIBOR would create a substantial repapering burden and additional margining costs for the entire market of non-centrally cleared derivatives.