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I n t roduct ion

The recent financial crisis, fuelled in particular by the 2008 collapseof Bear Stearns, the bankruptcy of Lehman Brothers, and the bail-out of major derivatives trader American International Group (AIG),has led to ample discussions among regulators and policymakers inboth Europe and the US about structural improvements to be madeto the financial markets. Already today, it is foreseeable that effortsto improve the stability and resilience of the international financialsystem will cover a variety of aspects: first and foremost, theeffectiveness of banks' own risk management processes andpractices; so-called macro-prudential financial supervision thatmonitors systemic risk; reform of capital requirements, resulting inbanks needing to hold more and higher-quality capital; revisedliquidity regulations under an internationally co-ordinated approach;better market infrastructure that reduces interconnectednessbetween individual market participants; and last but not least, strongsupervisory authorities that can monitor compliance, as well as

identify and react in time to emerging risks.

In terms of the structural deficiencies in financial marketinfrastructure, it can be stated that whilst over-the-counter (OTC)derivatives were not a central cause of the crisis, weaknesses in thedesign of derivatives markets became apparent. This marketscomplex and opaque nature and the corresponding inability ofregulators and market participants to have a clear view of riskexposures held increased the systemic risk of contagion andexacerbated the crisis as some market participants built upexcessive risk positions.

Derivatives have a long-standing history as financial tools for riskinsurance (hedging) and risk acquisition (speculation), thusproviding important risk management and liquidity benefits tofinancial institutions as well as to non-financial corporations andother market participants. Past growth rates of these marketsindicate the intensified desire of both real-economy and financialinstitutions to manage risks inherent to their industry or to managefinancial risks stemming from changes in macroeconomicconditions.

Regulators efforts to comprehensively reorganise derivativesmarkets threaten to hamper the viability and innovative powers ofthese segments. The apparent focus on Credit Default Swaps(CDSs), which had been singled out for blame for increasingsystemic risk, is particularly unfortunate as this segment constitutesless than 10 percent of the overall OTC derivatives market, whileother products (such as interest rate or currency swaps) that are byfar more relevant in terms of volume proved robust during the crisis.

In this study, we intend to shed light on the organisation,shortcomings and merits of derivative markets. This report providesa brief overview of the size, structure and scope of the USD 600trillion OTC derivative markets, and also seeks to serve as a guide,explaining the two most immediate ways of mitigating counterpartyrisk: bilateral collateralisation and centralised clearing. An overviewand discussion of the current regulatory initiatives in the US and theEU aimed at overhauling the financial markets and in particular theOTC derivatives markets complement this analysis.


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Non-financial companies primarilyuse interest rate, currency, and

commodity derivatives ...

while financial companies typicallyengage in all types of derivatives

these various underlying assets lead to a cornucopia of availableproduct types.

In the recent political debate on derivatives regulation, muchattention has been focused on CDSs. However, a very largeproportion of OTC derivatives had no involvement at all in the

financial crisis. Interest rate derivatives and FX derivatives, whichtogether account for some 80% of all OTC derivatives trades, werenot found to be contributors to the financial crisis, and of theremaining 20%, equity derivatives played virtually no part andcommodity derivatives only a small part in the crisis.

Usage of OTC derivatives

In the past, derivatives seem to have been used primarily byfinancial institutions. However, demand for derivatives exists in allindustries: A recent ISDA survey reports that 94% of Fortune 500firms are using derivatives to manage business and macro-economic risks. Foreign exchange and interest rate derivatives arethe instruments most heavily traded by these corporations.

Breaking usage down into financial and non-financial companiesshows that the latter typically use derivatives to help protect thecompany from unanticipated events such as adverse foreign-exchange or interest-rate movements and unexpected increases ininput costs

1, as evidenced by the widespread use of interest rate,

currency, and commodity derivatives. For that reason, non-financialsare by and large less involved in equity and credit derivatives.

Financial companies (banks, insurers, and diversified financial firms)are generally engaged in all types of derivatives and make particularuse of these instruments to mitigate interest-rate and exchange-ratefluctuations, industry-specific credit risk and equity price risk. Banks apart from their role as dealers (see section 3) use creditderivatives for managing their loan portfolios.

Chart 5 provides an overview of the use of derivatives by type of riskcovered (the numbers are % of Fortune 500 companies that usederivatives

2). Foreign exchange and interest rate risks clearly

dominate.

Amounts outstanding of OTC derivatives by counterparty

Derivatives usage in the three largest market segments (interestrate swaps IRS, foreign exchange, and equity & commodityderivatives) varies as regards the composition of counterparties (seechart 6). Statistics from the BIS indicate that of the USD 437.2 trillionmarket in single-currency interest rate derivatives, transactions of

non-financial firms comprise only 9%, while dealer-to-dealertransactions comprise 34% and other financial institutionstransactions 57% of the market. In foreign exchange (FX)derivatives, transactions of non-financial firms comprise 17% of theUSD 48.7 trillion market, while 39% are dealer-to-dealertransactions and 44% are other financial institutions transactions. Ofthe USD 6.6 trillion market in equity-linked and commodityderivatives, transactions of non-financial firms comprise 10%, whiledealer-to-dealer transactions amount to 40% and other financialinstitutions transactions to 50% (BIS, 2009).

1Utilities and companies in basic materials, for instance, typically use commodityderivatives.

2The sample includes financial institutions and corporate users.

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

H1 05 H1 06 H1 07 H1 08 H1 09

FX InterestEquity CommodityCDS

OTC gross mark et va luesUSD bn, semi-annual data

Source: BIS4

0 50 100

Credit

Equity

Commodity

Interest rate

FX

Derivat ive usage% of Fortune 500 companies, by risk type

Source: ISDA 5


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Broker:

An individual or firm that charges a fee or

commission for executing buy and sell orders

submitted by an investor.

Dealer:

An individual or firm willing to buy or sell

securities for their own account.Broker-dealer:

A person or firm in the business of buying and

selling securities operating as both a broker

and a dealer depending on the transaction.

2.Organisat ion of OTC mar ket s

The organisation of OTC markets has ever and anon and inparticular since the offset of the financial crisis been portrayed in thepublic debate as the weak link in financial markets. Given theextraordinary size of the OTC derivatives markets, the questionarises how these are organised in terms of how contracts areconcluded between market participants.

OTC derivatives markets have traditionally been organised aroundone or more dealers who make a market by maintaining bid andoffer quotes to market participants (Dodd, 2002). The tradingprocess of negotiating by phone nowadays also enhanced throughthe use of electronic bulletin boards is referred to as bilateraltrading because only the two market participants directly observe

the quotes or execution. OTC markets have also adopted electronicbrokering platforms (sometimes referred to as electronic brokeringsystems), which resemble electronic trading platforms used byexchanges as they create a multilateral trading environment. In anOTC market organised through an electronic brokering platform, thefirm operating the platform acts only as a broker and does not take aposition or act as a counterparty to any of the trades made throughthe system (Dodd, 2002). Lastly, composites of the traditional dealerand the electronic brokering platform have developed in which OTCderivatives dealers set up their own proprietary electronic tradingplatforms. In such one-way multilateral platforms

3, bids and offers

are posted exclusively by the dealer who upon execution ultimatelybecomes the counterparty to every trade.

Thus, OTC markets, which have been known as informallyorganised markets in the past, are in fact well-organised marketplaces noticeably lacking regulatory oversight in comparison to anexchange (Dodd, 2002).

Individuals or firms may act as either a broker or a dealer. While abroker merely mediates as an agent between a buyer and a seller, adealer takes ownership of an asset as a principal, even if only for aninstant, between a purchase from one party and a sale to anotherparty. The dealer is thereby exposed to some risk, for which he iscompensated by the spread between the price paid and the price

3One way because only the dealers quotes are observable; those of other marketparticipants might at best be inferred from changes in the execution price.

148,150 18,891 2,656

250,069 21,441 3,277

38,979 8,442 686

0%

20%

40%

60%

80%

100%

IRS FX Equity & Commodity

Non-financial customers Other financial institutions Reporting dealers

OTC derivat ives by c ounterpart yAmounts outstanding (USD bn)

Sources: DB Research, BIS 6


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received. Dealers tend to be broker-dealers4

and/or large globalbanking institutions.

3.Counterpar t y r i sk and l im i t a t ions o f b i late ra l co l la te ra l i sat ion

One of the most important purposes of the derivatives market is riskmanagement, i.e. risk redistribution, mitigation, and acquisition orin other words, the process of identifying the desired and the actuallevel of risk and altering the latter to equal the former. End users,which can include financial institutions, have specific riskmanagement concerns that can be mitigated (hedged), whereasother market participants do not necessarily aim to minimise risk butrather to benefit from the inherently stochastic nature of the marketby taking speculative positions. They aim to profit from the very pricechange that hedgers are protecting themselves against. However,the financial crisis has brought to light many weaknesses in OTC

derivative markets, such as their intransparency, inherentcounterparty risks, or the danger of contagion, i.e. the risk of adefault of one firm spreading through the financial system. Tomitigate such risks, collateralisation and counterparty riskmanagement are essential practices. This section explores theclassic method for market participants to protect themselves againstthe risks inherent from trading derivative contracts, outlining also thelimitations and deficiencies of this practice.

Derivatives contracts bind counterparties together for the duration ofthe contract. The duration varies depending on product type andmarket segment, ranging from e.g. a few days sometimes in FXderivatives to several decades for certain interest rate derivative

contracts. Throughout the life of the contract counterparties build upclaims against each other as the rights and obligations contained inthe contract evolve with the price of the underlying the contract isderived from. This gives rise to counterparty credit risk, i.e. the riskthat the counterparty may not honour its obligations under thecontract. It is difficult to calculate this counterparty risk in view of theopaque nature of OTC derivatives markets, in particular for partiesoutside a certain bilateral transaction and due to the high level ofconcentration in the market in terms of participants which leads to alack of risk diversification possibilities. The markets opaqueness isalso critical due to the fact that the price determined in thederivatives markets may be used to calculate the price of other

instruments, which could spill over to further segments.In the public debate, the term bilateral clearing is frequently usedto describe the bilateral collateralisation of uncleared OTCtransactions. In the following, the more appropriate term bilateralcollateralisation will be used. The underlying principle of bilateralcollateralisation is that both parties will mark-to-market (MTM)contracts so as to monitor the evolution of their residual value.Should the MTM process show that one party has built up a claimon the counterparty, it is then entitled to ask its counterparty forcollateral in order to mitigate the risk that the counterparty may nothonour its obligation or may default during the lifetime of thecontract.

4A person or firm in the business of buying and selling securities operating as botha broker and a dealer depending on the transaction.


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Further issues relating to bilateralcollateralisation raised by the COM:

Bilateral collateralisation fundamentally

relies on each party's internal approach to

and method for assessing the current

value of and risk associated with the

constituent components of its OTC

derivatives portfolio.

Collateral is generally based on mark-to-market values only. It does not incorporate

the potential cost of replacing the contract

in the market should the original

counterparty default.

The level of collateral that is effectively

provided often also takes into account the

perceived credit quality of the

counterparty. The crisis has shown that

the reliance on only one single source of

credit rating may be detrimental to the

bilateral collateral model (Paulson 2010).

Bilateral collateralisation and in particular

each institutions individual risk

management approach is vulnerable tocompeting intra-institutional

considerations, such as the aim to

maximise commercial opportunities and

associated profits. The crisis has

highlighted the difficulty faced by

institutions to uphold a conservative

approach to risk in a competitive market

environment.

Under bilateral collateralisation,

sovereigns, AAA insurers, corporates and

large banks do not post or mark-to-market

collateral. Those who do post collateral

only meet the threshold as per the ISDA

Credit Support Annex, which does not

mandate a 100 percent coverage.

Source: COM, Singh

Cash is the dominant source of collateral, amounting to 84% ofcollateral received in 2008 and 83% of collateral delivered (ISDA2009).

5Cash is exchanged on a net basis, i.e. a single net cash

value is calculated for the overall OTC derivative portfolio betweenthe two counterparties in question. Each counterparty thereforebenefits from cross-margining (i.e. compensation of claims built up

in one derivative market segment by liabilities built up in another).Government securities are the second source of collateral (9% ofcollateral received and 15% of collateral delivered). Other sourcesinclude corporate bonds, letters of credit and commodities.

Collateral is only an effective insurance against counterparty creditexposure if exposure is calculated frequently and collateral iseffectively exchanged in a timely manner. This is not consistently thecase, so bilateral collateralisation, while essential, may have anumber of potential weaknesses: weekly and even monthlyvaluation and exchange of collateral continue to be market practice,although the collateral cycle should ideally mirror the (daily)valuation cycle. Collateral coverage is not comprehensive: while

collateral now covers 66% of credit exposure overall, more thanone-third remains uncollateralised. From an operational perspective,too, bilateral collateralisation is not ideal as it requires themanagement of numerous counterparty relationships. The EuropeanCommission (COM) has identified a number of further weaknessesof bilateral collateralisation (see box).

4.Cent r a l Counter par t y Clear ing

One common practice to reduce counterparty risk in derivativesmarkets is trade compression, a method of multilateral

consolidation independent of any central counterparty (CCP) where the number of redundant contracts is minimised. Here,existing trades are terminated and substituted by a far lower numberof new replacement trades which have the same risk profile andcash flows as the initial portfolio, but with less capital exposure.This practice brings gross exposures closer to the net risk positions(see Weistroffer, 2009) and improves settlement efficiency.

Moving from bilateral collateralisation to central clearing by usingone or several central counterparties takes this principle one stepfurther and is the most immediate way of addressing the limitationscited in the previous section, as CCPs will, for example, requirecollateral to be posted by all participants, without exception. CCP

clearing may have significant benefits, but requires a certain numberof market characteristics for it to work.

This section briefly describes the concept of multilateral CCPclearing and its prerequisites, and addresses issues potentiallyarising in multiple CCP environments. We will subsequentlyelaborate on four selected aspects of centralised clearing: firstly, thebenefits of CCP clearing for market participants and infrastructureproviders; secondly, the implications for financial stability; thirdly, theoptimal number of CCPs per market; and lastly, CCP ownershipstructure and supervision.

5The ISDA Margin Survey tracks the gross amount of collateral, defined as the sumof all collateral delivered out and all collateral received in by survey respondents,and does not adjust for double counting of collateral assets. Double counting ofcollateral is discussed in Appendix 2 of ISDA (2009).


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Transparency

Fungibility

Standardisation

Concept and prerequisites of CCP clearing

When a CCP is involved in the post-trade processes, the singlecontract between two initial counterparties that characterises anOTC trade is executed and replaced by two new contracts between the CCP and each of the two contracting parties. Thisprocess is referred to as novation if an existing contract isterminated and replaced by two contracts with the CCP, or as openoffer if a contract is concluded with the CCP immediately after thematching of trading details. The original buyer and seller are nolonger counterparties to each other; instead, the CCP becomes thebuyer to every seller and the seller to every buyer. This structure hasthree clear benefits: First, it improves the management ofcounterparty risk. Second, it allows the CCP to perform multilateralnetting of exposures and payments. Third, it increases transparencyby making information on market activity and exposures bothprices and quantities available to regulators and the public (BIS,2009).

What is most important for a successful introduction of CCP clearingto a certain market is that the CCP must be able to mark positionsand to manage counterparty risks. For this purpose, a number ofprerequisites that have also been recognised as relevant byEuropean policymakers

6have been defined which must be met in

order for CCP clearing to be used:

Standardisation of trade flows throughout the trading and post-trading chain in order to allow a CCP to step in after a transactionhas been concluded (electronic trade confirmation largelyfacilitates this process).

Transparency of price discovery venues as to facilitate riskvaluation in mark-to-market processes. CCPs rely on the price

discovery process on liquid, transparent markets for the pricesused to mark positions and to determine collateral; CCPs shouldtherefore not only been seen as producers of transparency, butalso as its consumers.

7

Fungibility in order to enable novation and netting. This requiresminimum levels of industry-wide standardisation of the main legalparameters contained in contracts (varying according tosegment) in order for OTC derivatives to be able to betransferred between one exchange or electronic trading systemand another (COM, 2009a; CFTC, 2009). The concept offungibility allows contracts traded at different locations withdifferent parties to substitute for one another, provided that they

have identical legal construct and contract specifications.

8

Netting through a CCP does have advantages as, in contrast tobilateral clearing / collateralisation, multilateral clearing (and netting)yields private and public benefits, for example, via robust andhomogeneous margining procedures that guarantee that thecollateral cycle is in sync with the valuation cycle. In many OTCderivative transactions today initial margin is negotiated betweendealers and clients, and has commonly been zero in CDS trading. In

6Cf. COM (2009a).

7Cf. Pirrong (2009).

8Because of non-fungibility, market participants that wish to close a position canonly do so by going back to the original counterparty (usually a dealer). This gives

the dealer a certain amount of market and hence pricing power. Marketparticipants could also achieve the same economic effect by entering into anopposite position with a different counterparty; while this would effectively eliminatethe risk related to the instrument itself, it would not eliminate counterparty risk: ifone of the counterparties defaulted, the hedge would be undone (COM, 2009a).


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a centrally cleared market, clearing houses and regulators willimpose initial and variation margin requirements.

9Clearing members

derive economic benefits from the fact that contracts betweendifferent counterparties are made fungible so that they can be offsetagainst each other, and from a reduced number of counterparties(ideally only one, the CCP) where they have to deposit collateral.

Thus, central clearing reduces interconnectedness betweencounterparties. However, the fact that not everyone can easilybecome a member of a clearing house but that clearing memberstatus is only granted to applicants that meet the necessaryadmission criteria restricts the potential multilateral netting benefits(notwithstanding the fact that such minimum standards can have astabilising overall effect). Such minimum requirements may include,for instance, satisfying minimum capital requirements, beingauthorised by the home country banking supervisors or maintainingan adequately staffed and equipped back office.

Multilateral netting is likely to be more difficult in a multiple-CCPenvironment (as opposed to a single-CCP environment) unless

sufficient international coordination takes place. Difficulties mainlyrelate to two aspects:

Issues arising between the CCPs: Generally, all CCPs arestructured differently and their approach to risk management andthus the risk protection they offer will vary. CCPs typically operatein a similar, but not necessarily identical, manner when managingrisk; primary risk protection is generally standard amongst CCPs(see section on CCP risk bearing). However, practical issuessuch as payment and collateral timings, legal arrangements,regulatory oversight, insolvency laws, and most notably thebalance of risks intended to be covered by initial margin andthose covered by the, often mutualised, post-default backing are

often arranged differently in each CCP, so that the exactapproach and the overall risk management framework is typicallydifferent for each CCP (European Association of CentralCounterparty Clearing Houses EACH 2008). These risksmust be managed effectively when setting up an interoperabilityarrangement between two (or more) CCPs.

Issues arising between users and CCPs: Multiple clearingentities present a challenge for users because of the need tocommit collateral to several guarantee funds for separateclearing houses as well as to meet the connectivity demands ofeach of them.

We should point out that netting, in conjunction with CCP clearing,leads to a redistribution of wealth among a defaulters creditors. Thisredistribution depends inter alia on the insolvency scheme in forceand on the order of the claims and does not necessarily enhancewelfare.

10Moreover, by transferring counterparty risk to the CCP, the

bank or broker is assuming a new type of risk: mutualisation risk.This refers to the possibility that in case of a default where thedefaulting members initial margin turns out to be insufficient, the

9Initial margin is intended to cover potential future losses on open positions and iscalculated by taking the worst probable one or two-day loss that the position couldsustain. It can be paid in cash or collateral. Variation margin consists of funds to

cover losses on open positions and is calculated by the CCP using recent marketprices (Wendt, 2006).

10This hypothesis is exemplified in Pirrong (2009). Under pro ratadistribution of thedefaulters assets, netting effectively transfers wealth in a default from a defaultersother creditors to its derivatives counterparties.


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Risk mitigation and mutualisation oflosses

Positive effect on market liquidity

Increase in operational efficiency

Reduction of operational risk

Improved transparency

clearing house is forced to draw on its other members default fundand in extremis to allocate contracts to its non-defaulting members.

Benefits for market participants and infrastructure providers

The benefits and advantages for users of introducing centralcounterparty clearing are straightforward given the above discussion

of the limitations arising from bilateral collateralisation. IntroducingCCPs would firstly allow risk mitigation, which has a fundamentalqualitative difference to bilateral collateral provisioning. Riskmitigation is guaranteed by multilateral netting, by novation/openoffer as well as by robust margining procedures and other riskmanagement controls performed by the CCP.

Secondly, the introduction of CCP clearing may have a positiveeffect on market liquidity: the usage of a CCP for OTC derivativesmay allow a user (clearing member) to free capital for otherpurposes, as less collateral should be required, thanks tomultilateral netting, payment netting and possible cross-marginingarrangements. Instead of collateralising with each individual

counterparty bilaterally, with a CCP as the central counterparty, eachclearing member will ideally need to post collateral with the clearinghouse only. However, to what extent this advantage materialises willdepend on ex ante conditions: against the background of currentbilateral under-collateralisation and re-hypothecation (i.e. re-use) ofcollateral, some maintain that even more collateral may be requiredonce a (mandatory) CCP starts to systematically andcomprehensively call for collateral to be posted.

A third benefit of CCP clearing is that its introduction may reducedisruptive information problems by mitigating uncertainty, mayincrease operational efficiency through centralisation and may allowfor regulatory capital savings since the CCP is considered a zero-

risk counterparty.

Last, but not least, the CCP model, by its very nature, catalyses andenforces standardisation of processes and operations, resulting insignificant workflow reforms that provide the opportunity for asubstantial reduction of operational risk: while initially costly to setup, standardisation brings the opportunity to drive down the potentialcost of errors made by the front office.

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Benefits for financial stability

Central counterparty clearing for derivatives may not only befavourable for market participants and infrastructure providers, butmay also benefit financial stability in several ways: introducing CCPs

would improve transparency by allowing for central collection ofhigh-frequency, market-wide information on market activity,transaction prices and counterparty exposures. The centralisation ofinformation in a CCP enables market participants, policymakers andresearchers to be provided with the information necessary to bettergauge developments in the positions of individual marketparticipants in the different market segments (BIS, 2009).

11According to Dhall (2009), front office operations (especially trade capture /booking) in OTC derivatives are highly error-prone. A large percentage of errors orbreaks are due to improper trade data and detail capture. Reasons include thehighly subjective nature of trades and the manual use of spreadsheets for bookingtrades. Standardisation is likely to reduce operational risk by substantially reducing

the number of errors and thus the per-trade processing cost. Another industry-wideproblem has been the low level of confirmation rates, which are at present near60%. In contrast, currently operating CCPs provide T+0 confirmations with asuccess rate of 90%, which is further strong evidence of the benefits stemmingfrom the introduction of CCP clearing.


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Level playing field

CCPs lines of defence providemore financial resources to coverlosses from default

Reduction of systemic risk fromLCFIs

The introduction of central clearing would create a more levelplaying field as identical, non-discriminatory admission to a CCPwould guarantee small banks the same opportunities for access aslarge banks. In that sense, a centrally cleared world may lead to animproved competitive environment for smaller institutions.

Equities CCPs in Europe and the US have typically installed severallines of defence to protect themselves against the negativeconsequences of a possible default of a clearing member. Theseinclude membership criteria, daily marking-to-market, the calculationof initial margin to cover potential future losses in normal marketconditions, and in extremis some form of post-default backing tocover exceptional market events. CCP clearing would entail thatthrough participants margins and default fund contributions morefinancial resources were available to cover potential losses in theevent of a participants default. Margins are called by the CCP andposted by the participants to cover the losses incurred should aparticipant default. If the margin deposited by the defaulting clearingmember appears to be insufficient to cover the loss of the closing

out of its positions under normal market circumstances, the CCPcan use the contribution to the clearing fund of this defaultingclearing member to cover the losses in excess of these margins. Ifthis contribution appears to be insufficient, the CCP may use thecontributions from the non-defaulting clearing members. The finalline of defence comprises other financial resources, like the ownfunds of the CCP or the CCPs contingent claims on parentorganisations or insurers (Wendt, 2006, Bliss/Papathanassiou,2006).

A dichotomous effect may be anticipated in terms of procyclicality:on the one hand, more netting should result in less use of collateral,which would tend to reduce procyclicality. A CCP may involve fewer

downgrade-induced jumps in collateral, as it would require collateralto be posted by all counterparties, including those that are AAA-rated; this feature may in turn reduce pressure on markets for thesecurities used as collateral. On the other hand, though, because oftheir higher frequency in a CCP, centralised and uniform margincalls (compared with decentralised and less uniform collateralpractices in bilateral OTC markets) could aggravate procyclicality.

By lowering counterparty risk concerns in periods of market stress, aCCP might help ensure that trading continues in situations in whichbilateral OTC markets might seize up. In addition, introducing CCPsmay reduce systemic risk from Large and Complex FinancialInstitutions (LCFI) by partially transferring the risk to an entity, the

CCP, that is better able to bear it and tends to be more capable ofcollateralising it and which is from a regulatory aspect easier tomonitor and to supervise. In the course of the financial crisis marketparticipants displayed an aversion to dealing with some LCFIs dueto their counterparty risk. LCFIs clients feared that their high-gradecollateral might get stuck in the LCFIs, while LCFIs themselveslocked up collateral in their balance sheets.

12This had negative

implications for global liquidity. With the existence of derivatives

12Goldman Sachs, for instance, argued in terms of hoarding good quality collateral:Our most important liquidity policy is to pre-fund what we estimate will be ourlikely cash needs during a liquidity crisis and hold such excess liquidity in the form

of unencumbered, highly liquid securities that may be sold or pledged to providesame-day liquidity. Across the entire market, these liquidity buffers amounted toalmost USD 5 trillion of risk capital and balance sheet capacity; considering thevelocity of collateral (which is greater than 1), the adverse impact on globalliquidity was even greater than USD 5 trillion (Singh, 2009).


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One single CCP per derivative classseems to be optimal

but regulators favour competition

CCPs, it is likely that systemic risk will be spread to about 10 to15entities (LCFIs plus CCPs) instead of being borne by the present 6to 10 LCFIs that currently dominate the OTC derivatives market(IMF, 2009).

Reasons for little CCP usage

Considering the positive effects from a central clearinginfrastructure, the question arises why CCP usage has not hithertobecome more widespread in OTC derivatives markets. Most likely,insufficient economic incentives are the main motive: existing rulesallowing firms to treat derivatives processed through a clearinghouse as zero risk did not apparently provide enough motivationfor the market to introduce CCPs. Incomprehensive bilateralcollateralisation and the possibility to re-hypothecate collateral forother purposes instead of dedicating and segregating it explicitly tothe purpose for which it was received were apparently strongerincentives. Possible further reasons include:

Regulatory requirements for CCPs (e.g. in France and Germany:

the obligation for CCPs to have banking licences; in Italy: theconstraint that prohibits participants in Italian settlement systemsfrom settling trades on behalf of clearing houses).

Higher operational costs that arise from putting in place amargining and collateral management process.

Optimal number of CCPs per market

An economically interesting question is the discussion of theoptimal number of CCPs per market or market segment: shouldclearing be channelled via a single CCP or through multiple CCPs?In their academic research, Duffie and Zhu (2009) find thatintroducing a CCP for a particular asset class, such as credit

derivatives, improves the efficiency of counterparty risk mitigationand collateral demands, relative to bilateral netting between pairs ofdealers. They show that adding a second CCP for one class ofderivatives such as CDSs can reduce netting efficiency and therebylead to an increase in collateral demands and in average exposureto counterparty default. They therefore conclude that (from a purelyefficiency-based view) whenever it is efficient to introduce a CCP fora certain class of derivatives, it cannot be efficient to introduce morethan one CCP for the same class of derivatives.

From the perspective of market participants, a single CCP wouldmake economic sense due to improved efficiency, firstly in terms ofreaping economies of scale and secondly in terms of risk mitigation

and collateral demands (collateral would need to be posted only withthat specific clearing house). However, the common problem ofmonopolistic markets in terms of dynamic gains (innovation) arises.

From the perspective of regulators and supervisors, the efficiencyargument in favour of a centralised CCP clearing market structurehas to be aligned with the stability argument which favours a morecompetitive, diverse and reliable structure. In times of crisis, a singleCCP would be the single point of failure, putting all marketparticipants at risk, which must be avoided from a regulatory andsupervisory perspective. If a CCP is successful in clearing a largequantity of derivatives trades, the CCP is itself a systemicallyimportant financial institution. The failure of a CCP could suddenly

expose many major market participants to losses (Federal ReserveBank, 2010).


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CCP supervision and regulators'access to trade data still

undetermined

In order to effectively avoid a race to the bottom in terms of riskmanagement, the European Commission intends to include in itslegislative proposals rules to ensure that CCPs do not employ lowrisk management standards (COM, 2009b).This will probably entailthat ESMA

13will be mandated to develop technical standards and

guidelines. Market participants will benefit from high standards to

the extent that compliance with them should result in the lowestpossible regulatory capital charge for counterparty credit risk ofcentrally cleared contracts. In general, CCPs should not compete onprice (i.e. the amount of margin required for a particular position),but rather on the quality of the service offered. An EU directive couldensure a level playing field for all EU CCPs. Authorisation andsupervision to a specified level will give market participantsworldwide the confidence that such CCPs are robust and well run.

Public discussion, though, does not currently seem to be focused onthe number of CCPs per market segment, but rather on the globalnumber of CCPs and in particular on the jurisdiction and supervisionunder which they should fall. This latter question is of special

importance in the debate on which party might act as a possiblelender of last resort in case of a CCPs failure (nature of publicsupport and possible access to central bank credit facilities; seenext paragraph). Access to market-wide OTC derivative contractinformation held by CCPs is another issue still undetermined.Information on OTC trades may be needed by different public andprivate entities, depending on their nature and mandate; it may berecorded by CCPs or specialised trade repositories (TRs). Thecurrent debate focuses on the granularity of information (aggregatedvs. trade-level), to whom it should be provided (regulators, marketparticipants, and/or the general public) and on whether (foreign) TRsshould be mandated to provide trade data to any regulator that has

requested it.

CCP loss bearing and access to facilities of last resort

The public discussion has also focused on how and by whompotential losses of a CCP should be borne in the case of a defaultingmember, if losses exceed collateral. A clear procedure is needed fordefining a default event, for valuation and for margining. In order toavoid cross-border distortions, uniform application of standards isneeded across all CCPs handling derivatives. For this purpose, aworking group was set up in July 2009 to review the application ofthe 2004 CPSS-IOSCO risk management recommendations forcentral counterparties in order to reflect future clearing of OTCderivatives. Proposals are expected for the first half of 2010,addressing in particular five issues, namely: conduct of businessand governance, risk standards, legal protection to collateral andpositions, authorisation and recognition of third-country CCPs.

One important but as yet unresolved question is whether CCPsshould have access to central bank credit facilities and, if so, when.Keeping a CCP liquid in the face of the failure of one or moreparticipants requires that liquidity be available somewhere.Currently, however, access to central bank liquidity varies widelyacross jurisdictions. The Association Franaise des marchsfinanciers (AMAFI) urges that each CCP should haveintraday/overnight access to central bank money in the currency itoperates in to be in a position to rapidly and securely obtain thenecessary liquidity for it to limit systemic risk (AMAFI, 2009).

13ESMA: European Securities Markets Authority.


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Interoperability of CCPs is currently amajor unresolved issue

Interoperability of multiple CCPs

The European Code of Conduct for Clearing and Settlement, whichis a voluntary self-commitment by the undersigning organisations,comprises, inter alia, the provision of clearing and CCP services byclearing houses, CCPs and potentially also central securitiesdepositories (CSDs). All signatories of the Code must adhere to theprinciple of interoperability, i.e. the creation of links between CCPsto facilitate cross-border clearing and to give traders a choice overwhere to send their deals for clearing, rather than being reliant upona single monopoly clearer.

14The Code specifically states that CCPs

should be able to access other CCPs (see FESE, EACH & ECSDA,2006).

Pursuant to the Code of Conduct, there are three types of accessand interoperability between CCPs:

1. Standard access: one CCP becomes a normal participant(member) in another CCP. This means that the marketinfrastructure gaining access assumes all rights and obligations

associated with regular participation. However, this may beinconsistent with the subordinate CCPs status as a CCP with thequestion arising whether it is fully collateralised for thepurposes of its users regulators for capital requirementscalculation.

2. Data feed access: a CCP accesses a continuous flow of datafrom another CCP and/or trading venue that is necessary toperform the function of a CCP in the market of the other CCPand/or trading venue in question.

3. Interoperability: two or more CCPs enter into an arrangementwith one another on an equal basis (peer-to-peer relationship)which involves cross-system execution of transfer orders. This

implies advanced forms of relationships where a CCP does notgenerally connect to existing standard service offerings of theother CCP but where they agree to establish mutual solutions.Here, the problem lies in the asymmetry in inter-CCPcollateralisation; moreover, there are no internationally agreedstandards for inter-CCP risk management.

A number of issues unresolved up to now are currently preventingaccess and interoperability between CCPs: in the wake of thefinancial crisis, European regulators are concerned that the creationof these links could be the source of another systemic crisis. Theworry is that the weakest link in the chain could bring others down ifit were involved in a default and was insufficiently capitalised to

meet margin calls (contagion risk). And even if covered by collateral,inter-CCP exposures could give rise to liquidity risk, i.e. the risk thata CCP cannot find the necessary liquidity to cover the collateral call.Attempting to link together CCPs has proved complex enough in thecase of cash equities, and interoperability for derivatives wouldexacerbate the difficulties.

15Besides, while the protection of financial

14MiFID already gives some access rights in the post-trade area to regulatedmarkets and to investment firms, and this Code is not intended to contradict any ofthose rights.

15In October 2009, efforts to promote competition between clearing houses inEurope were stalled by regulators concerned by the risks that such anarrangement might pose to the wider financial system: The UKs FSA and the

Dutch regulator AFM had blocked the plans of a three-way link betweenLCH.Clearnet, EMCF, and SIX x-clear in light of concerns that such a link mightcause excessive systemic risk. Concerns were prompted by ambiguities abouthow clearing houses handle margin and perform risk management between eachother in the event that one clearer fails.


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Ownership structure providesdiffering incentives for risk

monitoring and risk management

Inter-CCP Risk ManagementStandards

This document (by EACH) states that in a

CCP-to-CCP interoperability scenario (e.g. in

a link between CCPs) the receiving CCP

recognise the requesting CCP as having the

nature and regulatory status of a CCP, not arisk-taking intermediary. In particular, the

Guideline requires that (i) The CCPs involved

have to arrange an adequate collateralisation

scheme to cover the exposure of potential

losses. (ii) No CCP is obliged to contribute to

the other CCPs participants default fund or

other post-default backing schemes. (iii) A

default of a clearing member at one CCP

should not affect the other CCP unless the

first CCP itself is in default.

Source: EACH

stability is the main central bank concern, interoperability is amedium-term objective that should not be forced. Apart from that,since the Code of Conduct came into effect it has become apparentthat commercial barriers exist, on account of which incumbentoperators have no interest in accepting link requests that wouldjeopardise their established business models.

In July 2008, EACH16

published a documentation of Inter-CCP RiskManagement Standards (see EACH, 2008) based on the Code ofConducts Access and Interoperability Guidelines (see box).

CCP ownership structure and governance

A last key topic is the question of the optimal ownership structureand governance of a CCP. Theoretically, five key types ofgovernance models are feasible for a market infrastructureinstitution: the non-profit, cooperative, for-profit, public utility, andhybrid models (Lee, 2010). Given the potential CCPs have forensuring financial stability by reducing systemic risk, the keyquestion is which governance model best incentivises risk

monitoring and risk management. As the owners of a for-profit CCPwill typically not be its customers, they will not bear the direct costsof a large-scale clearing failure. Shareholders may therefore nothave as strong an incentive to ensure the financial stability of suchan institution compared with user-owners. In contrast, a CCP underuser ownership and governance i.e. governed by the underwritersof the risk taken on by the CCP has a stronger, reciprocalincentive (and capability) to monitor and control risks incurred by itsmembers due to the mutualisation of losses through loss-sharingrules. It would deliver higher risk and operational efficiency benefits,setting margins and returns at the right level to reflect users' pricingof mutual risk.

Majority exchange control or influence over a CCP and profit-maximising financial models may also raise concerns about the feestructure as they enable the extraction of supra-normal profits fromcustomers of the CCP. While acknowledging innovation, dynamicproduct development and other benefits of competition provided bythe for-profit models, an exchange-owned CCP might possiblycreate a monopoly through the de facto vertical integration with theexchanges trading platform where there is no fungibility withcontracts traded anywhere else. On the other hand, a businessstrategy characterised by greater innovation and greater associatedcommercial and operational risks, than cooperative, non-profit, orother governance models can enhance a CCPs risk management

process, for example by improving systems that accelerateinformation flow, by establishing an early warning system, or byimplementing real-time risk management (Lee, 2010).

16EACH: European Association of Central Counterparty Clearing Houses.


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Non-user shareholder control can lead to inefficiencies and highcosts as the risk appetite of external shareholders is different to thatof users. In the case of a profit-maximising entity, this couldtheoretically lead to margins being set at too high a level in order toprotect external shareholders from the effect of a failure of the CCP.Yet, as the limited evidence we have so far shows, the

predominantly user-owned CCP, LCH.Clearnets SwapClear, ismuch more conservative in the levels of margin it sets for interestrate swaps than, for instance, the CME, a profit-maximising firm.The following table illustrates the ownership structure, markets andproducts eligible for clearing at selected European equityclearinghouses.

Against the background of the competing objectives, it is ratherdifficult to identify the optimal ownership model and governance of aCCP. Ultimately, the decision will be taken by the institutionsthemselves, in accordance with the regulatory framework that iscurrently being drafted by the legislators. We do, however, think thatthe underwriters of the risk taken on by the CCP, hence the parties

paying for the safe management of counterparty risk, should at leasthave a say in governance and risk steering committees.Furthermore, market participants should, in principle, be able to ownpart of the clearing house.

Supervision of CCPs

The discussion of CCP supervision is another delicate issue. If aCCP were located in Europe, it would be subject to European rulesand supervision. Supervisors would accordingly have undisputedand unfettered access to the information held by CCPs. If the CCPwere located outside Europe, EU supervisors would have to rely on

Clearinghouse Ownership structure Markets served Products

CC&G

86% Borsa Italiana SpA,14% Unicredit,(with Borsa Italiana SpA fully owned subsidiaryof London Stock Exchange Group)

Borsa Italiana marketsSecurities, Exchange-tradedDerivatives, EmissionsProducts

CCP Austria50% Wiener Brse,50% OeKB

Wiener BrseSecurities, Exchange-tradedDerivatives,

EMCF77% Fortis Bank Global Clearing N.V.,1% Fortis Bank (Nederland) N.V.,22% OMX AB

7 exchanges and MTFs Equities

Eurex Clearing50% Deutsche Brse AG,50% SIX Swiss Exchange

DBAG markets, EEX, IrishStock Exchange

Securities, Exchange-tradedDerivatives, OTC Derivatives,Emissions Products, Bonds

and Repos

EuroCCP 100% Depository Trust & Clearing CorporationTurquoise, SmartPool, NYSEArca Europe, PipelineFinancial Group Limited

Equities

ICE Credit Clear 100% IntercontinentalExchange, Inc.ICE OTC Energy,ICE OTC Credit

Energy Futures, OTCDerivatives

LCH.Clearnet83% Users,17% Exchanges (Euronext, LME, ICE Futures)

22 exchanges and othertrading platforms

Securities, Exchange-tradedDerivatives, OTC Derivatives,Emissions Products, Freight,IRS, Bonds and Repos

MEFFClear 100% BME BME markets Securities, Repos

SIX x-clear 100% SIX GroupSIX Swiss Exchange,London Stock Exchange,Liquidnet, NYFIX, Equiduct

Securities, Bonds

Sources: Corporate websites, DB Research 7


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Current Issues

18 April 28, 2010

Mutual trust is currently still an issue

third country supervision. Currently, supervisory bodies seem to beuncomfortable with third country regulators overseeing systemicallyrelevant financial infrastructures such as CCPs, especially in timesof market stress. In consequence, it is currently hardly imaginablethat a central bank would provide liquidity to institutions locatedoutside its currency area.

In order to build mutual trust, the objective of international regulatorsshould therefore be to establish reasonable structures for cross-jurisdiction supervisory cooperation to the same extent as structuresfor the supervision of cross-border financial institutions have evolvedover time in the past. Once an adequate level of cooperation withsufficient access to and comfort with the supervising regulator hasbeen created, a CCPs location should no longer be an issue. We dorecognise, however, that this will be a politically difficult process.

Clearing houses in Europe are currently regulated by the nationalsecurities regulators in each country. Given the systemic importanceof clearing houses, the European Commission intends to give the

future ESMA (currently the Committee of European SecuritiesRegulators CESR) powers to supervise CCPs. This is logical tothe extent that the CCPs in question serve more than one nationalmarket, i.e. constitute a pan-European infrastructure. Even then,however, the issue arises that, in the event of failure, a CCP mayultimately fall back on the support of national authorities, as long asthere is no EU-level process for dealing with failed CCPs.

Interim conclusion

The introduction of CCPs alone is unlikely to be sufficient to ensurethat OTC derivatives markets operate efficiently and remain resilientin the face of major shocks. It is important to complement theintroduction of CCPs with improvements in the trading and

settlement infrastructure. This includes the greater use of automatedtrading, registration of all trades in central data depositories, andenhanced risk management and disclosure requirements for marketparticipants themselves.

Whether or not to introduce CCPs for OTC derivatives can only beanswered per segment, not for the entire market. CCPs forderivatives other than CDSs, such as interest rate swaps, havebeen in place for a decade, and those for futures and options have,in some cases, been around for more than a century

17(BIS, 2009).

In the case of FX derivatives, CCPs are not urgent as the mostimportant risk management function is performed within the CLSsystem. This was affirmed by many of the respondents to the COMs

consultation who pointed out that the FX market is different and thatCCPs are not needed as the main source of risk is the settlementrisk, not replacement risk, and the former is already adequatelycovered.

5.Cont rac t s tandard isat ion

As outlined throughout this report, the introduction of CCP clearingfor OTC derivatives would be an effective way to mitigate inherentrisks that became apparent in the course of the financial crisis and

17

The Minneapolis Chamber of Commerce established the first modernclearinghouse for futures in 1891, and other futures exchanges in the UnitedStates adopted clearing in the years between 1891 and 1925. One of the lastfutures exchanges to adopt a CCP, the London Metal Exchange, did so only in1986 (Pirrong, 2009).


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Contractual standardisation iswelcomed by market participants

... while product standardisation ispredominantly rejected

Contract specificities make it difficultto introduce central trading of

derivatives

in its aftermath. One of the prerequisites that must be met in order tofacilitate CCP clearing is contract standardisation and electronicprocessing. The ongoing public debate, fuelled particularly by anofficial statement

18from the G-20 Pittsburgh summit in September

2009, has highlighted the perceived importance of standardisation ofderivatives for the purpose of creating a more stable financial

market infrastructure. However, what it is exactly that should bestandardised needs to be specified.

Standardisation can be broken down into: (i) contract uniformity(standard legal relationships, confirmation agreements,documentation, market conventions on event handling); (ii) productuniformity (standard valuations, payment structures, dates); and (iii)process uniformity and automation (straight-through processing(STP), matching, confirmation and settlement).

Contractual standardisation (as referred to by the Europeanregulators) has two dimensions, i.e. the standardisation of the legalterms of the contracts (e.g. applicable law, dispute resolution

mechanism etc.) and the standardisation of the economic terms ofthe contracts (e.g. in the case of CDSs the maturity of the contract,the coupon to be paid etc.). Over the years, interest rate swaps andforeign exchange derivatives have become highly standardisedthrough voluntary industry initiatives. For example, MasterAgreements developed by the ISDA represent the first type ofstandardisation. The recent market agreement to use only a handfulof standardised coupon values for European-referenced CDSs is anexample of the second type of standardisation.

Product uniformity, as far as standardising the economic parametersof the contract is concerned, is widely rejected by marketparticipants since it would limit hedging possibilities and might resultin a conflict with accounting rules. Technical standardisation, i.e. theautomation of processes, is widely seen as beneficial, but alsocomes with set-up costs.

Standardisation a prerequisite for central clearing and centraltrading?

There are a number of practical implications to the desired outcomeof the G-20 Pittsburgh summit, i.e. the reduction of operational andsystemic risk within a meaningful timeframe. In general, we canstate that getting OTC derivatives to be traded on-exchange isharder than getting them to be cleared centrally: any product tradedon an exchange can be cleared, but the opposite is not necessarilytrue.

Regarding standardised derivative contracts, the difference betweenhow a clearing house can deal with standardised OTC derivativesand how an exchange cannot do the same must be highlighted: forinstance, a 5-year interest rate swap the most standard, liquidOTC interest rate contract available in the market when transactedtoday is a different product tomorrow, when it becomes a 4-year364 day interest rate swap. It is still the same standardised productin the eyes of users and of a clearing house, in the sense that it issimple to value and to risk manage. It is, however, not easy to

18G-20 leaders had agreed at that meeting that for improving over-the-counter

derivatives markets, all standardised OTC derivative contracts should be traded onexchanges or electronic trading platforms, where appropriate, and cleared throughcentral counterparties by end-2012 at the latest. OTC derivative contracts shouldbe reported to trade repositories. Non-centrally cleared contracts should be subjectto higher capital requirements".


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OTC derivatives

April 28, 2010 23

The European Commission announced that an economic impactassessment will accompany any future policy actions.

Cost-benefit analysis for the industry

While the implementation of the new regulations will lead to costs forthe public sector as discussed above, a severe impact on revenues,

profits and on risk weighted assets (RWAs) of the infrastructureusers (banks) can also be expected.

While the impact on revenues and profits is mainly driven byexpected margin compression and operational costs respectively,impact on risk weighted assets can be assessed on the basis ofcounterparty credit risk being included in the credit risk componentof the banks RWA:

Total RWA = Credit Risk + Market Risk + Operational Risk

According to both EU and US legislators plans (which are, however,not yet finalised) it is very likely that (i) less capital will be requiredfor centrally cleared OTC derivatives while there will be (ii)

increased capital requirements for non-CCP cleared derivatives.In the first case (if centrally cleared), banks will benefit from lowerRWAs and from a capital relief for those OTC derivatives that arecentrally cleared as there will be no need to hold capital forcounterparty risk. In consequence, higher ROEs should result, andfor the largest banks with high OTC derivative dealer volumes, thebenefit would be significant, so that a minimal direct P&L benefit canbe expected.

In the second case (bilaterally cleared OTC derivatives), higherRWAs, higher capital requirements, and hence lower ROEs shouldresult. The higher capital requirements for non-CCP cleared OTCderivatives may more than offset the capital relief benefits to banks

of centrally cleared derivatives. As regulators and the BaselCommittee have not yet indicated how high the new capital chargeswill be, it is not yet ultimately foreseeable how high the incrementalcapital charges will be. New capital charges are, however, expectedto be sharply higher in order to create incentives for the migrationtoward centralised clearing and the reduction of systemic risk.

8.Conclus ions and policy impl ic at ions

In the aftermath of the recent financial crisis, the enormous growthrates in OTC derivatives volumes that could be observed over the

past years have increasingly brought the systemic relevance ofthese markets to the collective consciousness.

While originally derivatives were thought to have predominantlybeen used by financial institutions, a current ISDA survey revealsthat demand for derivatives exists in all industries: a vast majority ofFortune 500 firms use derivatives to manage business and macro-economic risks. In this context, foreign exchange and interest ratederivatives are the most heavily traded instruments.

We illustrated that OTC derivatives market characteristics differsubstantially from those of equity markets. Most significantly, tradingpartners are exposed to substantial counterparty risk, i.e. the riskthat one counterparty may not honour its obligation or may default

during the lifetime of the contract. In contrast to equity markets,counterparty risk in derivatives is much more difficult to measureand thus to mitigate. This peculiarity is based on the fact thatcontracts are more often than not bespoke and that their payout


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Current Issues

24 April 28, 2010

structure in conjunction with the often extensive duration regularlymakes them difficult to value as no observable and tradable marketprices exist. This is why OTC derivatives markets are often referredto as opaque and intransparent. Trading partners typically mitigatecounterparty risk by means of bilateral collateralisation, a methodthat in the past proved to be associated with a number of

weaknesses.

Central counterparty clearing seems to be an effective and efficientmeans to address these limitations. EU and US regulators inaccordance with G-20 leaders are therefore pushing for increasedusage of CCPs in derivatives markets; both intend to present theirregulatory strategies in the coming months. Rules on eligibility ofcontracts for central clearing, interoperability of CCPs andownership of the market infrastructure are issues set to shape theindustry, but are undetermined at the moment.

In order to prevent regulatory arbitrage between jurisdictions, wethink that a uniform pan-European regulatory framework should be

developed for CCPs, including high standards for risk management.This framework and its risk management standards should beconsistent with global standards, in particular with the US. CCPsshould not compete on those standards (i.e. the amount of marginrequired for a particular position), but rather on the quality of theservice offered.

Central clearing should not be mandatory for all standardisedderivatives. Certain counterparties (e.g. non-financials) that do notpose a systemic risk and for whom use of CCPs would introducenew risks that they are ill-equipped to manage (e.g. management ofliquidity risk), should be exempted. Bilateral risk managementtechniques can address risk for these and all non-clearedderivatives. Generally, eligibility of products for central clearingshould be determined by the members of the CCP who aremutualising the risk, having considered key characteristics of theproduct class in question, the capability of the CCP, and the ability ofmajor market participants to support the default process.

Market participants should be able to own part of the clearing house.As the underwriters of the risk taken on by the CCP, they arestrongly incentivised to ensure a CCP is soundly risk managed.Users have long experience in the risk management of derivatives;this should be deployed by involving them in governance and riskcommittees. Paying for the safe management of counterparty risk bythe CCP (margin, default funds etc.), clearing members have anincentive to maximise use of central clearing on a safe basis.

The introduction of trade repositories as proposed by the G-20leaders may be a useful measure to provide transparency toregulators on the market activity in each OTC derivative asset class.To satisfy the needs of global regulators in the most efficient andlowest cost manner, regulators should work together to determine aconsistent global legal framework that allows a limited number oftrade repositories to be built (one per asset class) but enables allregulators to have unfettered access.

Electronic and/or centralised trading does not appear to benecessary to lower systemic risks in OTC derivative markets. Whilerecent regulatory proposals in the EU seem to have moved away

from mandating central trading and now target a natural evolutionover a mandatory approach, current US plans are still in line with theoriginal G-20 recommendation. Admittedly, the advantages ofelectronic trading are significant. It improves price transparency,


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L i te ra tu re

AMAFI Assocation Franaise des marchs financiers (2009).French Market Position towards the Draft Recommendationsfor CCPs revised for CCPs clearing OTC derivatives. April2009.

BIS Bank for International Settlements (2009). Centralcounterparties for over-the-counter derivatives. BIS QuarterlyReview. September 2009.

Bliss, R. and C. Papathanassiou (2006). Derivatives clearing,central counterparties and novation: The economic implications.

CFTC Commodity Futures Trading Commission (2009). Remarksof Chairman Gary Gensler before the Managed FundsAssociation. Chicago, Illinois. June 24, 2009.

City of London (2009). Current Issues Affecting the OTC DerivativesMarket and its Importance to London. April 2009.

COM European Commission (2009a).Commission Staff WorkingPaper Accompanying the Commission CommunicationEnsuring efficient, safe and sound derivatives markets.SEC(2009) 905 final.

COM European Commission (2009b). Communication from theCommission to the European Parliament, the Council, theEuropean Economic and Social Committee, the Committee ofthe Regions and the European Central Bank Ensuring efficient,safe and sound derivatives markets: Future policy actions.COM(2009) 563 final.

COM European Commission (2009c). Summary of theconsultation on Possible initiatives to enhance the resilience of

OTC Derivatives Markets. October 2009.

Dodd, R. (2002). The Structure of OTC Derivatives Markets. TheFinancier. Vol. 9, Nos. 1-4. 2002.

Duffie, D. and H. Zhu (2009). Does a Central Clearing CounterpartyReduce Counterparty Risk? Rock Center for CorporateGovernance Working Paper No. 46. July 2009.

EACH European Association of CCP Clearing Houses (2008).Inter-CCP Risk Management Standards. July 2008.

Federal Reserve Bank (2010). Policy Perspectives on OTCDerivatives Market Infrastructure. Federal Reserve Bank of NewYork Staff Reports. No. 424. January 2010.

FESE, EACH & ECSDA Federation of European SecuritiesExchanges, European Association of Clearing Houses andEuropean Central Securities Depositories Association (2006).European Code of Conduct for Clearing and Settlement.

IMF International Monetary Fund (2009). Counterparty Risk,Impact on Collateral Flows, and Role for Central Counterparties.IMF Working Paper WP/09/173.

ISDA International Swaps and Derivatives Association (2009).ISDA Margin Survey 2009.

ISDA International Swaps and Derivatives Association (2010).ISDA explanatory document the real size and risk associated

with the OTC derivatives market. February 2010.


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Lee, R. (2010). The Governance of Financial Market Infrastructure.Oxford Finance Group. Princeton University Press.Forthcoming.

Paulson, H.M. (2010). How to Watch the Banks. New York Times.February 16, 2010.

Pirrong, C. (2009). The Economics of Clearing in DerivativesMarkets: Netting, Asymmetric Information, and the Sharing ofDefault Risks Through a Central Counterparty. Working Paper.

SNB Schweizerische Nationalbank (2009). Optimal CentralCounterparty Risk Management. Swiss National Bank WorkingPapers 2009-7.

Wendt, F. (2006). Intraday Margining of Central Counterparties: EUPractice and a Theoretical Evaluation of Benefits and Costs. DeNederlandsche Bank.

Weistroffer, C. (2009). Credit Default Swaps Heading towards amore stable system. Current Issue. Deutsche Bank Research.

Frankfurt am Main.


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OTC Derivate