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Che Sidanius

Advisor

Financial Stability

OTC derivatives reform and estimating collateral demand

‘I think there is a world market for maybe five computers’

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- Thomas Watson (1943), Chairman of IBM

Agenda

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•Regulatory

reforms

•OTC derivatives market

•Liquidity & capital standards

•Collateral impact: demand vs supply

•BoE approach

•OTCD market overview

•Estimating initial margin

•Multi-factor methodology (netting, rehypothecation, etc)

•Prefer range over single estimate

•Final

thoughts

•Financial stability issues

•Market response

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•Regulatory

reforms

•OTC derivatives market

•Liquidity & capital standards

•Collateral impact: demand vs supply

•BoE approach

•OTCD market overview

•Estimating initial margin

•Multi-factor methodology (netting, rehypothecation, etc)

•Prefer range over single estimate

•Final

thoughts

•Financial stability issues

•Market response

Regulatory reforms

• G20 commitments Increased regulation & supervision of derivatives market

participants, including pension funds and insurance firms; Greater standardisation of derivatives contracts; Mandatory clearing through central counterparties (CCPs) Margin requirements for bilateral contracts Increased transparency (pre- and post-trade) and trade reporting

• However, together with other regulatory reform... Liquidity coverage ratio – promotes short-term funding CCP default fund contributions (PFMI) Basel III & Solvency II – increases need for high quality assets

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OTC reforms: Demand vs supply impact

• Direct impact channel: increased demand for high-quality, liquid assets

As collateral for OTCD transactions (cleared and non-cleared)

As liquid asset buffers (Basel III liquidity regulation)

As collateral in securities and repo lending (shadow banking)

• Indirect impact channels: limitations on collateral velocity

Restrictions on collateral re-use/re-hypothecation (OTCD; shadow banking)

Greater use of account segregation (encouraged by regulation)

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• Direct impact channel: supply of high-quality, liquid assets AAA/AA government-securities outstanding: US$33 trillion (IMF)

o However, significant amount held by CBs, long-term investors, or repo marketso Sovereign debt considered safe could fall by US$9 trillion by 2016

Source: IMF (2012)

Outstanding amounts of potentially safe assets

(US$ trillions and percent in total)

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OTC reforms: Demand vs supply impact cont.

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•Regulatory

reforms

•OTC derivatives market

•Liquidity & capital standards

•Collateral impact: demand vs supply

•BoE approach

•OTCD market overview

•Estimating initial margin

•Multi-factor methodology (netting, rehypothecation, etc)

•Prefer range over single estimate

•Final

thoughts

•Financial stability issues

•Market response

OTC derivatives market – overview

$650 trillion in notional amount outstanding (BIS)– More than 10x world GDP

IRS – around 78% of OTCD market– Highly standardised – USD, EUR, Yen, GBP: 83% of

notional value (FRBNY)– Mostly short-term tenor (<1 yr)

CDS – around 4% of OTCD market– USD, EUR: 98% of notional

value (FRBNY)– Significant activity in 5 yr

maturities

Source: BIS, IMF and Bank calculations (2012)

OTCD notional outstanding and world GDP ratio

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OTC derivatives reforms: Estimating initial margin

• Several studies; however, different scope, assumptions and methodologies

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OTC derivatives: market opaque

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OTC derivatives reform – intended to shed light, not heat

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BoE quantitative approach

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• Objective: Consider methodology carefully when estimating collateral demand?– Netting– Rehypothecation– Market conditions

• Our data sources: trade repositories & CCPs– Volume/value– Type of market participants– Margin models

• Benefit: transparency, modifiable, replicable & provides a range

Quantitative estimates: our methodology

Product scope: IRS & CDS (80% of total OTCD market)

1. Gross notional

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Quantitative estimates cont: our methodology

Product scope: IRS & CDS (80% of total OTCD market)

1. Gross notional 2. Netting ratio/proportion cleared

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Quantitative estimates cont: our methodology

Product scope: IRS & CDS (80% of total OTCD market)

1. Gross notional 2. Netting ratio/proportion cleared 3. Apply VaR to estimate IM

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Ten-day VaR

Quantitative estimates cont: our methodology

TR data breakdown: • TriOptima for IRS: ~ 50% centrally cleared

Gross notional in IRS

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Quantitative estimates cont: our methodology

TR data breakdown: • TriOptima for IRS: ~ 56% centrally cleared• DTCC for CDS: ~ 10% centrally cleared

Gross notional in IRS Gross notional in CDS

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Quantitative estimates cont: our results for IRS & CDS

Total IM : US$200-800 billion• 80% centrally cleared• Netting assumptions• Bilateral: no rehypothecation & 10-day VaR; Cleared: no rehypothecation & 5-day VaR

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Quantitative estimates cont: results for IRS

Total IM demand (US$ billions, ‘normal’ market conditions): netting matters

90 95 96 97 98 990

200

400

600

800

1,000

1,200

1,400

Lower bound netting netting range

Total IM increases to US$1,3 trillion if netting reduced by 5%

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Quantitative estimates cont: results for CDS

Total IM demand (US$ billions, ‘normal’ market conditions): Regulatory impact

90 91 92 93 94 950

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40

60

80

100

120

140

160

180

Pre-OTC reform Post-OTC reform

netting range

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Effect of rehypothecation – IRS & CDS

• Proposed rule would limit rehypothecation (IOSCO)

IRS market CDS market

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Effect of market conditions - methodology

• Margin rates vary with market conditions

• ‘Normal’ market conditions – avg. volatility during 2006 -2011

• ‘Tranquil’ market conditions – 2/3 of average volatility (e.g. January 2006)

• ‘Stressed’ market conditions – 2x average volatility (e.g. October 2008)

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IM short position (bps) IM long position (bps) 99.7% 99.5% 99.0% 99.0% 99.5% 99.7% USD 254 239 209 191 214 228 EUR 168 155 136 127 145 152 Average 211 197 172 159 179 190

Effect of market conditions: results for IRS & CDS

• Under ‘stressed’ conditions - total IM for cleared and non-cleared may reach up to US$ 1.7 trillion– Haircuts applied to non-cash collateral

IRS marketCDS market

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Pace of transition

• Clearing obligation & margin rules for non-cleared contracts expected to affect new contracts

• Pace of transition depends on maturity profile*

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• Regulatory reforms

• OTC derivatives market• Liquidity & capital standards

• Collateral impact: demand vs supply

• BoE approach

• OTCD market overview• Estimating initial margin

• Multi-factor methodology (netting, rehypothecation, etc)

• Prefer range over single estimate

• Final thoughts• Financial stability issues

• Market response

Final thoughts• Financial stability issues

OTCD reform benefits:• Counterparty credit risk• Transparency

Collateral demand vs supply; asset encumberance

Fragmentation of clearing, reduction of netting

Pro-cyclicality issues

• Market response on-going– Compression, netting efficiencies, collateral transformation, cross-

margining

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Market response cont.

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Market response cont.

References

• OTCD reform and collateral demand impact (BOE): http://www.bankofengland.co.uk/publications/Pages/fsr/papers.aspx

• Safe assets: financial system cornerstone (IMF): http://www.imf.org/external/pubs/ft/gfsr/2012/01/pdf/c3.pdf

• An analysis of CDS transactions (FRBNY): http://www.newyorkfed.org/research/staff_reports/sr517.html

• An analysis of OTC IRS derivatives transactions (FRBNY): http://www.newyorkfed.org/research/staff_reports/sr557.html

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