The xVA Challenge. Gregory Jon

Figure 3.1). This was due to the use of OTC derivatives as customised hedging instruments and also investment vehicles. The OTC market has also seen the development of completely new products (for example, the credit default swap market increased by a factor of ten between the end of 2003 and the end of 2008). The relative popularity of OTC products arises from the ability to tailor contracts more precisely to client needs, for example, by offering a particular maturity date. Exchange-traded products, by their very nature, do not offer customisation.

      The total notional amount of all derivatives outstanding was $601 trillion at 2010 year-end. The curtailed growth towards the end of the history can be clearly attributed to the global financial crisis, where banks have reduced balance sheets and reallocated capital, and clients have been less interested in derivatives, particularly as investments. However, the reduction in recent years is also partially due to compression exercises that seek to reduce counterpart risk via removing offsetting and redundant positions (discussed in more detail in Section 5.3).

      A significant amount of OTC derivatives are collateralised: parties pledge cash and securities against the mark-to-market (MTM) of their derivative portfolio with the aim of neutralising the net exposure between the counterparties. Collateral can reduce counterparty risk but introduces additional legal and operational risks. Furthermore, posting collateral introduces funding costs, as it is necessary to source the cash or securities to deliver. It also leads to liquidity risks in case the required amount and type of collateral cannot be sourced in the required timeframe.

      Since the late 1990s, there has also been a growing trend to centrally clear some OTC derivatives, primarily aimed at reducing counterparty risk. Centrally cleared derivatives retain some OTC features (such as being transacted bilaterally) but use the central clearing function developed for exchange-traded derivatives. This is discussed in more detail in Chapter 9. It is possible to centrally clear an OTC derivative that is not liquid enough to trade on an exchange. However, central clearing does still require an OTC derivative to have a certain level of standardisation and liquidity, and to not be too complex. This means that many types of OTC derivatives may never be suitable for central clearing.

      Broadly speaking, derivatives can be classified into several different groups by the way in which they are transacted and collateralised. These groups, in increasing complexity and risk are:

      • Exchange traded. These are the most simple, liquid and short-dated derivatives that are traded on an exchange. All derivatives exchanges now have central clearing functions whereby collateral must be posted and the performance of all exchange members is guaranteed. Due to the lack of complexity, the short maturities and central clearing function, this is probably therefore the safest part of the derivatives market.

      • OTC centrally cleared. These are OTC derivatives that are not suitable for exchange-trading due to being relatively complex, illiquid and non-standard, but are centrally cleared. Indeed, incoming regulation is requiring central clearing of standardised OTC derivatives (Section 9.3.1).

      • OTC collateralised. These are bilateral OTC derivatives that are not centrally cleared but where parties post collateral to one another in order to mitigate the counterparty risk.

      • OTC uncollateralised. These are bilateral OTC derivatives where parties do not post collateral (or post less and/or lower quality collateral). This is typically because one of the parties involved in the contract (typically an end-user such as a corporate) cannot commit to collateralisation. Since they have nothing to mitigate their counterparty risk, these derivatives generally receive the most attention in terms of their underlying risks and costs.

The question, of course, is how significant each of the above categories is. Figure 3.2 gives a breakdown in terms of the total notional. Only about a tenth of the market is exchange-traded with the majority being OTC. However, more than half of the OTC market is already centrally cleared. Of the remainder, four-fifths is collateralised, with only 20 % remaining under-collateralised. For this reason it is this last category that is the most dangerous and the source of many of the problems in relation to counterparty risk, funding and capital.

      The majority of this book is about the seemingly small 7 % (20 % of the 40 % of the 91 % in Figure 3.2) of the market that is not well collateralised bilaterally or via a central clearing function. However, it is important to emphasise that this still represents tens of trillions of dollars of notional and is therefore extremely important from a counterparty risk perspective. Furthermore, it is also important to look beyond just counterparty risk and consider funding, capital and collateral. This in turn makes all groups of derivatives in Figure 3.2 important.

3.1.4 Market participants

      The range of institutions that take significant counterparty risk has changed dramatically over recent years – or, more to the point, institutions now fully appreciate the extent of counterparty risk they may face. It is useful to characterise the different players in the OTC derivatives market. Broadly, the market can be divided into three groups:

Figure 3.2 Breakdown of different types of derivatives by total notional.

      Source: Eurex (2014).

      • Large players. This will be a large global bank, often known as a dealer. They will have a vast number of OTC derivatives trades on their books and have many clients and other counterparties. They will usually trade across all asset classes (interest rate, foreign exchange, equity, commodities, credit derivatives) and will post collateral against positions (as long as the counterparty will make the same commitment and sometimes even if they do not).

      • Medium-sized player. This will typically be a smaller bank or other financial institution that has significant OTC derivatives activities, including making markets in certain products. They will cover several asset classes although may not be active in all of them (they may, for example, not trade credit derivatives or commodities, and will probably not deal with the more exotic derivatives). Even within an asset class, their coverage may also be restricted to certain market (for example, a regional bank transacting in certain local currencies). They will have a smaller number of clients and counterparties but will also generally post collateral against their positions.

      • End-user. Typically this will be a large corporate, sovereign or smaller financial institution with derivatives requirements (for example, for hedging needs or investment). They will have a relatively smaller number of OTC derivatives transactions on their books and will trade with only a few different counterparties. They may only deal in a single asset class: for example, some corporates trade only foreign exchange products; a mining company may trade only commodity forwards; or a pension fund may only be active in interest rate and inflation products. Due to their needs, their overall position will be very directional (i.e. they will not execute offsetting transactions). Often, they may be unable or unwilling to commit to posting collateral or will post illiquid collateral and/or post more infrequently.

      The OTC derivatives market is highly concentrated with the largest 14 dealers holding around four-fifths of the total notional outstanding.9 These dealers collectively provide the bulk of the market liquidity in most products. Historically, these large derivatives players have had stronger credit quality than the other participants and were not viewed by the rest of the market as giving rise to counterparty risk. (The credit spreads of large, highly rated, financial institutions prior to 2007 amounted to just a few basis points per annum.10) The default of Lehman Brothers illustrated how wrong this assumption had been. Furthermore, some smaller players, such as sovereigns and insurance companies, have had very strong (triple-A) credit quality. Indeed, for this reason such entities have often obtained very favourable terms such as one-way collateral agreements as they were viewed as being practically risk-free. The failure of monoline insurance companies and near-failure of AIG illustrated the naivety of this assumption. Historically, a large amount of counterparty risk has therefore been ignored simply because large derivatives players or entities with the best credit

10

Meaning that the market priced their debt as being of very high quality and practically risk-free.