Reform in the OTC derivatives market

Reform in the OTC derivatives market

In 2010, the European Commission (EC) made a number of proposals concerning reform in the over-the-counter (OTC) derivatives market. The EC is of the opinion that OTC derivatives contributed to the worldwide contagion of the crisis in the American housing market. The results of the reform should deliver a safer and more effi cient OTC market in order to reduce these systemic risks.

One of the problems highlighted by the EC is that the counterparty risk in the current OTC market is not suffi ciently mitigated. Mitigation of this risk is normally taken care of by means of bilateral ‘clearing’, whereby the resulting risk is covered by the exchange of collateral. Daily exchange of collateral is only the norm for the larger parties. Smaller parties exchange on a weekly and sometimes even on a monthly basis, which can lead to a sharp increase in risk. Moreover, the risk measurement is often carried out with less than the required care due to lack of information regarding the transactions and the quality of the models used. And finally, many parties have stipulated that they can exchange less collateral than the resulting risk (for example, through the use of credit rating dependent thresholds).

All in all, in many cases the exchange of collateral proves to be defi cient; it is often delayed and rather volatile, which results in unexpected liquidity needs.


The EC has published a concept regulation with the obligation for both financial as well as non-financial parties to apply ‘central counterparty (CCP) clearing’ for standard OTC derivatives. The decision as to which derivatives are standard lies with the European Securities and Market Authority (ESMA), which aims to implement the regulation before the end of 2012. This regulation is in line with the Dodd-Frank Act which is currently being prepared in the US.

In CCP clearing, an entity mediates between the counterparties in a financial contract (in this case, a derivative). This entity, the CCP, becomes the buyer for the seller and the seller for the buyer. Since the two contracts are opposite, the CCP runs a counterparty risk, but not a market risk. The CCP counterparties are the ‘clearing members’. Parties that cannot or do not want to become a clearing member will need to agree a contract with a clearing member in order to complete the desired transaction under their name.

In bilateral clearing, the clearing members are exposed to counterparty risk on each other. This situation is illustrated in the left-hand diagram. The right-hand diagram shows CCP clearing, whereby a CCP is placed in between the various diff erent clearing members. In this way, every clearing member only runs the counterparty risk in relation to the CCP. Bilateral clearing Central counterparty clearing

In practice, multiple CCPs can exist alongside each other. In the current European market, for example, SwapClear is the market leader for the clearing of interest rate swaps, while ICE takes care of the largest portion of the clearing of credit default swaps. The CCPs are commercial institutions; their authorization and supervision both lie with the local regulatory authority. In order to gain a license, a CCP needs to conform to various diff erent organizational and prudential demands. This means that a CCP will at least need to comply with the following measures in order to be able to mitigate the counterparty risk:


  • A CCP will set stringent demands for the clearing members. They must have suffi cient capital and operational capacity in order to be able to participate
  • The resulting counterparty risk will be mitigated by claiming margin calls. As already stated in bilateral clearing collateral is often claimed less frequently. Only extremely liquid instruments, which carry little market and credit risk, will be accepted as collateral, depending on the characteristics of the product. The risks may therefore be greater for products with a volatile market value
  • A fund will be set up for protection against a possible bankruptcy of one of the clearing members. The clearing members will be obliged to contribute to this fund, which will create an extra obligation for them in comparison to bilateral clearing. Besides this, extra capital must be set aside in case the deposited margins and the fund prove to be insuffi cient. Under no circumstances will the deposited margins be used by the other clearing members


Not all financial partners will be obliged to clear their positions via CCPs. Exceptions to this include the European central banks and pension funds. Besides this, the non-financial partners will only need to clear those positions that are larger than a particular clearing threshold. It should be noted that these parties are permitted to disregard the OTC derivatives that are used for hedging their core activities. Further details of the clearing threshold are still awaited.


It is expected that the quantity of collateral in circulation will increase through the obligation for CCP clearing. Besides this, the clearing members will be obliged to contribute to a CCP fund as protection against possible bankruptcy of one of the clearing members. This will lead to an increase in liquidity needs and related costs, which in turn could result in users deciding to reduce the number of derivative transactions. The risks could then be covered in alternative ways, which would probably be less refined and with the possible introduction of a basis risk. However, the costs do not only increase through the use of CCP clearing. In the Basel Accords, the counterparty risk is considered to be lower compared to bilateral clearing. This leads to the capital obligations for banks being lower for CCP cleared transactions.