OTC derivatives are cleared and settled within two distinct institutional environments. While these environments vary in a great many respects, they share the common feature that they are designed to respond to problems stemming from the fact that OTC derivatives contemplate the performance of, often contingent, contractual obligations by the counterparties over time. It is the performance of obligations over time, in turn, which introduces the liquidity and counterparty credit risks at the heart of the contemporary policy debate surrounding the regulation of these markets.
Within bilaterally cleared markets, market participants have historically managed these risks through contractual provisions such as payment and closeout netting, along with the use of credit support agreements. Market participants may also actively monitor the creditworthiness of their counterparties. Within centrally cleared markets, CCPs manage these risks through the use of multilateral netting, the collateralization of residual net exposures, and the mutualization of losses amongst clearing members via default waterfalls and other mechanisms.
In theory, then, the institutions at the heart of both bilaterally and centrally cleared OTCD markets can be understood as effective substitutes for one another. To understand whether and to what extent these institutions are substitutes in practice, however, necessitates closer examination. To date, such an examination has been problematic due to a lack of publicly available data regarding, for example, the amount and quality of collateral being posted within bilateral markets, the re-hypothecation and re-use of collateral, and collateral triggers. Simultaneously, the regulatory regimes governing centrally cleared markets vary from jurisdiction to jurisdiction and, in the wake of the global finance crisis,
have been in a more or less constant state of flux. (For example, important potential differences exist in terms of central bank liquidity provision and resolution. Subsequent sessions will explore these themes.) Compounding matters, even within centrally cleared markets, there is often significant opacity in terms of the detailed risk management practices of CCPs.
The purpose of this session is to drill down into this institutional detail as far as possible, identifying areas of functional similarity and difference, and where further information is required. Such an examination is necessary if we are to understand how market participants view the costs and benefits of these institutional structures, how these views are likely to influence their behavior and, ultimately, how this behavior may contribute to the build-up or amelioration of risk within the financial system.