## _cr10252

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---

### I. Introduction — key observations
- OTC derivatives markets were an increasing source of vulnerability heading into the crisis due to leverage, low prudential standards, and lack of transparency.
- Market-structure weaknesses:
  - absence of designated market makers and frequent, thorough reporting requirements;
  - bilateral trading (or interdealer brokering) with inadequate collateral usage;
  - heavy concentration of trading in a few dealers.
- Improvements prior to and during the crisis:
  - reduction in backlog of trade confirmations;
  - increased automation of trade processing;
  - establishment of novation protocol;
  - increased use of auction-based settlement mechanisms for cash settlement of credit events;
  - establishment of a central repository for CDS trade data and central payment settlement through CLS.
- Post-crisis additional improvements:
  - portfolio reconciliation and trade compression efforts (e.g., daily automated reconciliation of derivative positions; pilot ISDA dispute resolution protocol).
- Role in the crisis:
  - credit derivatives facilitated growth of structured securities markets and distribution of several trillions of dollars of poorly underwritten loans and mortgages.
  - crisis effects on OTC derivatives: lower trading volumes, wider bid-ask quotes, smaller trading lot sizes, impaired price discovery.
  - inconsistent collateral requirements exacerbated counterparty risk aversion and a destabilizing rush to collateralize exposures.

### II. Regulatory reform objectives and measures
- Reform goals reflected in H.R. 4173, Restoring American Financial Stability Act of 2010, and related Conference Report:
  - introduce registration and reporting requirements;
  - raise prudential standards and higher capital requirements for dealers;
  - promote exchange trading (swap execution facilities) and central clearing through derivatives clearing organizations (clearing houses);
  - improve transparency;
  - broaden enforcement actions against market misconduct;
  - collateral requirements for OTC derivatives (with exemptions for certain end-users);
  - enhanced regulators’ enforcement authority and additional investor protections.

### III. Market size, growth, and concentration — exact figures
- Notional amounts outstanding (Table 1: Notional Outstanding, US$ billion)
  - Interest rate: 1998 24,785; 1999 27,772; 2000 32,938; 2001 38,305; 2002 48,347; 2003 61,856; 2004 75,518; 2005 84,520; 2006 107,415; 2007 129,574; 2008 164,404; 2009 179,555.
  - Foreign exchange: 1998 7,386; 1999 5,915; 2000 6,099; 2001 5,736; 2002 6,076; 2003 7,182; 2004 8,607; 2005 9,282; 2006 11,900; 2007 16,614; 2008 16,824; 2009 16,553.
  - Equities: 1998 501; 1999 672; 2000 858; 2001 770; 2002 783; 2003 829; 2004 1,120; 2005 1,255; 2006 2,271; 2007 2,522; 2008 2,207; 2009 1,685.
  - Commodities: 1998 183; 1999 171; 2000 222; 2001 179; 2002 233; 2003 214; 2004 289; 2005 598; 2006 893; 2007 1,073; 2008 1,050; 2009 979.
  - Credit derivatives: 1998 144; 1999 287; 2000 426; 2001 395; 2002 635; 2003 1,001; 2004 2,347; 2005 5,822; 2006 9,019; 2007 15,861; 2008 15,897; 2009 14,036.
  - TOTAL: 1998 32,999; 1999 34,816; 2000 40,543; 2001 45,385; 2002 56,075; 2003 71,082; 2004 87,880; 2005 101,477; 2006 131,499; 2007 165,645; 2008 200,382; 2009 212,808.
  - Growth rate, annual: 5.5%; 16.4%; 11.9%; 23.6%; 26.8%; 23.6%; 15.5%; 29.6%; 26.0%; 21.0%; 6.2% (as presented in the table).
  - Source: OCC Fact Sheet (includes open interest in futures and exchange traded options).

- Derivatives vs. other financial assets (Table 2, US$ billions)
  - Non-financial business debt: 2003 7,336; 2004 7,800; 2005 8,480; 2006 9,366; 2007 10,633; 2008:I 10,832; 2008:II 11,034; 2008:III 11,140; 2008:IV 11,200; 2009:I 11,204; 2009:II 11,178.
  - Financial sector debt: 2003 10,925; 2004 11,920; 2005 12,984; 2006 14,272; 2007 16,192; 2008:I 16,408; 2008:II 16,667; 2008:III 16,944; 2008:IV 17,084; 2009:I 17,014; 2009:II 16,521.
  - Household debt: 2003 8,974; 2004 10,039; 2005 11,175; 2006 12,248; 2007 13,037; 2008:I 13,078; 2008:II 13,100; 2008:III 13,092; 2008:IV 13,023; 2009:I 12,948; 2009:II 12,877.
  - Equities (market cap.): 2004 16,451; 2005 18,947; 2006 20,643; 2007 24,334; 2008 25,565; 2008:I 23,290; 2008:II 22,777; 2008:III 20,142; 2008:IV 15,780; 2009:I 13,926; 2009:II 16,932.
  - Total (sum of listed categories): 2003 43,686; 2004 48,706; 2005 53,282; 2006 60,219; 2007 65,427; 2008:I 63,608; 2008:II 63,577; 2008:III 61,318; 2008:IV 57,086; 2009:I 55,093; 2009:II 57,509.
  - Derivatives - notional: 2003 71,100; 2004 87,900; 2005 101,500; 2006 131,500; 2007 165,600; 2008 180,300; 2008:I 182,100; 2008:II 175,800; 2008:III 200,400; 2009:I 202,000; 2009:II 203,500.
  - Gross fair values: 2003 1,173; 2004 8,242; 2005 8,763; 2006 9,782; 2007 1,902; 2008:I 3,237; 2008:II 2,753; 2008:III 2,772; 2008:IV 7,100; 2009:I 6,325; 2009:II 4,641.
  - Source: OCC Fact Sheet and Federal Reserve Z Survey.

- Current credit exposure on derivatives (Table 3: Gross Fair Value Prior to Netting and After Netting, US$ billions)
  - 2009: Gross fair value 4,053; net current credit exposure (NCCE) 398.
  - 2008: Gross fair value 7,100; NCCE 800.
  - 2007: Gross fair value 1,902; NCCE 309.
  - 2006: Gross fair value 1,132; NCCE 185.
  - 2005: Gross fair value 1,235; NCCE 191.
  - 2004: Gross fair value 1,328; NCCE 220.
  - 2003: Gross fair value 1,173; NCCE 217.
  - 2002: Gross fair value 1,171; NCCE 219.
  - Note: left column is gross fair value and right column is net current credit exposure measured at end of calendar year.
  - Source: OCC Fact.

- Concentration of derivatives transactions (Table 4, US$ bn and Percent)
  - Top 5 Banks totals and percent of all banks:
    - Futures & forwards: 22,670 (11.1%); Other Banks 2,034 (1.0%); All Banks 24,704 (12.1%).
    - Swaps: 132,513 (65.1%); Other Banks 3,090 (1.5%); All Banks 135,602 (66.6%).
    - Options: 28,809 (14.2%); Other Banks 904 (0.4%); All Banks 29,714 (14.6%).
    - Credit derivatives: 12,546 (6.2%); Other Banks 894 (0.4%); All Banks 13,440 (6.6%).
    - Total: Top 5 Banks 196,538 (96.6%); Other Banks 6,922 (3.4%); All Banks 203,460 (100.0%).
  - Almost 97 percent of outstanding notional amounts are concentrated in 5 banks.
  - Note: figures include former broker-dealers Goldman Sachs and Morgan Stanley reorganized into bank holding companies.
  - Source: Data from OCC from Call Reports.

- Total credit exposure to risk based capital (Table 5, In Percent)
  - JPMorgan Chase: 2001 439; 2002 427; 2003 548; 2004 361; 2005 315; 2006 347; 2007 419; 2008 382; 2009:I 323; 2009:IV 265.
  - Goldman Sachs: reported as 1,024; 1,048; 766 (table shows these values but context/year alignment as presented).
  - Bank of America: 2001 95; 2002 114; 2003 119; 2004 143; 2005 97; 2006 93; 2007 115; 2008 179; 2009:I 169; 2009:IV 151.
  - Citibank: 2001 123; 2002 147; 2003 198; 2004 221; 2005 267; 2006 268; 2007 223; 2008 278; 2009:I 213; 2009:IV 180.
  - Wells Fargo: reported value 60 (context/year as presented).
  - Top 5 Banks (aggregate): 2001 175; 2002 180; 2003 243; 2004 228; 2005 205; 2006 220; 2007 239; 2008 330; 2009:I 286; 2009:IV 284.
  - Source: OCC Fact Sheet.

### IV. Transparency — findings and implications
- OTC markets provide less transparency on market prices than exchange-traded markets.
- OTC trading is largely interdealer; clients/end-users typically cannot observe transaction prices and depend on dealer quotes.
- Lack of reporting requirements for price, volume, open interest, and large trader positions results in limited public information on amount, maturity, and concentration of outstanding OTC positions.
- Consequences:
  - participants unable to reliably mark some exposures to the market;
  - impaired price discovery relative to exchange-traded markets where prices, volumes, open interest, and trader categories are published and large positions are monitored.
- Pre-trade data sources:
  - Interdealer brokers, Bloomberg, and Markitwire provide quotes and execution prices for single-currency interest rate swaps, options, and credit derivatives.
  - ICAP estimates: “about 80 percent of all trading in credit default swap indices and 50 percent of all trading in credit default swap single-name derivatives in Europe is conducted electronically.”
- Standardization trends:
  - credit derivative indices are highly standardized (dates, referenced entities, definitions of credit events);
  - transition to fixed coupon CDS likely to reinforce standardization.

### V. Leverage and risk taking — observations and examples
- Derivatives are inherently leveraged and reduce capital cost, encouraging greater risk taking for a given capital amount.
- Leverage can quickly generate large counterparty credit risk via sharp market moves producing large gains on one side and large losses on the other.
- Insufficient collateral amplifies this effect.
- Example: AIG Financial Products’ failure:
  - uncollateralized credit derivatives positions allowed AIG to amass enormous long credit exposure with massive mark-to-market losses;
  - AIG’s credit rating downgrade triggered margin calls, requiring government support to meet margin calls and maintain solvency.

### VI. Counterparty risk — nature, mitigation, and market effects
- Counterparty risk arises from the uncertainty regarding whether the other party to the derivatives transaction will fully perform on the contract.
- When counterparty risk becomes heightened:
  - market activity can become impaired by trading volume reductions and increasing bid-ask spreads;
  - market prices may begin to reflect the riskiness of the counterparty as well as the underlying referenced item.
- Mitigation and management techniques:
  - Credit evaluation: traders can limit trading to highly-rated counterparties and limit exposures.
  - Margin and collateral:
    - exchange-traded derivatives typically require initial margin, maintenance margin, and daily variation margin;
    - OTC markets often allow no initial or maintenance collateral up to a threshold, followed by variation margin once exposure exceeds the threshold;
    - Credit Support Annex (CSA) formalizes amount and types of allowable collateral.
  - Market forces and collateral pressure: no minimum collateral requirements in OTC markets; cash collateral absorbs liquidity and has an opportunity cost.
- Supermargining and procyclicality:
  - Supermargining: practice of imposing higher collateral requirements upon a counterparty downgrade, creating procyclical effects.
  - Crisis examples: Lehman Brothers and AIG faced higher collateral demands after credit deterioration.
- Rehypothecation and its risks:
  - Lehman had rehypothecated an estimated US$427 billion of counterparties’ and prime brokerage clients’ assets at failure.
  - Hedge funds using Lehman’s prime brokerage in London discovered that Lehman had rehypothecated $22 billion of $40 billion of securities received as collateral.
- Credit risk complexities:
  - Derivatives credit exposure is volatile and linked to market risk; an in-the-money derivatives claim can change materially in a month.

### VII. Trading liquidity, price discovery, and market conduct
- Liquidity importance:
  - liquidity facilitates risk management and large transactions without impacting prices.
  - disruptions impair hedging, dynamic hedging, and exiting losing positions, and degrade price discovery.
- Evidence of liquidity decline during the crisis (Table 6: Trading Activity — Percentage Increase in Trading)
  - June 2006 - June 2008 vs June 2008 - December 2008:
    - IRS single currency: 75.5 ; -13.0
      - Less than 1 year: 71.9 ; 2.0
      - 1 to 5 years: 49.3 ; -16.1
      - More than 5 years: 118.7 ; -25.9
    - Commodity: 111.6 ; -72.6
      - Forward+swap: 247.1 ; -74.0
      - Option: 32.8 ; -70.6
  - (Source: BIS data, author’s calculations.)
- Price discovery breakdowns during crisis:
  - Interest rate swaps (IRS) sometimes traded at a negative spread to Treasury yields and were used as credit instruments.
  - Some credit derivatives indices stopped trading; prices reflected counterparty risk rather than underlying creditworthiness.
  - September and October 2008 disruptions between one- and three-month LIBOR skewed pricing of OTC interest rate and exchange rate contracts.
- Market conduct concerns and enforcement:
  - OTC markets’ opacity raises manipulation and insider trading concerns.
  - SEC, Department of Justice, and New York State Attorney General investigations referenced.
  - SEC Chairman described potential manipulation in CDS markets as “completely lacking in transparency and completely unregulated.”
  - Industry guidelines exist (Bond Market Association, ISDA) but lack enforcement powers; SEC anti-fraud authority over credit swaps linked to securities is contested in court.

### VIII. Regulatory proposals: registration, clearing, reporting, and structural reforms
- Registration requirements and scope
  - OTC derivatives dealers and “major swap participants” (MSP) required to register with the CFTC or the SEC depending on swap or security-based swap classification.
  - Registration extends to firms that hold collateral or margin for cleared transactions, bilaterally cleared swap participants, swap data repositories, swap execution facilities, and derivatives clearing organizations and clearing agencies.
  - Managers of private pools with assets under management exceeding US$100 million must register as investment advisers.
- Reporting requirements
  - Every OTC derivatives transaction must be reported to a registered repository or the relevant regulatory agency.
  - Derivatives cleared through a clearing house will be reported by the clearing house.
  - Pricing data will be reported in real time and other transactional data aggregated and released to the public.
  - Daily “large trader reporting” required by swap dealers and major swap participants.
- Clearing and multilateral trading
  - Historically, most OTC derivatives cleared bilaterally; exceptions include LCH Clearnet Group’s SwapClear and exchange-linked clearing.
  - DTCC Deriv/Serv and Warehouse Trust Company provide trade confirmation and a ‘gold’ copy of contracts.
  - LCH SwapClear services about 20 percent of total global OTC interest rate derivatives markets, 50 percent of inter-dealer trades in that market and some 93 percent of eligible trades.
  - Estimated that between 75-80 percent of OTC derivatives transactions are sufficiently standard for multilateral clearing.
  - CFTC and SEC authorized to determine instruments appropriate for multilateral clearing and exchange trading; clearing houses must justify acceptance decisions.
  - Exemptions: regulator determination, absence of a DCO that would accept them, or if one party is an end-user hedging commercial risk.
- Capital and collateral
  - Act requires higher capital requirements for OTC derivatives risk exposures, especially for non-cleared swaps.
  - Prudential regulators, CFTC and SEC, authorized to set collateral (margin) requirements for all non-cleared derivatives transactions and to oversee DCO collateral rules.
  - Segregation of collateral or margin funds required for cleared derivatives; for bilateral trades counterparties may have initial margin held in a segregated account by a third party.
  - Parties may elect comingled initial margin, but segregation rights reduce comingling and rehypothecation risks.
- Market conduct and enforcement
  - Extends anti-fraud and anti-manipulation measures to OTC derivatives.
  - Position reporting and limits enhance monitoring and can require reduction of large positions.
  - Business conduct rules require disclosure of material risks, conflicts of interest, and a daily mark to market valuation when trading with non-dealers and non-MSPs; higher standards for special entities.
  - CFTC granted greater enforcement authority, including over information releases that might affect market prices.

### IX. Assessment of reforms and remaining uncertainties
- Expected improvements from reforms:
  - Improved transparency through blanket reporting requirements for derivatives transactions.
  - Strengthened ability of authorities to monitor derivatives market positions and trading.
  - Reduced leverage through authority to increase capital requirements for OTC derivatives trading.
  - Authority to establish minimum collateral requirements for all non-cleared derivatives transactions.
  - Regulated clearing houses setting collateral requirements for cleared derivatives.
  - Substantially reduced counterparty risk and better-managed remaining exposures.
- Remaining uncertainties and regulatory role:
  - Uncertainty about how extensively OTC trades will be cleared through clearing houses and migrated to exchanges or multilateral trading venues.
  - Regulatory agencies will determine which contracts must be cleared and traded on exchanges and will interpret end-user exemptions and standardization requirements.
- Omitted measures and market-making concerns:
  - Proposed reforms do not require dealers to maintain binding bid and ask quotes.
  - If trading migrates to exchanges omission is less critical; if trading remains OTC, absence of binding market-making requirements could leave liquidity gaps.
  - Binding market-making requirements are not unusual (e.g., New York Federal Reserve Bank requirement for primary dealers in U.S. Treasury securities markets).
- Regulatory reversal
  - Reversal of the 2000 deregulation of OTC derivatives characterized as a major improvement closing an important regulatory gap.

### X. Appendix I — Primer on derivatives markets: key definitions and examples
- Derivative: transaction creating price exposure determined from an underlying commodity, security, index, rate or event; generally does not involve transfer of title or principal and links value to a notional amount.
- Forward contract examples:
  - Party A buying (party B selling) 1,000,000 Euros for U.S. dollars at US$1.3605 on December 1, 2010.
  - Forward rate agreement: party A borrowing (party B lending) US$1,000,000 for three months (91 days) at a 2.85 percent annual rate beginning December 1, 2010.
- Exchange-traded futures: highly standardized, cleared through clearing houses, fungible on the exchange listing the contract.
- Clearing houses: novate exchange trades so clearing house becomes the counterparty to every contract, assuming credit risk.
- Options: buyer right to buy (call) or sell (put); styles include American, European, Asian, barrier, and exotic options.
- Swaps: counterparties agree to swap payments calculated by applying rates or indexes to a notional principal; types include vanilla interest rate swap, foreign exchange swap, foreign currency swap, equity swap.
- Structured notes: combine features of conventional debt and derivatives; maturities often between two and ten years.
- Economic purposes: risk management (hedging), price discovery.
- Market liquidity benefits: greater liquidity lowers transaction costs and facilitates hedge adjustments; illiquid markets raise hedging costs.
- Legal/policy recognition: price discovery importance was written into U.S. law (Commodity Exchange Act, Section 3, “The Necessity of Regulation”) prior to 2000 deregulation.

*Italic: Source: _cr10252 - References (PDF)._*

### References .............................................................................................................

### _cr10252 - References

### I. Introduction — key observations
- OTC derivatives markets were an increasing source of vulnerability heading into the crisis due to leverage, low prudential standards, and lack of transparency.
- Market structure weaknesses cited:
  - absence of designated market makers and frequent, thorough reporting requirements;
  - bilateral trading (or interdealer brokering) with inadequate collateral usage;
  - heavy concentration of trading in a few dealers.
- Improvements prior to and during the crisis:
  - reduction in backlog of trade confirmations;
  - increased automation of trade processing;
  - establishment of novation protocol;
  - increased use of auction-based settlement mechanisms for cash settlement of credit events;
  - establishment of a central repository for CDS trade data and central payment settlement through CLS.
- Post-crisis additional improvements:
  - portfolio reconciliation and trade compression efforts (e.g., daily automated reconciliation of derivative positions; pilot ISDA dispute resolution protocol).
- Role in the crisis:
  - credit derivatives facilitated growth of structured securities markets and distribution of several trillions of dollars of poorly underwritten loans and mortgages.
  - crisis effects on OTC derivatives: lower trading volumes, wider bid-ask quotes, smaller trading lot sizes, impaired price discovery.
  - inconsistent collateral requirements exacerbated counterparty risk aversion and a destabilizing rush to collateralize exposures.

### II. Regulatory reform objectives and measures
- Reform goals (as advanced by the Administration and passed by Congress in H.R. 4173, Restoring American Financial Stability Act of 2010, and related Conference Report):
  - introduce registration and reporting requirements;
  - raise prudential standards and higher capital requirements for dealers;
  - promote exchange trading (swap execution facilities) and central clearing through derivatives clearing organizations (clearing houses);
  - improve transparency;
  - broaden enforcement actions against market misconduct;
  - collateral requirements for OTC derivatives (with exemptions for certain end-users);
  - enhanced regulators’ enforcement authority and additional investor protections.

### III. Market size, growth, and concentration — exact figures
- Notional amounts outstanding (Table 1: Notional Outstanding, US$ billion):
  - Interest rate: 1998 24,785; 1999 27,772; 2000 32,938; 2001 38,305; 2002 48,347; 2003 61,856; 2004 75,518; 2005 84,520; 2006 107,415; 2007 129,574; 2008 164,404; 2009 179,555.
  - Foreign exchange: 1998 7,386; 1999 5,915; 2000 6,099; 2001 5,736; 2002 6,076; 2003 7,182; 2004 8,607; 2005 9,282; 2006 11,900; 2007 16,614; 2008 16,824; 2009 16,553.
  - Equities: 1998 501; 1999 672; 2000 858; 2001 770; 2002 783; 2003 829; 2004 1,120; 2005 1,255; 2006 2,271; 2007 2,522; 2008 2,207; 2009 1,685.
  - Commodities: 1998 183; 1999 171; 2000 222; 2001 179; 2002 233; 2003 214; 2004 289; 2005 598; 2006 893; 2007 1,073; 2008 1,050; 2009 979.
  - Credit derivatives: 1998 144; 1999 287; 2000 426; 2001 395; 2002 635; 2003 1,001; 2004 2,347; 2005 5,822; 2006 9,019; 2007 15,861; 2008 15,897; 2009 14,036.
  - TOTAL: 1998 32,999; 1999 34,816; 2000 40,543; 2001 45,385; 2002 56,075; 2003 71,082; 2004 87,880; 2005 101,477; 2006 131,499; 2007 165,645; 2008 200,382; 2009 212,808.
  - Growth rate, annual: 5.5%; 16.4%; 11.9%; 23.6%; 26.8%; 23.6%; 15.5%; 29.6%; 26.0%; 21.0%; 6.2% (as presented in the table).
  - Source: OCC Fact Sheet (includes open interest in futures and exchange traded options).

- Derivatives vs. other financial assets (Table 2, US$ billions):
  - Non-financial business debt: 2003 7,336; 2004 7,800; 2005 8,480; 2006 9,366; 2007 10,633; 2008:I 10,832; 2008:II 11,034; 2008:III 11,140; 2008:IV 11,200; 2009:I 11,204; 2009:II 11,178.
  - Financial sector debt: 2003 10,925; 2004 11,920; 2005 12,984; 2006 14,272; 2007 16,192; 2008:I 16,408; 2008:II 16,667; 2008:III 16,944; 2008:IV 17,084; 2009:I 17,014; 2009:II 16,521.
  - Household debt: 2003 8,974; 2004 10,039; 2005 11,175; 2006 12,248; 2007 13,037; 2008:I 13,078; 2008:II 13,100; 2008:III 13,092; 2008:IV 13,023; 2009:I 12,948; 2009:II 12,877.
  - Equities (market cap.): 2004 16,451; 2005 18,947; 2006 20,643; 2007 24,334; 2008 25,565; 2008:I 23,290; 2008:II 22,777; 2008:III 20,142; 2008:IV 15,780; 2009:I 13,926; 2009:II 16,932.
  - Total (sum of listed categories): 2003 43,686; 2004 48,706; 2005 53,282; 2006 60,219; 2007 65,427; 2008:I 63,608; 2008:II 63,577; 2008:III 61,318; 2008:IV 57,086; 2009:I 55,093; 2009:II 57,509.
  - Derivatives - notional: 2003 71,100; 2004 87,900; 2005 101,500; 2006 131,500; 2007 165,600; 2008 180,300; 2008:I 182,100; 2008:II 175,800; 2008:III 200,400; 2009:I 202,000; 2009:II 203,500.
  - Gross fair values: 2003 1,173; 2004 8,242; 2005 8,763; 2006 9,782; 2007 1,902; 2008:I 3,237; 2008:II 2,753; 2008:III 2,772; 2008:IV 7,100; 2009:I 6,325; 2009:II 4,641.
  - Source: OCC Fact Sheet and Federal Reserve Z Survey.

- Current credit exposure on derivatives (Table 3: Gross Fair Value Prior to Netting and After Netting, US$ billions):
  - 2009: Gross fair value 4,053; net current credit exposure (NCCE) 398.
  - 2008: Gross fair value 7,100; NCCE 800.
  - 2007: Gross fair value 1,902; NCCE 309.
  - 2006: Gross fair value 1,132; NCCE 185.
  - 2005: Gross fair value 1,235; NCCE 191.
  - 2004: Gross fair value 1,328; NCCE 220.
  - 2003: Gross fair value 1,173; NCCE 217.
  - 2002: Gross fair value 1,171; NCCE 219.
  - Note: left column is gross fair value and right column is net current credit exposure measured at end of calendar year.
  - Source: OCC Fact.

- Concentration of derivatives transactions (Table 4, US$ bn and Percent):
  - Top 5 Banks totals and percent of all banks:
    - Futures & forwards: 22,670 (11.1%); Other Banks 2,034 (1.0%); All Banks 24,704 (12.1%).
    - Swaps: 132,513 (65.1%); Other Banks 3,090 (1.5%); All Banks 135,602 (66.6%).
    - Options: 28,809 (14.2%); Other Banks 904 (0.4%); All Banks 29,714 (14.6%).
    - Credit derivatives: 12,546 (6.2%); Other Banks 894 (0.4%); All Banks 13,440 (6.6%).
    - Total: Top 5 Banks 196,538 (96.6%); Other Banks 6,922 (3.4%); All Banks 203,460 (100.0%).
  - Almost 97 percent of outstanding notional amounts are concentrated in 5 banks.
  - Note: figures include former broker-dealers Goldman Sachs and Morgan Stanley reorganized into bank holding companies.
  - Source: Data from OCC from Call Reports.

- Total credit exposure to risk based capital (Table 5, In Percent):
  - JPMorgan Chase: 2001 439; 2002 427; 2003 548; 2004 361; 2005 315; 2006 347; 2007 419; 2008 382; 2009:I 323; 2009:IV 265.
  - Goldman Sachs: reported as 1,024; 1,048; 766 (table shows these values but context/year alignment as presented).
  - Bank of America: 2001 95; 2002 114; 2003 119; 2004 143; 2005 97; 2006 93; 2007 115; 2008 179; 2009:I 169; 2009:IV 151.
  - Citibank: 2001 123; 2002 147; 2003 198; 2004 221; 2005 267; 2006 268; 2007 223; 2008 278; 2009:I 213; 2009:IV 180.
  - Wells Fargo: reported value 60 (context/year as presented).
  - Top 5 Banks (aggregate): 2001 175; 2002 180; 2003 243; 2004 228; 2005 205; 2006 220; 2007 239; 2008 330; 2009:I 286; 2009:IV 284.
  - Source: OCC Fact Sheet.

### IV. Transparency — findings and implications
- OTC markets provide less transparency on market prices than exchange-traded markets.
- OTC trading is largely interdealer; clients/end-users typically cannot observe transaction prices and depend on dealer quotes.
- Lack of reporting requirements for price, volume, open interest, and large trader positions results in limited public information on amount, maturity, and concentration of outstanding OTC positions.
- Consequences:
  - participants unable to reliably mark some exposures to the market;
  - impaired price discovery relative to exchange-traded markets where prices, volumes, open interest, and trader categories are published and large positions are monitored.
- Some pre-trade data availability:
  - Interdealer brokers, Bloomberg, and Markitwire provide quotes and execution prices for single-currency interest rate swaps, options, and credit derivatives.
  - ICAP estimates: “about 80 percent of all trading in credit default swap indices and 50 percent of all trading in credit default swap single-name derivatives in Europe is conducted electronically.”
- Standardization trends:
  - credit derivative indices are highly standardized (dates, referenced entities, definitions of credit events);
  - transition to fixed coupon CDS likely to reinforce standardization.

### V. Leverage and risk taking — observations and examples
- Derivatives are inherently leveraged and reduce capital cost, encouraging greater risk taking for a given capital amount.
- Leverage can quickly generate large counterparty credit risk via sharp market moves producing large gains on one side and large losses on the other.
- Insufficient collateral amplifies this effect.
- Example: AIG Financial Products’ failure:
  - uncollateralized credit derivatives positions allowed AIG to amass enormous long credit exposure with massive mark-to-market losses;
  - AIG’s credit rating downgrade triggered margin calls, requiring government support to meet margin calls and maintain solvency.

### VI. Counterparty risk (introductory note)
- The text identifies increasing counterparty credit risk accompanying OTC derivatives growth and highlights how price volatility impacted gross fair values and credit exposures (see Table 3 figures).

*Italic: Source: _cr10252 - References (PDF)._*

### 13. Counterparty risk arises from the uncertainty regarding whether the other

### _cr10252 - 13. Counterparty risk arises from the uncertainty regarding whether the other

### Counterparty risk: nature and market effects
- Counterparty risk arises from the uncertainty regarding whether the other party to the derivatives transaction will fully perform on the contract.
- OTC derivatives trading entails counterparty risk because each side is exposed to the potential failure of the other party to adhere to the contract.
- When counterparty risk becomes heightened:
  - market activity can become impaired by trading volume reductions and increasing bid-ask spreads;
  - market prices may begin to reflect not only the underlying referenced item (e.g., interest rate risk) but also the riskiness of the counterparty in performing on the contract.

### Mitigation and management techniques
- Credit evaluation
  - Conduct a credit evaluation of the counterparty to determine its ability to pay or fulfill the terms of the derivative over the life of the contract.
  - Traders can limit trading to entities with highly-rated credit and limit exposure to each counterparty.
  - Reliance solely on creditworthiness to manage counterparty risk is sometimes called “trading on capital.”
- Margin and collateral
  - The use of margin or collateral is described as a more effective means of mitigating counterparty risk.
  - Counterparties can post margin as a performance bond against full performance on the contract.
  - Exchange-traded derivatives (with multilateral clearing houses) typically require:
    - initial margin on new net positions;
    - maintenance margin requirements that are sometimes slightly lower;
    - daily margin adjustments (variation margin) when positions lose value.
  - In OTC markets, industry practice often differs:
    - counterparties often trade without requiring initial or maintenance collateral up to a threshold, then require posting of variation margin or collateral once exposure exceeds the threshold;
    - the amount and types of allowable collateral vary and are formalized through the Credit Support Annex (CSA) of the master trading agreement signed by counterparties;
    - industry standards changed during the crisis to require greater collateralization.
- Market forces and collateral pressure
  - There are no minimum collateral requirements in OTC derivatives markets; counterparties can agree on low or high rates, and competition tends to lower collateral requirements.
  - Cash collateral absorbs liquidity; using Treasury bills or other high-quality liquid securities as collateral has an opportunity cost equal to the credit spread between a firm’s borrowing cost and the return on Treasuries or cash.
  - Competitive pressure to economize on collateral contrasts with investors’ interest in adequate management of off-balance sheet derivatives credit exposure.

### Supermargining and crisis procyclicality
- Supermargining
  - Defined as the practice whereby one party can impose higher collateral requirements if the other counterparty is downgraded, especially to below investment grade status.
  - Collecting additional collateral only after a counterparty’s credit deterioration can create procyclical effects during widespread downgrades as counterparties scramble to post additional collateral.
- Crisis examples
  - Lehman Brothers: months of rising credit spreads preceded its collapse and counterparties required higher rates of collateral on Lehman’s derivatives transactions, encumbering capital and liquid assets when Lehman was short of capital and struggling for funding.
  - AIG: downgrading forced it to begin posting collateral and brought it to the brink of collapse.

### Rehypothecation and its risks
- Rehypothecation defined
  - The recipient of collateral posted to secure a derivative may be permitted to use that collateral as part of its own capital structure (e.g., lending the collateral, selling it in a repurchase agreement, or posting it as collateral for the recipient’s other obligations).
  - Example: a hedge fund posts collateral to its prime broker; the prime broker may then use this collateral to secure its own transactions.
- Scale and impact
  - At the time of its failure, Lehman had rehypothecated an estimated US$427 billion of its counterparties’ and prime brokerage clients’ assets.
  - Hedge funds using Lehman’s prime brokerage services out of its London subsidiary discovered that Lehman had rehypothecated $22 billion of $40 billion of securities received as collateral.
  - Counterparties (including remote banks) found themselves without the hedge or investment position and unable to recover liquid assets posted as collateral.

### Credit risk complexities in OTC derivatives
- Credit exposure in derivatives is volatile and linked to market risk:
  - A bank lending US$100 million today most likely faces US$100 million in credit exposure in a month (pre-payment notwithstanding).
  - A US$100 million in-the-money derivatives claim might be 50 percent greater or less a month later depending on volatility and contract structure.
  - The amount of counterparty credit risk is immediately impacted by market risk.

### Trading liquidity: importance and crisis observations
- Liquidity facilitates risk management: the ability to trade continuously and execute large transactions without impacting market prices.
- When the trading process is disrupted (due to counterparty credit risk, operational failures, or extreme market price risk), trading volume and market liquidity can suffer, producing economic costs or instability such as:
  - impaired capability for risk management activities (entering/adjusting hedges, dynamic hedging, trading out of losing positions);
  - loss of price discovery and benchmarks for pricing related instruments.
- Evidence of liquidity decline during the crisis (Table 6: Trading Activity — Percentage Increase in Trading)
  - June 2006 - June 2008 vs June 2008 - December 2008:
    - IRS single currency: 75.5 ; -13.0
      - Less than 1 year: 71.9 ; 2.0
      - 1 to 5 years: 49.3 ; -16.1
      - More than 5 years: 118.7 ; -25.9
    - Commodity: 111.6 ; -72.6
      - Forward+swap: 247.1 ; -74.0
      - Option: 32.8 ; -70.6
  - (Source: BIS data, author’s calculations.)
- The lack of reporting requirements and limitations on privately collected data limit accurate trading volume measurement, but available data suggest sharp drops in trading activity (see Table 6, Figures 3 and 4).

### Price discovery and market conduct concerns
- Price discovery
  - Essential for mark-to-market valuation, accurate financial statements, and determining collateral needs.
  - Price discovery relies on liquid markets to reflect new information quickly.
  - During the crisis, price discovery in certain OTC derivatives markets broke down:
    - Interest rate swaps (IRS) faced price distortions—at times trading at a negative spread to Treasury yields; IRS were sometimes used as credit instruments rather than for interest rate risk.
    - Some credit derivatives indices completely stopped trading; prices sometimes reflected counterparty risk rather than the creditworthiness of the referenced name or index.
    - In September and October of 2008, disruptions between one- and three-month LIBOR rates skewed pricing of OTC derivatives contracts on interest rates and exchange rates.
- Market misconduct and regulatory enforcement
  - OTC derivatives markets lack the transparency and oversight of exchange-traded markets, raising concerns about misconduct, particularly in credit derivatives.
  - Banks participate as dealers and in proprietary trading and may possess non-public client information; unlike prohibitions on banks holding equities or corporate debt on balance sheets, they are allowed to be major OTC derivatives dealers.
  - Regulatory scrutiny increased:
    - SEC, Department of Justice, and New York State Attorney General launched investigations;
    - SEC Chairman described potential manipulation in CDS markets as “completely lacking in transparency and completely unregulated.”
  - Insider trading and manipulation are harder to police in OTC markets due to lack of centralized, automated surveillance; industry guidelines exist (Bond Market Association, ISDA) but these are trade associations without enforcement authority.
  - Pursuant to the Securities Exchange Act of 1934, the SEC has anti-fraud authority over credit swaps linked to securities, but the scope of that authority is contested in court.

### Regulatory proposals: registration and structural reforms
- U.S. legislative reforms (timeline)
  - U.S. Congress passed comprehensive reforms in July of 2010 following the Treasury Department’s June 2009 white paper.
  - House passed H.R. 4173 on December 13, 2009; Senate passed its version on May 20, 2010; a conference report (H. Rept. 111-517) was produced on June 29 and passed by both chambers.
- Registration changes under the reforms
  - Three registration changes are highlighted to address crisis problems:
    - OTC derivatives dealers and a class of market participants labeled major swap participants (MSP) are required to register with the CFTC or the SEC depending on whether they trade in “swaps” or “security-based swaps.”
    - MSPs would be required to register irrespective of whether they are otherwise registered as a financial firm (e.g., a hedge fund would be classified as an MSP; a farmer hedging his crop would not).
    - The “Lincoln Amendment” (push-out provision) will prohibit these entities from receiving federal assistance, FDIC deposit insurance, and access to the Fed discount window.
    - Exemptions exist for trading in interest rate and foreign exchange swaps, but trading in other derivatives products must be moved out of the bank and into an affiliate.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10252.pdf*

### 33. In addition, the Act requires registration for any firm that holds collateral or

### _cr10252 - 33. In addition, the Act requires registration for any firm that holds collateral or

### Registration requirements for firms and market infrastructures
- Requires registration for any firm that holds collateral or margin for a derivatives transaction cleared through a clearing house or clearing agency.
- Applies to bilaterally cleared swap participants.
- Requires registration for swap data repositories that receive transaction and price reports required in the Act.
- Will require ‘swap execution facilities’ to be registered if they trade swaps designed for clearing and exchange trading.
- Derivatives clearing organizations and clearing agencies that clear derivatives subject to clearing requirements must register with the respective agency.
- The Act will subject certain security-based swaps transactions to the registration process of the 1933 Securities Act to improve transparency and protect less sophisticated investors.

### Implicit registration and contract eligibility
- CFTC and SEC authorized to determine which instruments should be subject to multilateral clearing and, allowing for some exemptions, required to trade on an exchange (a ‘contract market’) or swap execution facility.
- Any registered entity (exchange, swap facility or clearing organization) must report any new contract for trading or clearing to the relevant Commission (See Section 125 of H.R. 3795).
- Registered clearing organizations and agencies must provide a list of contracts eligible for clearing, creating a ‘positive’ list of instruments reviewed and accepted as suitable for multilateral clearing and trading.

### Registration of private pool managers (hedge fund advisors)
- Managers of private pools of capital, such as hedge funds, must register as investment advisers if assets under management exceed US$100 million.
- Registered investment advisers required to register, keep records, and report on their activities.
- Requirement for “major swap participants” to register likely includes most relevant hedge funds; investment adviser registration helps close remaining loopholes.

### Reporting requirements
- Current disparity: futures exchanges collect information on every futures and options on futures trade and provide real-time price and volume data and aggregated end-of-day statistics; OTC reporting requirements differ sharply.
- Under the Act:
  - Every OTC derivatives transaction must be reported to a registered repository or the relevant regulatory agency.
  - Derivatives cleared through a clearing house will be reported by the clearing house.
  - Transactions not multilaterally cleared must report directly to a repository or the relevant regulatory authority.
  - Pricing data will be reported in real time and other transactional data will be aggregated and released to the public.
- The Act requires daily “large trader reporting” by swap dealers and major swap participants, in addition to existing reporting requirements.
- Publicly released analogue: Commitment of Traders report is released weekly for exchange traded activity and can be used to detect manipulation and destabilizing exposures.

### Clearing and multilateral trading requirements
- Historically, OTC derivatives largely cleared bilaterally; exceptions include LCH Clearnet Group’s SwapClear and certain exchange-linked clearing facilities (e.g., ClearPort, ICE services).
- Innovations:
  - DTCC Deriv/Serv confirms a large range of OTC derivatives trades and links to its trade data repository, the Warehouse Trust Company, storing a ‘gold’ copy of contracts and providing aggregate data.
  - LCH Clearnet Group’s SwapClear services about 20 percent of total global OTC interest rate derivatives markets, 50 percent of inter-dealer trades in that market and some 93 percent of eligible trades.
- The Act will generally require all derivatives transactions to be cleared by a regulated clearing house unless exemptions apply.
- It is estimated that between 75-80 percent of OTC derivatives transactions are sufficiently standard that they can be multilaterally cleared.
- CFTC and SEC authorized to review swap contracts and determine appropriateness for multilateral clearing; clearing houses must justify acceptance decisions.
- Once a contract is deemed appropriate for clearing and accepted by a clearing house, it is required to trade on an exchange or a registered swap execution facility.
- Exemptions to clearing requirements:
  - If the appropriate regulator determines certain OTC derivatives should not be subject to clearing.
  - If no existing DCO would accept them for clearing.
  - If one party is an end-user of derivatives and not a dealer or a ‘major swap participant.’

### Capital and collateral requirements
- The Act requires higher capital requirements for risk exposures arising from OTC derivatives trading, especially for swaps that are not cleared by a registered derivatives clearing organization.
- The Act contains non-discriminatory provisions that prohibit clearing organizations associated with exchanges or Swap Execution Facilities (SEF) from rejecting contracts traded in other venues.
- Prudential regulators, CFTC and SEC, authorized to set collateral (margin) requirements for all non-cleared derivatives transactions and to oversee collateral requirements set by registered derivatives clearing organizations.
- Exemptions for OTC trades with certain end-users using OTC derivatives only to hedge existing commercial risks.
- The Act will require segregation of collateral or margin funds for derivatives cleared through clearing houses.
- For bilaterally cleared trades, counterparties have the right to have initial margin funds held in a segregated account by a third party.
- Market participants may elect to allow initial margin funds to be comingled, but segregation rights reduce comingling and rehypothecation risks.

### Market conduct provisions and enforcement
- Extends anti-fraud and anti-manipulation measures to OTC derivatives markets similar to those for exchange-traded derivatives markets.
- Position reporting requirements and position limits increase regulators’ ability to monitor markets and require reduction of large positions.
- Business conduct rules require disclosure of material risks, conflicts of interest, and a daily mark to market valuation when trading with non-dealers and non-MSPs; higher standards apply for special entities such as pension funds and municipal governments.
- The Act grants the CFTC greater enforcement authority, including over information released by government agencies that might affect market prices, and prohibits trading when a counterparty is known to be engaging in fraud.
- The Act authorizes the CFTC and SEC to report on certain types of derivatives transactions deemed to threaten market stability; the statute does not include authority to create a negative list that outlaws trading in some contracts.

### Assessment of regulatory reforms (summary findings)
- Reforms make major improvements to the regulatory framework for derivatives and address many problems revealed in the financial crisis.
- Expected improvements include:
  - Improved transparency through blanket reporting requirements for derivatives transactions.
  - Strengthened ability of authorities to monitor derivatives market positions and trading.
  - Reduced leverage through authority to increase capital requirements for OTC derivatives trading.
  - Authority to establish minimum collateral requirements for all non-cleared derivatives transactions.
  - Regulated clearing houses setting collateral requirements for derivatives required to be cleared on a multilateral basis.
  - Substantially reduced counterparty risk and better-managed remaining exposures.

*Italic: Source: _cr10252 - 33. In addition, the Act requires registration for any firm that holds collateral or (PDF chapter/section).*

### 54. The proposed reforms would make major improvements to market trading

### 54. The proposed reforms would make major improvements to market trading

### Impact of proposed reforms on liquidity and price discovery
- The reforms to move trading onto exchanges, require market wide real-time transactional reporting, and better manage counterparty risk through collateral, capital and clearing houses will:
  - make the markets more transparent;
  - make market trading volume more resilient to economic disruptions.

### Remaining uncertainties and regulatory role
- It is uncertain how extensively OTC trades will be:
  - cleared through clearing houses, and
  - migrated to exchanges or similar multilateral trading venues.
- Recent developments in the credit derivatives markets indicate movement toward multilateral clearing and trading of standardized contracts is feasible.
- Regulatory agencies will play an important role in:
  - determining which contracts must be cleared through a clearing house (and thus which must be exchange traded);
  - interpreting exemptions for certain end-users;
  - issuing guidelines for determining appropriate degrees of standardization for multilateral clearing and trading.

### Omitted measures and market-making concerns
- The proposed reforms do not require dealers to support market liquidity by maintaining binding bid and ask quotes.
- Implications:
  - If OTC derivatives trading migrates to exchanges, omission is less critical.
  - If trading remains in OTC markets, the absence of binding market-making requirements could leave market structures with the same lack of dependable trading liquidity.
- Note: Binding market making requirements are not unusual; examples in the text include:
  - the New York Federal Reserve Bank requirement that primary dealers in the U.S. Treasury securities markets maintain binding quotes throughout the trading day;
  - OTC markets in equity shares having designated dealers required to maintain binding bid and offer quotes throughout the trading day.

### Regulatory reversal and closing of gaps
- The reversal of the 2000 deregulation of OTC derivatives is characterized as a major improvement in regulatory approach that closes an important gap in the regulatory framework.

### Appendix I — Primer on derivatives markets: key definitions and examples
- Derivative: a transaction creating price exposure by having value determined from an underlying commodity, security, index, rate or event; generally does not involve transfer of title or principal and links value to a notional amount.
- Forward contract:
  - Obligation to buy or sell a specified quantity at a specified price at a specified future time.
  - Examples in text:
    - Party A buying (party B selling) 1,000,000 Euros for U.S. dollars at US$1.3605 on December 1, 2010.
    - A forward rate agreement: party A borrowing (party B lending) US$1,000,000 for three months (91 days) at a 2.85 percent annual rate beginning December 1, 2010.
- Exchange-traded futures:
  - Highly standardized, cleared through clearing houses, fungible on the exchange listing the contract; enhances liquidity and allows offsets.
- Exchange trading characteristics:
  - Public and multilateral (e.g., open outcry or electronic order matching), allowing participants to observe bid, offer and execution prices.
- Clearing houses:
  - Novate exchange trades so clearing house becomes the counterparty to every contract, assuming credit risk.
  - Futures traders evaluate the clearing house and clearing member creditworthiness rather than every trading partner.
- Options:
  - Buyer has the right (not obligation) to buy (call) or sell (put) the underlying at the strike price by or at expiration; seller (writer) has the obligation if exercised and may face potentially unlimited losses.
  - Styles: American (exercise any time during life), European (exercise only on expiration date), Asian (path dependent), barrier options (knock-out/knock-in), exotic options (complex).
  - Premium determined by time to expiry, volatility, current market price, strike price, and market rate of interest.
- Swaps:
  - Counterparties agree to swap two different types of payments calculated by applying interest rates, indexes, exchange rates or prices to a notional principal.
  - Notional principal generally not exchanged (except some FX swaps); payments netted when in same currency.
  - Types mentioned: vanilla interest rate swap, foreign exchange swap, foreign currency swap, equity swap.
- Structured notes:
  - Securities combining features of conventional debt and derivatives (maturities often between two and ten years).
  - Examples include callable bonds, convertible bonds, and convertible preferred stock.
- Economic purposes of derivatives markets:
  - Risk management (hedging and risk transfer or elimination) — examples include a farm hedging crop and a bank using a vanilla interest rate swap.
  - Price discovery — derivatives markets often serve as primary markets for determining prices of commodities and financial assets and market value of certain risks and events.
- Market liquidity benefits:
  - Greater liquidity lowers transaction costs and facilitates hedge adjustments.
  - Illiquid markets raise hedging costs and may prevent adjustments.
- Legal/policy recognition:
  - Price discovery importance was written into U.S. law (Commodity Exchange Act, Section 3, “The Necessity of Regulation”) prior to 2000 deregulation.

*Source: _cr10252 - 54. The proposed reforms would make major improvements to market trading*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10252.pdf_