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### Introduction: context and motivation
- Recent financial crisis accelerated momentum to move lightly regulated over-the-counter (OTC) derivative contracts to central counterparties (CCPs) rather than bilateral clearing.
- Regulators in the United States and European Union are seeking legislative approval to mitigate systemic risk associated with large complex financial institutions (LCFIs).
- Moving standardized OTC derivative contracts to CCPs implies either:
  - users holding more collateral against bilaterally traded contracts, or
  - margin being posted to CCPs to cover potential losses.
- Empirical context:
  - Credit default swaps (CDS) represent only about 6 percent of the overall notional OTC derivatives market (BIS data).
  - BIS surveys show notional amounts of all categories of the OTC contracts stood at $605 trillion at the end of June 2009.
- Prior literature highlights:
  - Barclays (2008) estimate that the default by a major derivative dealer could lead to losses of around $40 billion (assumptions do not factor in re-pricing risk at default or associated losses from other OTC derivatives).
  - Duffie and Zhu (2009) find in simulations that one global CCP covering all OTC derivatives contracts would provide the most efficient allocation of capital, but do not use actual data nor address concentration risk and use i.i.d. assumptions across products.
  - IMF papers (Singh and Aitken, 2009b; Segoviano and Singh, 2008) find large parts of counterparty risk in the OTC derivatives market are under-collateralized—up to $2 trillion—relative to system risk.
  - Post Bear Stearns and after Lehman’s collapse, demand for high quality collateral increased while supply was reduced due to hoarding of (unencumbered) collateral by LCFIs (Singh and Aitken, 2009a).
- Framing from this paper:
  - Margin and collateral requirements at CCPs are functions of the risks from OTC derivatives.
  - Moving standardized OTC derivative contracts to CCPs could impose additional costs on LCFIs; achieving a critical mass of cleared contracts may require higher charges on bilateral counterparties or sizable collateral to be posted and held at CCPs.
  - Partial offloading (only clearable standardized contracts) could increase measured systemic risk and adversely impact net exposures on LCFI books because netting between standard and nonstandard contracts would not occur if nonstandard contracts remain bilaterally held.

### Collateral, netting, and measurement of systemic exposure
- Measurement choice:
  - To measure exposure of the financial system to the failure of an LCFI active in the OTC derivatives market, use the LCFI’s total “derivative payables” (not “derivative receivables”).
  - Derivative payables = sum of the counterparty’s contracts that are liabilities of the LCFI at any given time; derivative receivables = assets of the LCFI.
  - Derivative payables represent the risk imposed on the rest of counterparties when an LCFI fails; derivative receivables represent the credit risk of counterparties to whom the LCFI is exposed and are covered by Basel II capital charges.
- Rationale:
  - Currently derivative payables do not carry an explicit regulatory capital charge; using derivative payables as a yardstick provides an available measure of systemic risk.
- Collateral dynamics:
  - Collateral is posted because it correlates with the requesting side’s assessment of default likelihood, transaction risk (market, credit, operational, counterparty), tenor, client relationship, liquidity, and other factors.
  - Residual derivative payables exposure can indicate the maximal extent of under-collateralization.
- Empirical snapshot (Q3 2009):
  - Five key U.S. LCFIs—Goldman Sachs, Citi, JP Morgan, Bank of America, and Morgan Stanley—are jointly carrying almost $500 billion in OTC derivative payables exposure as of Q3, 2009.
  - Figure 1 numerical values (as presented): 59, 53, 62, 64, 40, 119, 123, 106, 81, 75
- Note on assigned collateral:
  - “Assigned collateral is collateral posted against specific OTC derivative contracts that may be reused (rehypothecated) for other purposes by the institution to which it is posted.”

### Residual derivative payables: definition and magnitudes
- Definition:
  - Residual Derivative payables = sum of the negative replacement values, after netting (including legally enforceable master netting agreements such as ISDA), associated with an institution’s outstanding contracts.
- Measured magnitudes (as presented):
  - Five largest European banks (Deutsche Bank, Barclays, UBS, RBS and Credit Suisse) had about $600-$700 billion in under-collateralized risk (measured by residual derivative payables) as of December 2008.
  - U.S. banks had over $650 billion of derivative payables as of December 2008.
  - IMF research estimate of under-collateralized derivative payables may total at least $1.6 trillion using bottoms-up individual firm data as of end-Dec 2007.
  - BIS semi-annual OTC Derivative Activity suggests:
    - over $4 trillion when including non-US CDS contracts; or
    - roughly $2.0 trillion of derivative payables assuming the major players run matched-books (as of end-June 2009).
  - As of end-Dec 2008 BIS figures: about $5 trillion for derivative payables and receivables after netting (or about $2.5 trillion of derivative payables assuming matched-books).
  - BIS Quarterly Review (ISDA survey-based) concluded under-collateralization is about $1 trillion for both payables and receivables based on ISDA estimate of 80 percent collateralization (implying roughly $0.5 trillion for derivative payables).
  - ECB/Banking Supervisory Committee study finds collateralization only 44 percent of net exposures.
  - Reasonable estimate accounting for assigned collateral and matched-books: $2 trillion for derivative payables.
  - Estimated additional collateral that would become unavailable to re-use per large bank when moved to CCPs: often in the range of $20 -$70 billion per large bank.

### Causes and practices producing residual payables/receivables
- Key reasons residuals persist after ISDA netting:
  - Sovereigns, AAA insurers/corporates/large banks/multilateral institutions (e.g., EBRD), and “Berkshire Hathway” types of firms do not post adequate collateral because they are viewed by LCFIs as privileged and safe clients.
  - Dealers have agreed, based on the bilateral nature of contracts, not to mandate adequate collateral for dealer-to-dealer positions; dealers typically post no initial margin to each other for these contracts.
- Assigned collateral is often rehypothecated and not dedicated/segregated to reduce OTC derivative risk; this reduces effective collateralization.
- Many LCFIs presently have sizable unencumbered or cash collateral deposited with their central banks; the opportunity cost of posting collateral to CCPs is assumed to be the same whether LCFIs use deposits with central banks or opt for new funding in capital markets.

### Netting, CCP interoperability, and legal constraints
- ISDA master agreements permit netting of derivative receivables and payables across a given counterparty; focus is on payables after netting.
- CCPs require collateral from all members, making under-collateralization gaps obvious and requiring large increases in collateral if transactions are moved to CCPs.
- Multilateral netting and portfolio margining at CCPs can reduce counterparty risk and overall margin required if exposures across OTC products offset.
- Netting benefits are reduced if multiple CCPs are not linked (cross-product netting will not take place).
- To maximize netting benefits across multiple CCPs, important elements include:
  - Interoperability (linking of CCPs) to allow participants to concentrate portfolios at a CCP of choice and permit CCPi to have access to collateral from CCPj.
  - A multilateral cross-guarantee agreement to share excess collateral after closeout/bankruptcy of an LCFI at a different clearing agency, allowing CCPs legal priority over collateral of an LCFI.
  - If a CCP fails and collateral across CCPs is insufficient, consider an unlimited call on LCFIs dealing with the CCP to bridge losses (providing ‘skin in the game’).
- Legal/market constraints:
  - It is unlikely CCPi would be allowed access to collateral posted to CCPj registered in another country.
  - Excess collateral would generally be returned to the bankrupt estate unless there is a security interest in favor of the second CCP.
  - CPSS-IOSCO Recommendations for CCPs (RCCP 4) indicate a clearing member may not be exposed to significant risks they cannot control; a CCP is not allowed to expose members to an unlimited call to bridge losses, and a cap is defined on replenishments to the default fund (at least in Europe).

### Implications for capitalization and collateral when moving OTC derivatives to CCPs
- Regulatory proposals envision all standardized derivatives cleared by CCPs; regulators may mandate CCP use or make nonstandard contracts costly to hold.
- Offloading to CCPs will increase initial margin requirements (including monies toward guarantee/default funds).
- To attain a critical mass of two-thirds of all standardized OTC derivatives moved to CCPs, illustrative arithmetic suggests:
  - about $200 billion may be needed in initial margins and guarantee funds.
- Costs to dealers for moving trades to CCPs may be substantial due to:
  - inability to effectively net internal positions across products for any given client;
  - larger upfront cost of posting initial margin and guarantee fund contributions at CCPs;
  - loss from inability to rehypothecate existing posted collateral which they use and re-use to finance other parts of their business.
- Variation margin:
  - Variation margin is presently paid to mark portfolios to market and is a function of volatility and covariance within compressed portfolios; movement to CCPs is not expected to have a large impact on variation margins unless current LCFI methods are more lenient than CCPs.
- Initial margin characteristics by product:
  - CDS contracts: initial margin in bilateral contracts can reach 10–30 percent of notionals due to ‘jump risk’.
  - Interest rate swaps (IRS): initial margin is much lower, around 1 percent of notional or even less.

### Box 1 — Arithmetic on collateral requirements at CCPs (methodology and estimates)
- Methodology and assumption:
  - Use present ratio of initial margin and guarantee fund to notional positions already cleared to estimate costs to LCFIs of offloading contracts to CCPs.
  - Assume two-thirds of each OTC derivative market segment moves to CCPs for baseline calculations.
  - Empirical relation cited for DP_after netting to N is "approx 0.3 percent to 0.4 percent of N" (BIS surveys).
- Estimated collateral requirements by product (as presented):
  - Credit Default Swaps (CDS)
    - ICE clears 3 trillion index trades; supported by $2 billion guarantee fund and $3 billion initial margin.
    - Implied margin and guarantee fund/notional ratio: 1/600.
    - Calculation example: 1/600 x $36 trillion x 2/3 = $36 billion.
    - Market-sources alternative ratio for CDS (accounting for single-name jump risk): 1/300.
    - Alternative calculation: 1/300 x $36 trillion x 2/3 = $80 billion.
    - Reported extrapolated cost range: $40-$80 billion.
  - Interest Rate Swaps (IRS)
    - LCHClearnet/Swapclear: initial margin and guarantee fund as fraction of total notional IRS ≈ 1/10,000 for currently cleared (plain vanilla) IRS.
    - Additional $100 trillion of more complex/non-plain vanilla IRS offloading estimated to require:
      - Using 1/5000 x 100 trillion = $20 billion; using 1/3300 x 100 trillion = $30 billion.
    - This would be in addition to about $20 billion invested today.
    - Envisaged scenario: over time two-thirds of the IRS market will clear at CCPs (i.e., the $200 trillion cleared at present plus an additional $100 trillion).
    - Reported extrapolated cost range for IRS: $40-$50 billion.
  - FX, Equity, Commodities & other unallocated OTC derivatives
    - Assumed ratio (margin + guarantee fund)/notional: 1/1000.
    - Two-thirds of $130 trillion market: 1/1000 x 2/3 x 130 trillion = $90 billion.
- Aggregate estimates:
  - If two-thirds of the $600 trillion OTC derivatives market moves to CCPs, estimated aggregate initial margin and guarantee fund demand from LCFIs ≈ $170–220 bill (presented as $170– 220 bill).
  - Source comparison: TARP stress test exercise required about $75 billion capital injection to nineteen LCFIs.
- CCP compression note:
  - From a CCP view, clearing compressed portfolio(s) may shrink the $30 trillion notional to $3 trillion, but then they would use a ratio of 3/100 (or 3% for initial margin + guarantee fund/compressed notional cleared).

### Levy to incentivize migration and calibration example
- Proposed instrument: an ad hoc levy of 10 percent to 20 percent on contracts that stay on LCFIs’ books to induce migration to CCPs and mitigate systemic risk from LCFI failure.
- Example calculation:
  - If about one-third of OTC derivatives remain non-standardized, then additional capital needs for large LCFIs ≈ $70 billion to $140 billion = (10 percent to 20 percent) x 1/3 x $2 trillion.
- Caveats:
  - It is uncertain whether the present $2.0 trillion for uncollateralized derivative payables will decrease uniformly when 2/3 of OTC derivatives are offloaded to CCPs; residual derivative payables may be higher than 1/3 x $2 trillion due to loss in netting.
  - Levy design could be fine-tuned to encourage standardization and offloading; timing and calibration are important.

### Netting, interoperability, competition risks, and systemic implications
- Netting benefits at CCPs can significantly reduce under-collateralization if CCPs net offsetting exposures across multiple LCFIs and collect margin only on residual exposures — but requires:
  - A critical mass of derivatives migrating to CCPs.
  - Interoperability across CCPs (at least for the same product) to concentrate clearing and optimize netting.
- Risks:
  - Competing CCPs could lower initial margin standards (race to lowest common denominator), potentially inducing LCFIs to offload exposures to CCPs rather than pay higher levies.
  - Multiple CCPs reduce cross-asset class netting and may reduce incentives for LCFIs to offload contracts, moving away from the optimal single-CCP allocation result discussed by Duffie-Zhu (2009).
  - Without proper risk management or adequate default funds at CCPs, systemic risk may spread from present 8 to 10 LCFIs to about 14 to 15 entities (LCFIs plus CCPs with sizable business).

### Present CCP landscape (as reported)
- CCPs likely to seek new business include ICE Trust and ICE Europe (CDS clearing), SwapClear (interest rate swaps), and Chicago Mercantile Exchange (CME) supported by buy-side firms such as Blackrock, Pimco, and Blue Mountain.
- Several others (Eurex, LIFFE/NYSE, entities in Japan/Singapore/HK) are vying for business; not all are likely to succeed.

### Policy implications and recommendations (as presented)
- Regulators should recognize LCFIs active in OTC derivatives under-collateralize relative to the risk they assume (estimated shortfall of up to $2 trillion if measured by derivative payables carried by major market participants).
- Collateral rehypothecation: collateral already posted is currently allowed to be rehypothecated; collateral needs will be more onerous if placed at CCPs, making the shortfall obvious and requiring large increases in collateral.
- Moving only some ‘standard’ or ‘eligible’ contracts to CCPs will not reduce systemic risk within LCFIs; an appropriate levy (or tax) is advocated to force offloading of a critical mass (assumed two-thirds) and reduce instability from an LCFI failure.
- If CCPs compete and lower margin thresholds, regulatory oversight is required to ensure CCP robustness and reduce default probability; endorse adherence to strong globally consistent standards to prevent regulatory arbitrage.
- To maximize netting benefits, interoperability across CCPs (allowing maximum netting across asset classes and within asset classes) should be considered.

*Source: IMF staff (content from the referenced PDF chapter).*

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

### _wp1099 - References .............................................................................................................

### Introduction: context and motivation
- The recent financial crisis accelerated policy momentum to move lightly regulated over-the-counter (OTC) derivative contracts to central counterparties (CCPs) rather than bilateral clearing.
- Regulators in the United States and European Union are seeking legislative approval to mitigate systemic risk associated with large complex financial institutions (LCFIs).
- Regulatory changes will likely require offloading of standardized OTC derivatives to CCPs; this will imply either:
  - users holding more collateral against bilaterally traded contracts, or
  - margin being posted to CCPs to cover potential losses.
- Empirical and quantitative context:
  - Credit default swaps (CDS) represent only about 6 percent of the overall notional OTC derivatives market (BIS data).
  - BIS surveys show notional amounts of all categories of the OTC contracts stood at $605 trillion at the end of June 2009.
- Prior literature and studies:
  - Barclays (2008) estimate that the default by a major derivative dealer could lead to losses of around $40 billion (but their assumptions do not factor in re-pricing risk at default or associated losses from other OTC derivatives).
  - Duffie and Zhu (2009) find in simulations that one global CCP covering all OTC derivatives contracts would provide the most efficient allocation of capital; however, they do not use actual data nor address concentration risk and use i.i.d. assumptions across products.
  - IMF papers (Singh and Aitken, 2009b; Segoviano and Singh, 2008) find large parts of counterparty risk in the OTC derivatives market are under-collateralized—up to $2 trillion—relative to system risk.
  - Post Bear Stearns and after Lehman’s collapse, demand for high quality collateral increased while supply was reduced due to hoarding of (unencumbered) collateral by LCFIs (Singh and Aitken, 2009a).
- Key framing from this paper:
  - Margin and collateral requirements at CCPs are functions of the risks from OTC derivatives.
  - Moving standardized OTC derivative contracts to CCPs could impose additional costs on LCFIs; achieving a critical mass of cleared contracts may require higher charges on bilateral counterparties or sizable collateral to be posted and held at CCPs.
  - Partial offloading (only clearable standardized contracts) could increase measured systemic risk and adversely impact net exposures on LCFI books because netting between standard and nonstandard contracts would not occur if nonstandard contracts remain bilaterally held.

### Collateral, netting, and the measurement of systemic exposure
- Central counterparty (CCP) role:
  - A CCP interposes between buyer and seller through legal novation and assumes rights and obligations of both parties, thereby reducing systemic risk from LCFIs trading with each other.
- Key measurement choice:
  - To measure exposure of the financial system to the failure of an LCFI active in the OTC derivatives market, use the LCFI’s total “derivative payables” (not “derivative receivables”).
  - Derivative payables = sum of the counterparty’s contracts that are liabilities of the LCFI at any given time; derivative receivables = assets of the LCFI.
  - Derivative payables represent the risk imposed on the rest of counterparties when an LCFI fails; derivative receivables represent the credit risk of counterparties to whom the LCFI is exposed and are covered by Basel II capital charges.
- Rationale for focusing on derivative payables:
  - Currently derivative payables do not carry an explicit regulatory capital charge; using derivative payables as a yardstick provides an available measure of systemic risk.
- Collateral dynamics:
  - Collateral is posted because it correlates with the requesting side’s assessment of default likelihood, transaction risk (market, credit, operational, counterparty), tenor, client relationship, liquidity, and other factors.
  - Residual derivative payables exposure can indicate the maximal extent of under-collateralization, which the authors characterize as substantial.
- Empirical snapshot (Q3 2009):
  - Based on financial information from 10Q reports, the five key U.S. LCFIs active in the OTC derivatives market—Goldman Sachs, Citi, JP Morgan, Bank of America, and Morgan Stanley—are jointly carrying almost $500 billion in OTC derivative payables exposure as of Q3, 2009 (higher/orange bars in Figure 1).
- Figure 1 numerical values (as presented):
  - 59, 53, 62, 64, 40, 119, 123, 106, 81, 75
- Note on assigned collateral in Figure 1:
  - “Assigned collateral is collateral posted against specific OTC derivative contracts that may be reused (rehypothecated) for other purposes by the institution to which it is posted.”

### Findings, scenarios, and implications
- Findings:
  - A large part of counterparty risk in the OTC derivatives market is under-collateralized—up to $2 trillion—relative to the risk in the system.
  - The notional OTC derivatives market is very large: $605 trillion as of end-June 2009.
  - CDS constitute about 6 percent of the overall notional OTC derivatives market; focusing only on CDS understates systemic exposure from the full OTC market.
  - Moving contracts to CCPs will require posting additional collateral; demand for high-quality collateral has risen while supply has been reduced by hoarding.
- Scenario assumption used in the paper:
  - The analysis in Section III assumes that two-thirds of all eligible contracts could move to CCPs.
- Systemic-risk amplification scenarios:
  - Partial offloading where LCFIs only clear standardized/eligible contracts at CCPs could increase measured systemic risk because remaining nonstandard contracts would prevent netting across the full set of positions.
  - If critical mass does not offload to CCPs, multilateral netting benefits of CCPs may not be fully realized and LCFIs will continue to impose systemic risk from residual positions.

### Policy recommendations and regulatory considerations
- Regulators will need to take actions to ensure a critical mass of OTC derivatives moves to CCPs; possible policy levers and considerations include:
  - Mandating clearing of standardized contracts to CCPs (legislative action under consideration in the United States and European Commission measures expected).
  - Considering levies or incentive structures to encourage migration of contracts to CCPs (Section III of the paper analyzes margin, collateral requirements, and a levy to incentivize movement).
  - Recognizing that higher collateral and margin requirements at CCPs will translate into additional costs for LCFIs; policymakers should measure and address these costs explicitly when designing reforms.
  - Accounting for international legal and jurisdictional interactions in collateral and netting frameworks when moving OTC contracts to CCPs.
- Caveats and measurement focus:
  - Regulators and policymakers should include derivative payables in assessing systemic exposure because they represent the cost imposed on other counterparties if an LCFI fails.
  - Policy design should consider concentration risk and the distributional implications of collateral demand (e.g., pressure on supply of high-quality collateral).

*Source: Excerpt from IMF working paper content (Introduction and Section II: Collateral, Netting and Moving to CCPs).*

### 2. Residual Derivative payables are  the  sum of the negative replacement values, after netting, associated with the i n

### 2. Residual Derivative payables are  the  sum of the negative replacement values, after netting, associated with the i nstitutions outstanding contracts. After-netting  takes  into account the impact of legally enforceable master netting agreements.

### Definition and measured magnitudes
- Residual Derivative payables: the sum of the negative replacement values, after netting (including legally enforceable master netting agreements such as ISDA), associated with an institution’s outstanding contracts.
- Five largest European banks (Deutsche Bank, Barclays, UBS, RBS and Credit Suisse) had about $600-$700 billion in under-collateralized risk (measured by residual derivative payables) as of December 2008.
- U.S. banks had over $650 billion of derivative payables as of December 2008 (dislocations due to market volatility were higher relative to Q3, 2009 data).
- IMF research estimate of under-collateralized derivative payables may total at least $1.6 trillion (Segoviano and Singh, 2008; Singh and Aitken 2009b) using bottoms-up individual firm data as of end-Dec 2007.
- BIS semi-annual OTC Derivative Activity (aggregate survey data) suggests derivative payables and receivables, after netting, as of end-June 2009 stood at:
  - over $4 trillion when including non-US CDS contracts; or
  - roughly $2.0 trillion of derivative payables assuming the major players run matched-books.
- As of end-Dec 2008 BIS figures: about $5 trillion for derivative payables and receivables after netting (or about $2.5 trillion of derivative payables assuming matched-books).
- BIS Quarterly Review (ISDA survey-based) concluded under-collateralization is about $1 trillion for both payables and receivables based on ISDA estimate of 80 percent collateralization (implying roughly $0.5 trillion for derivative payables).
- ECB/Banking Supervisory Committee study finds collateralization only 44 percent of net exposures.
- Reasonable estimate accounting for assigned collateral and matched-books: $2 trillion for derivative payables.
- Estimated additional collateral that would become unavailable to re-use per large bank when moved to CCPs: often in the range of $20 -$70 billion per large bank.

### Causes and current market practices producing residual payables/receivables
- Key reasons residuals persist after ISDA netting:
  - Sovereigns, AAA insurers/corporates/large banks/multilateral institutions (e.g., EBRD), and “Berkshire Hathway” types of firms do not post adequate collateral because they are viewed by LCFIs as privileged and safe clients.
  - Dealers have agreed, based on the bilateral nature of contracts, not to mandate adequate collateral for dealer-to-dealer positions; dealers typically post no initial margin to each other for these contracts.
- Assigned collateral reported in LCFIs’ financial statements is often rehypothecated (re-used) and not dedicated/segregated to reduce OTC derivative risk; this reduces the effective degree of collateralization.
- Many LCFIs presently have sizable unencumbered or cash collateral deposited with their central banks; the opportunity cost of posting collateral to CCPs is assumed to be the same whether LCFIs use deposits with central banks or opt for new funding in capital markets.

### Netting, CCPs, and interoperability considerations
- ISDA master agreements permit netting of derivative receivables and payables across a given counterparty; focus is on payables after netting.
- CCPs require collateral from all members, making under-collateralization gaps obvious and requiring large increases in collateral if transactions are moved to CCPs.
- Multilateral netting and portfolio margining at CCPs can reduce counterparty risk and overall margin required if exposures across OTC products offset.
- Netting benefits are reduced if multiple CCPs are not linked (cross-product netting will not take place).
- To maximize netting benefits across multiple CCPs, three elements are important:
  - Interoperability (linking of CCPs) to allow participants to concentrate portfolios at a CCP of choice and permit CCPi to have access to collateral from CCPj.
  - A multilateral cross-guarantee agreement to share excess collateral after closeout/bankruptcy of an LCFI at a different clearing agency, allowing CCPs legal priority over collateral of an LCFI.
  - If a CCP fails and collateral across CCPs is insufficient, consider an unlimited call on LCFIs dealing with the CCP to bridge losses (providing ‘skin in the game’ and avoiding moral hazard).
- Market and legal constraints noted:
  - It is unlikely CCPi would be allowed access to collateral posted to CCPj registered in another country.
  - Excess collateral would generally be returned to the bankrupt estate unless there is a security interest in favor of the second CCP.
  - CPSS-IOSCO Recommendations for CCPs (RCCP 4) indicate a clearing member may not be exposed to significant risks they cannot control; a CCP is not allowed to expose members to an unlimited call to bridge losses, and a cap is defined on replenishments to the default fund (at least in Europe).

### Implications for capitalization and collateral when moving OTC derivatives to CCPs
- Current regulatory proposals envision all standardized derivatives cleared by CCPs; regulators may mandate CCP use or make nonstandard contracts costly to hold.
- Offloading to CCPs will increase initial margin requirements (including monies toward guarantee/default funds).
- To attain a critical mass of two-thirds of all standardized OTC derivatives moved to CCPs, illustrative arithmetic based on margin requirement trends at large CCPs suggests:
  - about $200 billion may be needed in initial margins and guarantee funds.
- Compared to the $75 billion capital injection to nineteen LCFIs required by the recent SCAP exercise, costs to move to CCPs seem relatively large.
- Costs to dealers for moving trades to CCPs may be substantial for at least three reasons:
  - inability to effectively net internal positions across products for any given client;
  - larger upfront cost of posting initial margin and guarantee fund contributions at CCPs;
  - loss from inability to rehypothecate existing posted collateral which they use and re-use to finance other parts of their business.
- Market-source note: variation margin is presently paid to mark portfolios to market and is a function of volatility and covariance within compressed portfolios; movement to CCPs is not expected to have a large impact on variation margins unless current LCFI methods are more lenient than CCPs.
- Initial margin characteristics by product:
  - CDS contracts: initial margin in bilateral contracts can reach 10–30 percent of notionals due to ‘jump risk’.
  - Interest rate swaps (IRS): initial margin is much lower, around 1 percent of notional or even less.

_Italic: Source: IMF staff (content from the referenced PDF chapter)._

### Box 1. Some Arithmetic on Collateral Requirements at CCPs

### Box 1. Some Arithmetic on Collateral Requirements at CCPs

### Methodology and assumptions
- Use present ratio of initial margin and guarantee fund to notional positions already cleared to estimate costs to LCFIs of offloading contracts to CCPs.
- Assume two-thirds of each OTC derivative market segment moves to CCPs for baseline calculations.
- Recognize potential changes over time: enhanced netting via compression may reduce requirements, but migration of single-name CDS and complex IRS may increase requirements due to higher jump risk.
- Note: empirical relation cited for DP_after netting to N is "approx 0.3 percent to 0.4 percent of N" (BIS surveys).

### Estimated collateral requirements by product
- Credit Default Swaps (CDS)
  - ICE clears 3 trillion index trades; supported by $2 billion guarantee fund and $3 billion initial margin.
  - Implied margin and guarantee fund/notional ratio: 1/600.
  - Calculation example: 1/600 x $36 trillion x 2/3 = $36 billion.
  - Market-sources alternative ratio for CDS (accounting for single-name jump risk): 1/300.
  - Alternative calculation: 1/300 x $36 trillion x 2/3 = $80 billion.
  - Reported extrapolated cost range: $40-$80 billion.

- Interest Rate Swaps (IRS)
  - LCHClearnet/Swapclear: initial margin and guarantee fund as fraction of total notional IRS ≈ 1/10,000 for currently cleared (plain vanilla) IRS.
  - Additional $100 trillion of more complex/non-plain vanilla IRS offloading estimated to require:
    - Using 1/5000 x 100 trillion = $20 billion; using 1/3300 x 100 trillion = $30 billion.
  - This would be in addition to about $20 billion invested today.
  - Envisaged scenario: over time two-thirds of the IRS market will clear at CCPs (i.e., the $200 trillion cleared at present plus an additional $100 trillion).
  - Reported extrapolated cost range for IRS: $40-$50 billion.

- FX, Equity, Commodities & other unallocated OTC derivatives
  - Assumed ratio (margin + guarantee fund)/notional: 1/1000.
  - Two-thirds of $130 trillion market: 1/1000 x 2/3 x 130 trillion = $90 billion.

### Aggregate estimates and comparison
- If two-thirds of the $600 trillion OTC derivatives market moves to CCPs, estimated aggregate initial margin and guarantee fund demand from LCFIs ≈ $170–220 bill (presented as $170– 220 bill).
- Source comparison: TARP stress test exercise required about $75 billion capital injection to nineteen LCFIs.

- Summary table values (as presented in source)
  - CDS: Ratio 1/600 to 1/300; Offloading 2/3 x 36 trill; Extrapolated Costs $40 – 80 bill
  - IRS: Ratio 1/5000 to 1/3300; Additional 100 trill; Extrapolated Costs $40 – 50 bill
  - FX, Equity, Commodities & Unallocated contracts: Ratio 1/1000; 2/3 x 130 trill; Extrapolated Costs $90 bill
  - Total Costs: 2/3* 600+ trill; $170– 220 bill

- CCP compression note: From a CCP view, clearing compressed portfolio(s) may shrink the $30 trillion notional to $3 trillion, but then they would use a ratio of 3/100 (or 3% for initial margin + guarantee fund/compressed notional cleared).

### Levy (tax) to incentivize migration and calibration example
- Proposed instrument: an ad hoc levy of 10 percent to 20 percent on contracts that stay on LCFIs’ books to induce migration to CCPs and mitigate systemic risk from LCFI failure.
- Example calculation in source:
  - If about one-third of OTC derivatives remain non-standardized, then additional capital needs for large LCFIs ≈ $70 billion to $140 billion = (10 percent to 20 percent) x 1/3 x $2 trillion.
- Caveats from source:
  - It is uncertain whether the present $2.0 trillion for uncollateralized derivative payables will decrease uniformly when 2/3 of OTC derivatives are offloaded to CCPs; residual derivative payables may be higher than 1/3 x $2 trillion due to loss in netting.
  - Levy design could be fine-tuned to encourage standardization and offloading; timing and calibration are important.

### Netting, interoperability, and CCP competition
- Netting benefits at CCPs can significantly reduce under-collateralization if CCPs net offsetting exposures across multiple LCFIs and collect margin only on residual exposures — but requires:
  - A critical mass of derivatives migrating to CCPs.
  - Interoperability across CCPs (at least for the same product) to concentrate clearing and optimize netting.
- Risk of margin dilution: competing CCPs could lower initial margin standards (race to lowest common denominator), potentially inducing LCFIs to offload exposures to CCPs rather than pay higher levies.
- Multiple CCPs reduce cross-asset class netting and may reduce incentives for LCFIs to offload contracts, moving away from the optimal single-CCP allocation result discussed by Duffie-Zhu (2009).
- Without proper risk management or adequate default funds at CCPs, systemic risk may spread from present 8 to 10 LCFIs to about 14 to 15 entities (LCFIs plus CCPs with sizable business).

### Present CCP landscape (as reported)
- CCPs likely to seek new business include ICE Trust and ICE Europe (CDS clearing), SwapClear (interest rate swaps), and Chicago Mercantile Exchange (CME) supported by buy-side firms such as Blackrock, Pimco, and Blue Mountain.
- Several others (Eurex, LIFFE/NYSE, entities in Japan/Singapore/HK) are vying for business; not all are likely to succeed.
- Table of present central counterparties in business (or seeking new business) provided in source (locations, regulators, expected launch dates/products).

### Policy implications (bulleted as in source)
- Regulators should be cognizant that LCFIs active in OTC derivatives under-collateralize relative to the risk they assume (estimated shortfall of up to $2 trillion if measured by derivative payables carried by major market participants).
- Collateral rehypothecation: whatever collateral is already posted is currently allowed to be rehypothecated; collateral needs will be even more onerous if placed at CCPs, making the shortfall obvious and requiring large increases in collateral.
- Moving only some ‘standard’ or ‘eligible’ contracts to CCPs will not reduce systemic risk within LCFIs; an appropriate levy (or tax) is advocated to force offloading of a critical mass (assumed two-thirds) and reduce instability from an LCFI failure.
- If CCPs compete and lower margin thresholds, regulatory oversight is required to ensure CCP robustness and reduce default probability; endorse adherence to strong globally consistent standards to prevent regulatory arbitrage.
- To maximize netting benefits, interoperability across CCPs (allowing maximum netting across asset classes and within asset classes) should be considered.

### Appendix I — Objective of a Large Bank to minimize costs of moving to CCPs (as presented)
- Parameters facing a large bank:
  - L: Levy in percent on derivative payables (after netting) to reduce systemic risk.
  - DP_after netting: Derivative Payables after netting on the books of an LCFI.
  - M: Initial Margin and associated contribution to the Guarantee Fund (as a ratio to Notional).
  - N: Notional amount of derivatives offloaded to CCPs.
- Hypothetical minimization problem (as shown in source):
  - Minimize: L x DP_after netting + M x N
- Assumptions noted in source:
  - CCPs will not lower margins (M) to gain business in this analysis.
  - A high L (levy) will impact DP_after netting by encouraging higher standardization and offloading to CCPs.
  - Empirically, DP_after netting is related to N (approx 0.3 percent to 0.4 percent of N, per BIS semi-annual OTC derivative activity surveys).

*Source: IMF Working Paper content unit "_wp1099 - Box 1. Some Arithmetic on Collateral Requirements at CCPs"*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2010/_wp1099.pdf_