Dodd-Frank mandates the central clearing of most swaps, ostensibly to reduce counterparty risk, but market participants are already asking the same kinds of questions about this arrangement that they asked about CDSs in the first place. If protection buyers had diversified their positions among several counterparties, are they actually better off taking on the risk of a single derivatives clearing organization (DCO) instead?
That all depends on the capitalization and risk management practices of the DCO, and the competition between DCOs to increase their clearing business might serve to weaken both. Add to that the fact that most end users will interact with the DCOs through a futures commission merchant (FCM) and the counterparty risk picture becomes even more convoluted.
Rule 2 – Value at risk (VAR) is almost never the notional amount of the position. In fact, VAR is almost always less than the notional amount.
Let’s take a look at the typical fixed-floating interest rate swap (IRS), where Party 1 agrees to earn LIBOR, currently say 1 percent, and pay a fixed rate, say 2 percent, for five years, and Party 2 agrees the opposite. If Party 1 should immediately default on its obligation, the maximum total loss to Party 2 would be 10 percent of the notional (2 percent X 5 years), and that is only true if LIBOR goes to 0 percent. If LIBOR stays at 1 percent, Party 2’s VAR would be 5 percent of the notional (since Party 1 would immediately stop paying LIBOR). Party 1’s VAR is much more variable, and potentially larger, although nowhere near the notional amount of the position. So when the press mentions the trillions of dollars of IRSs outstanding, we should remember that the actual risk involved is a small fraction of that amount.
For certain derivatives, of course, VAR can be a much larger fraction of notional. In CDSs, for example, the protection seller is theoretically on the hook for the full notional amount, at least in physical delivery CDSs. However, should the seller default at the time of a credit event, the protection buyer would be out the difference between par and the securities’ value at that point, perhaps 70 percent of the notional. Should the protection buyer default, however, the seller’s VAR is much less, which brings us to...
Rule 3 – VAR is almost never symmetrical for both sides of a derivative. This is obvious in the case of CDSs, but is also the case in many other derivatives. In an IRS, for example, the floating receiver has significantly more VAR than the fixed receiver, even though his current income may be lower. For contracts for differences (CFDs) and total return swaps (TRSs) the VAR is more symmetrical, generally not completely. For commodity swaps, as for commodity futures, the VAR is not symmetrical, simply because a commodity’s price can only fall to zero, but it could theoretically rise an unlimited amount.
The commodity case brings to light another symmetry issue – the absolute value of the swap parameters. If we look at the previous IRS case, for example, the absolute value of LIBOR has a practical impact on the floating receiver’s VAR. If LIBOR is at 2 percent, the potential for a sustained rise of 6 percent is significantly higher than if LIBOR is at 10 percent, at least in the minds of most market participants. However, the initial margin (IM) requirements for many listed contracts are symmetrical.
Whether regulators and DCOs recognize the asymmetrical nature of VAR in setting IM requirements remains to be seen.
Rule 4 – Calculating counterparty risk is a multi-part, multi-step process. Take, for example, the calculations an FCM needs to make before allowing a clearing customer to enter into a new trade. The FCM must consider the following:
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Internal customer financials, which are updated monthly or quarterly
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Current derivatives and collateral positions, which are updated daily or in real time
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Product and market data, which is generally updated in real time
All this data must be compiled, evaluated and a conclusion drawn almost instantaneously.
The data flow for trade approval is set out below:
Needless to say, large FCMs with thousands of customers will have to make hundreds of these calculations every day and their financial health will depend on their accuracy. This is one of those cases where an investment in some good technology will pay off handsomely, both in safety and in market share.
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4 Comments to "Rules of Risk Management for OTC Derivatives":
paulconstantino
18 August 2011
Not sure that has been captured accurately;
Rule 1 - Add credit and liquidity risk as they are separate from market
Rule 2 - In the example, Party 2 only loses 1 fixed payment (which they were out anyway) + 1 floating payment + any posted margin. LIBOR is liquid so they could enter into a new swap with the same exposure with another CP, consequently, the exposure is less than suggested.
The exposure to CDS has multiple components including credit spread and liquidity such that in the time of an extreme market move, there may be no liquidity to unwind the position, thus exposure could be conserably higher due to liquidity factor as well as widening credit spreads.
Rule 3 - Risk of fixed payments are limited, floating payments are essentially limitless same with shorting an option or security. Margin assessed are not same for each side of trade given the risk which applies in the same manner to swaps. This has been around for awhile.
Rule 4 - If initial margin is calculated correctly (ie. IM = tick value x max price move), the other processes are relatively immaterial, which is the basis for margin at futures exchanges. The real risk would be that of a limit move (max price move) on multiple days.
The bottom line is that there are, and have always been, measures in place (both regulatory and company) to migiate exposure and which could have averted this crisis. The SEC, rating agencies and companies decided to override their risk limits to grab greater market share/profits while ratcheting up their exposure.
It is interesting to note that the major exchanges did not suffer the same losses nor need bailouts as the BDs and companies, which was largely due to the fact that they maintained their risk rules and thus required margin for trading. Of course the BDs and companies were bailed out (Greenspan/Bernacke put) such that the American taxpayer actually met the margin call for their trades.
Thus, do we really need Dodd-Frank, or rather, have a regulatory authority that merely enforces capital reserve and regulatory requirements with a healthy dose of monitoring the rating agencies? Seems like this could be (re)stated in a one page document and be a simple, yet effective fix...
Comments (20)
shamlet76
18 August 2011
counterparty risk has increased.
i relate this article to shortselling and the problems in the equity market because the basic principles are very similar.
we have more brokers acting as correspondent brokers for foreign brokerages that do not implement the rules of the SEC. how do the brokers know what the risk for their correspondent broker is? after all, if the correspondent broker places and order and an american broker takes that order, it is the american broker that will have to produce the asset. if a price goes up, will the foreign broker pay? what would compel them to pay?
margins are calculated that include the portfolios of their customers' long positions. this does not prove that a broker could cover a position. i have looked at lots of brokers' financial statements and i am finding things that bother me: AR less than AP, the use of the term net AR, a category like AP owed to their customer. i will be very happy when we are able to see broker audits.
we have lots of brokers and non-licensed clearinghouses clearing transactions. but these non-licensed clearinghouses have separate assets from the brokerage business that would guarantee business?
would a credit line guarantee a margin? credit lines could be withdrawn and is outside of the control of the broker or clearinghouse.
if there are IOU's, do those IOU's clear within market deadlines? are those IOU's revalued at any time? and why doesn't the investor's broker buy that IOU in?
i think that everyone in the industry needs to pay attention to the risk. ignoring risk is ruining this market.
i am still trying to figure out whether derivatives should exist in the first place.
Comments (149)
gbollenbacher
19 August 2011
Hi, Paul. I picked the two risks I did because one can quantify, at least to a degree, the VAR for them. I can't quantify the VAR for liquidity risk. I think credit risk is incorporated into counterparty risk.
I'm not sure I understand your comment on Rule 2. I would expect VAR to be used to calculate IM, and that IM would never be more than VAR, and perhaps less.
Certainly the asymmetry of VAR has been around for a while, but the tailoring of IM may not have been. For example, the proposed rules for margining uncleared trades appear to require CDS protection sellers to get IM from buyers without being specific about the IM requirements for sellers, even though the sellers' VAR is many times as high as the buyers'.
To shamlet76, I'm not sure how the risk parameters of OTCDs are so similar to short selling. Once a short sale has settled, the counterparty risk between buyer and seller goes away, replaced by the counterparty risk between the security borrower and lender. Is that what you mean?
Comments (48)
paulconstantino
19 August 2011
Hi George,
Liquidity risk is contained in VAR and thus would need to be quantified. Depending on the legal entity of the derivative, this is a factor that can be assessed.
Counterparty risk = risk of counterparty defaulting in a bi-lateral agreement
Credit risk = risk component attributed to the legal entity(ies) of a derivative
Rule 2 - this was pertinent to your example as the exposure is overstated in that Party 2 can execute the termination clause in the MSA (ISDA) and enter into a new swap and thus would not be exposed to the additional payment defaults for the term of the swap. The exposure would be opportunity risk to reivest at the same rate.
Reserve requirements have been in place for some time now such that Banks, IBs and Insurance Companies with CDS exposure had to meet regulatory reserve requirements. In the case of an AIG, those reserves were grossly misstated due to their exposure. This is not a new requirement, though I would agree that these groups were not marking their position to market. As a institutional trader in the early 90's, my positions were marked daily per Bank policy, what changed?
Comments (20)