Collateral, Netting and Systemic Risk in the OTC Derivatives Market

IMF Working Papers, April 1, 2010

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Canonical URL: Collateral, Netting and Systemic Risk in the OTC Derivatives Market

Some regulators have advocated greater use of centralized counterparties (CCPs) to clear Over-The-Counter (OTC) derivatives trades to mitigate systemic risk.
Large banks active in the OTC derivatives market do not hold collateral against all the positions in their trading book; the paper provides an estimate of this under-collateralization.
Collateral that banks do hold is allowed to be rehypothecated (re-used) to others.
CCPs would require all positions to have collateral against them; shifting a significant portion of OTC derivatives transactions to CCPs would therefore require large increases in posted collateral.
Large increases in posted collateral could require large banks to raise more capital.
These costs suggest most large banks will be reluctant to offload their positions to CCPs.
The paper proposes an appropriate capital levy on remaining (non-CCP-cleared) positions to encourage the transition to CCPs.

Under-collateralization: Large banks do not hold collateral against all trading book positions; the paper proves an estimate of this under-collateralization.
Rehypothecation: Collateral that is held by banks is permitted to be rehypothecated (re-used) to others, which has implications for collateral availability if CCPs demand full collateralization.
Collateral demand from CCPs: Requiring collateral against all positions would necessitate large increases in posted collateral across banks moving trades to CCPs.
Capital effects: Increased collateral requirements could force large banks to raise more capital.
Behavioral response: The magnitude of these costs suggests most large banks will be reluctant to move significant position volumes to CCPs without additional incentives or measures.
Policy instrument proposed: An appropriate capital levy on remaining non-cleared positions to encourage migration to CCPs.

Implement an appropriate capital levy on remaining (non-CCP-cleared) OTC derivatives positions to create incentives for banks to transition trades to CCPs.
Recognize and account for:
- Under-collateralization in banks' trading books.
- The rehypothecation practices that affect collateral availability.
- The capital-raising implications for banks facing higher collateral demands from CCPs.

Subject: Central counterparty clearing house, Collateral, Credit default swap, Derivative markets, Financial institutions, Financial markets, Financial sector policy and analysis, Money, Systemic risk
Keywords: CCPs, Central Clearinghouse, central counterparty, Central counterparty clearing house, Collateral, Credit default swap, credit default swap position, derivative, derivative contract, Derivative markets, derivative payables, derivative receivables, Europe, Margin, Netting, OTC derivative, OTC derivatives, payables, Systemic risk, well functioning CCP, WP