The Bilateral World vs The Cleared World

ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

As the OTC derivatives industry moves forward towards implementing the clearing mandate, it is becoming increasingly apparent that there is a need to maintain consistency between the bilaterally transacted OTC derivative world and the newly emerging cleared world. Failure to maintain consistency could prove problematic for all involved, including hedgers, market makers and CCPs. This might ultimately undermine the objective of policymakers and market participants: the creation of a safer, more robust system.

Regulators are creating another set of market rules which may or may not be consistent with the set of OTC derivatives market practices that have been developed over the past 30 years. Some concrete examples of this potential inconsistency include:

  • In the bilateral world, collateralization of exposures is the norm. But posting of initial margin is optional subject to one counterparty’s credit view of another. In the cleared world, initial margin is mandatory, irrespective of the quality of the counterparty. The result is different quoted prices based on whether initial margin is posted, its level (when posted) and how it is calculated and traded off against default fund contributions.
  • In the bilateral world, all aspects of an agreed trade — legal, credit, market and operational risks — are dealt with directly between the two transacting parties. In the cleared world, as many as four additional counterparties are potentially being inserted between the two transacting parties (a SEF, an FCM, a CCP and another FCM). Some of these parties are pure pass-through parties when it comes to risk, but some are not. Worse, one agreement is replaced potentially by a number of agreements, and apart from the increased complexity (always a red flag), there is an increased likelihood that the sum of this process is not comparable to or consistent with the initial contract.
  • In particular, in the bilateral world, counterparty risk is all aggregated in the ISDA Master Agreements between the parties. Considerable effort has been spent to ensure legal enforceability of this agreement (and associated CSA) around the world through the netting and collateral opinions. In the cleared world, this is substituted with a set of agreements involving CCPs and in some cases other parties (FCMs). These agreements, apart from being inconsistent among CCPs, typically only cover a single product. Even in the best case of a single CCP per product (which is clearly not where we are headed), there is a considerable loss of netting efficiency. These agreements are asymmetrical (one way) and it remains to be seen to what extent these agreements are enforceable in a variety of jurisdictions. Worse, because of the above, these transactions are no longer fungible with their bilateral counterparts, giving rising to a host of unexplored risk, legal, accounting and capital considerations. Again, all these factors translate to different quoted prices.
  • Bilateral OTC derivative portfolios are subject to elaborate capital requirements that have evolved. As transactions are moved to CCPs, capital is released but since CCPs are now taking up these risks, they have to put up capital which, in turn, determines clearing charges. Guess what? The methodology proposed for calculating required capital for the CCPs for these trades (the outdated current exposure method) is different from those for bilateral transactions. In fact, the charges are much higher than those prevailing for bilateral trades, acting as a disincentive for clearing as they make it too expensive, but also leading to inconsistent treatment of identical risks.

We’ll stop here as the purpose of this note is meant to be illustrative of the kind of inconsistencies that are emerging. The consequences from such inconsistencies are significant. Given the fact that a fair amount of OTC derivative business will continue to trade bilaterally, even after the clearing mandate is fully in place, inconsistency in practices between the bilateral world and the cleared world is likely to give rise to market fragmentation, lack of fungibility between cleared and uncleared products (with all the consequences for risk management) as well misguided incentives as to where to do business.

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