OTC Derivatives Reform (Some major participants in the FX derivatives market have resisted the clearing of counterparty default exposures. They correctly emphasize that, as opposed to derivatives that are settled by a payment of only the net market value of the contract, a large fraction of FX derivatives are settled when each of the two parties pays the gross amount of the currency due on its side, through a payment-versus-payment procedure at CLS Bank.
A conventional approach to clearing FX derivatives might therefore entail some special operational risks or costs. For example, if CLS were to clear counterparty default exposures and as a result be exposed to the failure of one or more clearing members, then CLS Bank might at some point become unable to complete crucial deliveries of large amounts of currencies. This could lead to a significant disruption of financial markets or international commerce. Arguably, this may suggest that CLS Bank should not provide clearing services in combination with its settlement services.
On the other hand, the claim by some market participants that FX derivatives exposures are small, thus representing little benefit from clearing, is not well supported by my preliminary review of the data on FX volatilities, gross market values of positions, volumes of derivatives trading by maturity and total outstanding notional amounts of FX derivatives.
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4 Comments to "Forex Derivatives Big, Risky Enough for Regulation":
shakespeare52
10 May 2011
We need to watch them, you know the quants can get a litte crazy !!!!
Comments (1)
udisela-superderivatives
11 May 2011
Perhaps it’s worthwhile noting that: - FX market was fast to adopt the notion of premiums of FX options paid on Delivery date - The CLS mechanism has mitigated the counterparty risk to a large extent as proved during the sub prime crisis - The default guarantee fund could indeed mitigate further the clearing risk, however it would probably entail additional costs + deleveraging a result
Comments (8)
John Harris
12 May 2011
Professor Duffie never fails to make illuminating, thought-provoking contributions to my understanding of financial instruments and markets, but in this rare instance, his analysis and explanations are off the mark in several important respects. First, he improperly uses the term "clearing" as a synonym for "novation." I would say he even incorrectly conflates the concepts of clearing, novation, and netting. Keeping these three concepts straight is vital. Clearing is reconciliation - nothing more. It is the process of confirming the understandings of parties to a contract: do they agree on the object(s) of trade, quantity, price, settlement terms, and so forth. Clearing does not require - and is not the same as - novation or netting. Novation is the process of replacing one party to a contract with another. Thus, after the trade is made, one party looks not to his original counterpart for satisfaction, but to a third party who steps into the trade for the original. (Note that both parties can be novated in a bilateral trade or all parties in a multilateral trade.) Netting is the process of reducing like obligations between or among parties: if Party A owes Party B two dollars from one transaction, but Party B owes Party A one dollar from another, they can settle both obligations through the payment by Party A of one dollar to Party B. Second, Professor Duffie wrongly asserts that central clearing arrangements - he really means clearinghouses that novate - reduce "systemic risk." There is no evidence that these arrangements reduce risk in the aggregate - at most, they shift risk; possibly they magnify it. The idea of "systemic risk" is itself flawed and indefensible - there is no "system," and the assertion of the existence of this beast is nothing more than a con used to socialize speculative losses. Finally, Professor Duffie errs in supporting additional government regulation of markets. To the extent such regulation aims at the production of economic goods, reposing such production in the hands of a forced monopoly is to ensure that the good will be mispriced, of shoddy quality, and supplied in amounts other than what consumers prefer.
duffie
09 January 2012
Here are some comments on the comments, for which I am grateful.
Udisela-sperderivatives: Thanks. In my submission, I make careful note that CLS takes care of gross settlement risk, but not mark to market risk. Only the MTM risk is pertinent in the usual case of swaps. FX derivatives have both types of risk, because, unusually, they are gross settled. The MTM counterparty risk, while much smaller than GS counterparty risk, is nevertheless very large, about as large or larger by my estimates as the MTM counterparty risk of any class of swaps other than interest-rate swaps. I do agree that reducing this MTM counterparty risk would be somewhat costly, in terms of extra infrastructure and the cost of handling margins. The cost will be similar to that for what is now mandated for the central clearing of other classes of swaps.
Mr. Harris. Thanks. On your first point, my submission makes clear that my proposed treatment is not equivalent to central clearing, because it does not novate to a CCP. Those against central clearing at CLS have claimed this would be a bad idea, as I explain. Assuming that CLS must not be a CCP leaves the alternative that I propose, of allowing CLS to continue to handle gross settlement counterparty risk, and taking care of mark-to-market counterparty risk through a separate margin-taking financial utility. Central clearing does (legally) require novation (IOSCO). My proposal has an economic effect which is quite similar to central clearing. On your second point, I do not believe that central clearing always reduces systemic risk. In fact, I show the contrary in certain cases in my paper on CCPs, co-authored with Haoxiang Zhu. In the case of FX swaps, I think central clearing, or something close to it such as my proposal, would reduce systemic risk. Adding a CCP does not simply "shift" risk, as you suggest. The effect of netting can actually reduce (or, in some cases, increase) counterparty risk, significantly. Then there are the supervisory advantages of clearing (provided regulators pay close attention). On your last point, that I err in supporting the government regulation of markets, I guess we may simply disagree. Regulators are not perfect, but I would rather work on improving regulation than having markets without regulation. There is significant evidence in support of the existence of negative externalities associated with failures of some market participants to fully internalize the costs they impose on other market participants. When this happens, regulation is sometimes indicated by cost-benefit analysis. Capital requirements for large banks is a good example.
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