Network Liquidity Failures of 2008: Did counterparty risk matter and will it count in the future?
The financial crisis following Lehman Brothers’ demise and the AIG bailout provided the impetus to move the lightly-regulated OTC derivative contracts from bilateral clearing to central counterparties (CCPs). The debate about the future of financial regulation has heated up as regulators in both the U.S. and the EU seek legislative approval to mitigate systemic risk associated with systemically important financial institutions that include large banks and nonbanks. In order to mitigate systemic risk that is due to counterparty credit risks and failures, either the users of derivative contracts will have to hold more collateral (or equivalent capital) from bilateral counterparties, or margin will have to be posted to CCPs.
This paper, “New Regulations and Collateral Requirements – Implications for the OTC Derivatives Market”, provides an overview of the OTC derivatives market and the associated drawbacks in the proposed regulatory initiatives that continue to unfold, as well as proposing an alternative that would make this market safe with relatively little additional collateral costs.
- The International Monetary Fund (IMF)