Work has now been completed on the research grant related to collateral requirements stemming from new regulations, and the implications for the OTC derivatives market.
The working paper is available for download here.
New Regulations and Collateral Requirements – Implications for the OTC Derivatives Market
Manmohan Singh – Senior Economist, International Monetary Fund
The paper provides a snapshot of the changing collateral space and how this will impact the regulatory push to move over-the-counter (OTC) derivatives to CCPs. With continued quantitative easing (QE) by some central banks, price signals from the repo market indicate a shortage of good collateral. This paper focuses on the collateral demand in the OTC derivatives market as they move to central counterparties (CCPs) and suggests alternatives on how to reduce risk in this market.
The proposed regulations skirt the fundamental risk within the OTC derivatives market that resides in a bank—derivative liabilities (after netting). This is the cost to taxpayers from a large bank’s failure due to its derivative positions. The proposed regulations do not address this risk directly. If every user of OTC derivatives posted their share of collateral (i.e. initial and variation margin), there would be no derivative liabilities on banks’ books. But regulators have exempted several users of OTC derivatives, including sovereigns, quasi-sovereigns, multilateral institutions, and end-users such as airlines etc. So the sizable under- collateralization in this market is not fully addressed. As regulations do not force “every user to clear”, a suggested alternative is to place a levy on the user or its bank (that may not want to let go the business) with the primary objective that derivative liabilities are minimized.
There needs to be justification for creating new systemically important financial institutions (SIFIs) like CCPs, since it is not (yet) clear if SIFIs can be unwound. The proposed regulations disregard the existing netting bundles prevalent in this market which then leads to sizable collateral requirements—although many academic/consulting papers use simulations to show otherwise. Furthermore, some key exempted users (like the sovereigns) will keep afloat the sovereign/bank nexus that sow the seeds of moral hazard for a taxpayer bailout of CCPs. Some recent initiatives on the CCP resolution/recovery front may offset the likely burden on taxpayers, but has drawbacks too. Yet, under the rubric of transparency, a piece- meal compromise has taken off without global consensus on several key issues.
With some central banks silo-ing good collateral and custodian held collateral not available in bulk, the only likely players in the financial system to bridge the demand and supply would be the 10-15 banks active in the global derivatives market. In general, central banks, sovereign wealth funds, and long-term asset managers desire good collateral that is low volatility, but not necessarily highly liquid. These entities should be net providers of liquidity in the financial system. On the other side are banks/hedge funds/mutual funds that need to constantly reshuffle liquid/good collateral within their portfolios. Thus the ensuing collateral transformation1 – via the 10-15 large banks – may bridge collateral shortages but will also increase interconnectedness of the financial system (and CCPs were supposed to break the interconnectedness). Recently, the U.S. Fed has acknowledged a collateral shortage and has started a “reverse repo” program to alleviate collateral constraints.
In summary, the proposed route of removing OTC derivatives from banks books creates new SIFIs, destroys the economics of netting on the books of the banks, silo(s) collateral and decreases collateral velocity, and increases the interconnectedness of the financial system. Alternately, if every user of OTC derivatives contributed their share of margin(s) when using OTC derivatives (relative to the proposed bifurcated “clearing” and “non-cleared” worlds including legacy trades that will not clear), the risk from derivatives at SIFIs would be eliminated. There would be no need for CCPs.