Rethinking Financial Derivatives - Motivation
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On September 15, 2008, the US investment bank Lehman Brothers filed for bankruptcy. Years later some claims still remain unsettled. Although Lehman’s derivative portfolio was not the reason for its bankruptcy, its notional of $35 trillion accounted for 5% of the total derivative market.Derivative contracts remain relevant tools for risk management and the global economy. In 2017,the notional of the OTC derivative market was $530 trillion and accounted for a market value of $12 trillion. Despite extensive regulatory changes and improvements, settlement risks of derivatives remain complex and hard to manage – and hence costly.Is it possible to use technologies like Distributed Ledgers and Smart Contracts to rethink derivatives from scratch? In this note we try to provide some answers.
Nature of OTC Derivatives
Important instruments
Financial derivatives are essential tools in risk management with economic value added, e.g. to reduce market risk. For example, by using interest rate swaps, the interest rate risk of a loan can be managed. However, a classical “Over-The-Counter” (OTC) derivative carries its own risk resulting from the bilateral contractual relationship. A prominent example is the counterparty risk related to the possibility of bankruptcy of the derivative counterparty.
Risk Management or Reduction
The common approach is to manage and control risk as good as possible and dedicate capital reserves to the remaining risk. This approach results in complex processes and high costs in the end. A proactive reduction of risk or even the complete removal of risk is desirable, not only because it is cheaper.
Regulatory Improvements
After the 2008 financial crisis regulators tried to successively improve the handling of derivative risk. Higher capital charges and processing costs put pressure on banks to improve their risk management and transaction processing front-to-back from trading over risk control to operations.
Complexity which does not exists need not be reduced
Many processes in the derivative business exist for historical reasons. Due to the high volume of the existing derivative positions, changes remain difficult. However, present technological advances and the increasing digital transformation of business processes demand for a review of derivative processes in regard of their complexity.How about rethinking derivatives that way? Complexity that does not exist, need not be reduced. Risk that does not exist by construction, need not be managed. Is this possible?
Derivatives Markets today
Counterparty Credit Risk
In case of a bankruptcy of a derivative counterpart the remaining party is forced to manage the resulting open risk positions by entering into new derivative contracts. This can lead to significant replacement costs since a bank's insolvency can lead to large market disruptions. Collateral processes are supposed to mitigate those replacement risks. If the market value of a derivative portfolio represents a liability, it has to be collateralised by posing cash or securities as collateral.
Collateral and Settlement Risk
The collateral exchange process, however, has procedural problems and inefficiencies which prevent final elimination of counterparty credit risk. The value of collateral is based on the portfolio’s market value and is determined by each counterparty separately. If counterparties disagree on the collateral value, this dispute may leave the actual claim insufficiently collateralised.Another example for an inefficiency results from non-synchronised bookings of derivative cash-flows and collateral postings. The booking of a contractual derivative cash flow,e.g. the payment of a fixed rate, will result in an opposite booking of respective collateral and will be transferred back to the payer usually with a timely offset.Such redundant bookings generate unnecessary settlement risks which especially will become evident in case of a looming bankruptcy.
CCP and Initial Margin
With the introduction of “European Market Infrastructure Regulation(EMIR)” in 2012 the EU has put stronger regulations on the OTC derivatives market with the objective of increasing transparency and reduce existing risks. Within that framework the clearing obligation for plain interest rate swap derivatives was introduced in 2016. Counterparties are not allowed to process the derivative’s life-cycle bilaterally but are forced to contract over a third institution–the clearing house. For all remaining derivatives which are not subject to clearing obligation and therefore still have to be processed bilaterally, e.g. cross currency swaps, a bilateral initial obligation was launched in 2017. Both counterparties are obliged to post additional collateral to a custodian with the aim to cover potential losses due to insufficient collateralised claims.
Is Risk removed?
Despite all those attempts counterparty credit risk has not been eliminated. On the one hand, the risk has been concentrate don few central hubs; on the other hand, it has been transformed into new elements of costs.A clearing house itself is also exposed to the risk of insolvency of one of its clearing members and can get into serious difficulties. Complex processes, including the so-called “Default Waterfall” process, are put into place to prevent such a situation from happening.But especially in a critical crisis scenario one thing is definitely undesired: Complex mechanisms unwinding in a strained market on a highly aggregated derivative volume. Looking at the bilateral initial margin obligation, which enters its third phase right now, one may observe that the additional collateral to be posted results in a strongly increasing funding demand. Essentially counterparty credit risk gets transformed into liquidity costs.