COLUMN – $2 trillion OTC derivatives may be undercollateralised

By Reuters Staff
April 14, 2010

– John Kemp is a Reuters market analyst. The views expressed are his own –

By John Kemp

LONDON, April 14 (Reuters) – As much as $2 trillion of over-the-counter derivatives held at the largest banks in the United States, Europe and the rest of the world could be under-collateralised, according to a working paper published by the International Monetary Fund this month.

Banks might have to find $200 billion in initial margin and guarantee funds if standardised contracts are moved into clearing houses, and hold an extra $70 billion to $140 billion in regulatory capital to cover the non-standard contracts they retain on their balance sheets.

The findings are set out in an IMF working paper on “Collateral, Netting and Systemic Risk in the OTC Derivatives Market” by , an economist in the IMF’s Monetary and Capital Markets Department (http://www.imf.org/external/pubs/ft/wp/2010/wp1099.pdf).

The scale of the under-collateralisation, and likely increase in collateral requirements if standardised OTC contracts are moved onto centralised counterparties (CCPs) explains why Wall Street is so anxious to fight clearing requirements set out in proposed legislation on derivatives reform.

THE BIG 10 OTC BANKS

Singh focuses on the derivatives payables position at large complex financial institutions (LCFIs) to estimate the total amount of systemic risk. The OTC market is dominated by 10 LCFIs — five in the United States (Goldman Sachs, Citigroup, JP Morgan, Bank of America and Morgan Stanley) and five in Europe, Barclays, UBS, RBS and Credit Suisse.

Most regulatory attention has centred on the amount of derivatives receivables at LCFIs. This is the amount of money they would stand to lose if one or more of their counterparties defaulted. It gives some idea of how much regulatory capital the banks should be required to hold to remain sound if one of its counterparties failed.

But Singh argues the relevant measure from a systemic risk perspective is derivatives payables, since these are the payments a bank would fail to make to its own counterparties in the events of its own failure. It is the real measure of how much damage a bank failure would inflict on the rest of the system.

SYSTEM-WIDE EXPOSURE

Unfortunately, the risk LCFIs pose to the rest of the system may not be fully collateralised. Residual (under-collateralised) exposure arises for two reasons:

(1) Sovereigns, as well as AAA-rated insurers, corporates, large banks and multilateral institutions “do not post adequate collateral since they are viewed by LCFIs as privileged and (apparently) safe clients.”

(2) Dealers have agreed, based on the bilateral nature of the contracts, not to mandate adequate collateral for dealer to dealer positions. “In fact, dealers typically post no collateral to each other for these contracts,” according to Singh.

In contrast, centralised counterparties would require collateral to be posted from all members, so the under-collateralisation gap would become much more obvious.

Using information from the 10-Q quarterly statements of financial condition, Singh estimates the five major LCFIs in the United States had (under-collateralised) derivatives payables totalling about $500 billion at the end of September 2009. The five European LCFIs had joint (under-collateralised) risk totalling another $600 billion to $700 billion.

Singh adjusts the residuals to account for netting. The International Swap and Derivatives Association netting agreements permit major derivatives players to net their derivatives exposure across each counterparty. If an LCFI defaulted, the impact on the rest of the system would be measured by its net payable position.

Singh nonetheless concludes the derivatives payable exposure which is under-collateralised might be as high as $1.6 trillion, including the United States, Europe and the rest of the world.

OTHER ESTIMATES

The Singh estimate is close to $2 trillion net credit exposure figure produced by the Bank for International Settlements in its semi-annual derivatives survey.

BIS actually records banks’ derivative payables and receivables, after netting, amounted to just under $4 trillion at the end of June 2009 (BIS Derivatives Statistics, Table 19, memo item). Assuming major OTC participants run matched books gives a figure of about $2 trillion for derivatives payables on their own.

Singh’s estimate is higher than a recent ISDA survey cited by the BIS in its September 2009 quarterly review. That put the volume of under-collateralised derivatives at $1 trillion (or about $500 billion of under-collateralised derivatives payables if participants run matched books).

But Singh argues $500 billion is an under-estimate. Even where LCFIs hold “assigned collateral” against the possibility of counterparty default on OTC derivatives, it is often “re-hypothecated” (ie re-used) for other purposes. “This implies that the ISDA estimate of under-collateralisation is low because the collateral that is posted is not dedicated to reduce risk in OTC derivatives.”

Based on the various studies, Singh argues a reasonable estimate for the amount of under-collateralised OTC derivatives worldwide would be around $2 trillion.

COST OF CLEARING

If the two-thirds of OTC contracts which are “standardised” were moved onto CCPs, as policymakers want, LCFIs would need to find an extra $200 billion in initial margins and guarantee funds. Singh reckons an extra $80 billion would be needed to cover clearing of credit default swaps; $40 billion to $50 billion for interest rate swaps; and $90 billion for equities, foreign exchanges and commodities.

In addition, if regulators charged an ad hoc capital levy of 10 to 20 percent on the remaining third (non-standard) OTC contracts retained by LCFIs on their own books, that would require the banks to hold extra capital of $70 billion to $140 billion to reflect the risks adequately.

Using CCPs would increase the potential for netting, and reduce the degree of under-collateralisation to some extent. But the full potential would only be available if netting could be carried out across CCPs on a global basis through some kind of link between them.

Clearing standardised derivatives could, perversely, increase collateral requirements associated with the non-standardised derivatives left on LCFIs’ own balance sheets. At the moment, LCFIs net exposure across standardised and non-standardised contracts; so losses on non-standard contracts can be reduced by any gains on standardised ones.

If standardised contracts are shifted into clearing houses, non-standardised derivatives could no longer be netted against them. Banks would therefore need to hold more capital against non-standardised contracts to immunise them against default.

Given the paucity of data on the size and practices of the OTC derivatives market, all these figures are estimates. But they provide some indication of why the apparently arcane issue of clearing and margining has become so controversial.

Not all LCFIs would default on their OTC derivatives payable obligations at the same time, so total risk is much smaller than the maximum $2 trillion figure. But if they had to post collateral or hold capital against the default risks, rather than rely on current bilateral netting arrangements, the extra cost for the sector would be very substantial. (Editing by James Dalgleish) ((john.kemp@thomsonreuters.com; Reuters Messaging: john.kemp.reuters.com@reuters.net; Tel: +44 207 542 9726))

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