1. Che Sidanius Advisor Financial Stability ‘I think there is a world market for maybe five...
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Transcript of 1. Che Sidanius Advisor Financial Stability ‘I think there is a world market for maybe five...
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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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