Does OTC derivatives reform incentivize central clearing?

Regulatory changes in the over-the-counter (OTC) derivatives market seek to reduce systemic risk. The reforms require that standardized derivatives be cleared through central counterparties (CCPs), and they set higher capital and margin requirements for non-centrally cleared derivatives. We investigate whether these requirements create a cost incentive in favor of central clearing, as intended. We compare the total capital and collateral costs when banks transact fully bilaterally and when they clear all contracts through CCPs. We calibrate our model using data on the OTC market collected by the Federal Reserve. We find that the cost incentive may not favor central clearing. The main factors driving the cost comparison are netting benefits, the margin period of risk, and CCP guarantee fund requirements. Lower guarantee fund requirements lower the cost of clearing but make CCPs less resilient.     

Margining in derivatives markets and the stability of the banking sector

We investigate the effects of margining, a widely-used mechanism for attaching collateral to derivatives contracts, on derivatives trading volume, default risk, and on the welfare in the banking sector. First, we develop a stylized banking sector equilibrium model to develop some basic intuition of the effects of margining. We find that a margin requirement can be privately and socially sub-optimal. Subsequently, we extend this model into a dynamic simulation model that captures some of the essential characteristics of over-the-counter derivatives markets. Contrarily to the common belief that margining always reduces default risk, we find that there exist situations in which margining increases default risk, reduces aggregate derivatives’ trading volume, and has an ambiguous effect on welfare in the banking sector. The negative effects of margining are exacerbated during periods of market stress when margin rates are high and collateral is scarce. We also find that central counterparties only lift some of the inefficiencies caused by margining.     

Clearing and Collateral Mandates: A New Liquidity Trap?

All too often, legislative solutions to some financial crisis have serious consequences that are both unwanted and unintended. The author of this article foresees several possible negative consequences arising from Title VII of the Dodd‐Frank Act, which mandates that eligible derivatives be cleared through central counterparties (CCPs) that require initial and variation margin. The new legislation also requires that the remaining non‐cleared derivatives that are traded by some market participants be more heavily collateralized. The Act's authors have argued that derivatives pose uniquely dangerous systemic risks because of the leverage and counterparty risk associated with them. Increased collateralization, their thinking goes, would reduce derivatives‐related leverage and the systemic risk to the financial system associated with such leverage. The author argues that these hopes are unduly optimistic because they fail to recognize how market participants can substitute other forms of leverage, such as bank lines of credit or collateral transformation trades, for the leverage derivatives provided previously. The author also believes that the larger collateral mandates and frequent marking‐to‐market will make the financial system more vulnerable since margin requirements tend to be “pro‐cyclical.” And more rigid collateralization mechanisms can restrict the supply of funding liquidity, and lead to spikes in funding liquidity demand that can reduce the liquidity of traded instruments and generate destabilizing feedback loops. The fragmentation of CCPs across jurisdictions and products will lead to greater demand for CCP‐eligible collateral to maintain the same level of hedging transactions. This demand will likely be met by using riskier assets as collateral and encourage the shadow banking system to create new assets that can be posted as collateral (for example, via collateral transformation services). In sum, although the Dodd‐Frank rules are intended to reduce systemic risk, their expected impact on liquidity makes it a very open question as to whether they will achieve this goal. Although they may reduce some risks, they will simply shift others while possibly creating new ones.     

Credit derivatives, capital requirements and opaque OTC markets

In this paper we study the optimal design of credit derivative contracts when banks have private information about their ability in the loan market and are subject to capital requirements. First, we prove that when banks are subject to a maximum loss capital requirement the optimal signaling contract is a binary credit default basket. Second, we show that if credit derivative markets are opaque then banks cannot commit to terminal-date risk exposure, and therefore the optimal signaling contract is more costly. The above results allow us to discuss the potential implications of different capital adequacy rules for the credit derivative markets.     

Derivatives Clearing Mandates: Cure or Curse?

The Dodd-Frank Act mandates the widespread adoption of centralized clearing of OTC derivatives and also includes measures designed to move more derivatives trading onto exchanges. But, as the author points out, such a clearing mandate appears to be based on the premise that the recent experience in OTC derivatives represents a major market failure and that participants in what is now the world's largest financial market have been systematically choosing the wrong institutions for risk management and trading. In this article, the author begins by explaining why all derivatives are not cleared or exchange-traded, and why the attempt to mandate such practices (as opposed to encouraging voluntary adoption through differential capital requirements) could have serious unwanted consequences. Among such consequences is a possible increase in the very systemic risk that such mandates are supposed to prevent.     

Should Derivatives Be Privileged in Bankruptcy?

Derivatives enjoy special status in bankruptcy: they are exempt from the automatic stay and effectively senior to virtually all other claims. We propose a corporate finance model to assess the effect of these exemptions on a firm's cost of borrowing and incentives to engage in derivative transactions. While derivatives are value‐enhancing risk management tools, seniority for derivatives can lead to inefficiencies: it transfers credit risk to debtholders, even though this risk is borne more efficiently in the derivative market. Seniority for derivatives is efficient only if it provides sufficient cross‐netting benefits to derivative counterparties that provide hedging services.     

An overview of the valuation of collateralized derivative contracts

We consider the valuation of collateralized derivative contracts such as interest rate swaps or forward FX contracts. We allow for posting securities or cash in different currencies. In the latter case, we focus on using overnight index rates on the interbank market. Using time varying haircuts, we provide an intuitive way to derive the basic discounting results, keeping in line with the most standard theoretical and market views. In a number of cases associated with margining with major central counterparties, pricing rules for collateralized trades remain linear, thus the use of (multiple) discount curves. We also show how to deal with partial collateralization, involving haircuts, asymmetric CSA, counterparty risk and funding costs. We therefore intend to provide a unified view. Mathematical or legal details are not dealt with and we privilege financial insights and easy to grasp concepts and tools.     

Handling Weather Related Risks Through the Financial Markets: Considerations of Credit Risk, Basis Risk, and Hedging

The profits of many businesses are strongly affected by weather related events, and insurance against weather related risks (acts of God) has been a traditional domain for transfer of (certain) of these risks. Recent innovations in the capital market have now provided financial instruments to transfer and hedge some of these risks. Unlike insurance solutions, however, using these financial derivative instruments creates a situation in which the return to the purchaser of the instrument is no longer perfectly correlated with the loss experienced. Such a mismatch creates new risks which must be examined and evaluated as part of ascertaining cost effective risk management plans. Two newly engendered risks, basis risk (the risk created by the fact that the return from the financial derivative is a function of weather at a prespecified geographical location which may not be identical to the location of the firm) and credit risk (the risk that the counterparty to the derivative contract may not perform), are analyzed in this article. Using custom tailored derivatives from the over the counter market can decrease basis risk, but increases credit risk. Using standardized exchange traded derivatives decreases credit risk but increases basis risk. Here also the effectiveness of using hedging methods involving forwards and futures having linear payoffs (linear hedging) and methods using derivatives having nonlinear payoffs such as those involving options (nonlinear hedging) for the purpose of hedging basis risk are examined jointly with credit risk.     

The Promise of Credit Derivatives in Nonfinancial Corporations (and Why It's Failed to Materialize)

Although industrial companies played a big part in the growth of foreign exchange, interest rate, and commodity price derivatives, such companies have had almost no role in the growth of credit derivatives. As the authors point out, industrial corporates are exposed to credit risk in a variety of ways, including customer accounts receivable, longer‐term supply contracts, loans to customers and vendors, and counterparty exposures. Credit derivatives, moreover, would allow corporate users to avoid a number of drawbacks associated with other methods for managing credit risk, including credit insurance, factoring, and surety bonds or securitization. But, as both surveys and interviews with credit derivatives dealers suggest, corporates' direct use of credit derivatives has been very limited, accounting for less than 5% of the credit protection purchased using credit derivatives. As the surveys and interviews also indicate, there are a number of reasons why corporates may be reluctant to use credit derivatives: (1) Unlike the cases of interest rate or currency risk, credit risk management is typically the purview of business units rather than the corporate treasury, and the business units tend to have considerably less experience with derivatives. (2) The protection provided by a credit derivative is unlikely to provide a perfect match for the loss that would be suffered by a corporate in the event of a default. (3) The liquidity in credit derivatives tends to be greatest in maturities that are much longer than those of most corporate credit exposures. (4) It is harder for a corporate to determine how much protection to buy than for a financial. (5) While the existing credit derivative documentation (which is based on loans or bonds) works well for banks and investors, it is less satisfactory for the credit risk faced by corporates, which is often based on “payment.” (6) While accounting standards require that credit derivatives be marked to market, the inability of corporates to mark to market their underlying exposure being hedged leads to unwanted volatility of earnings. Nevertheless, as the authors predict in closing, if the corporate demand for credit risk transfer becomes large and urgent enough, these obstacles will likely turn out to be temporary roadblocks.     

Optimal clearing arrangements for financial trades

Clearinghouses support financial trades by keeping records of transactions and by providing liquidity through short-term credit that participants clear periodically. We study efficient clearing arrangements for exchanges, where traders must clear with a clearinghouse, and for over-the-counter (OTC) markets, where traders can clear bilaterally. When clearing is costly, it can be efficient to subsidize OTC clearing by charging a higher clearing price for transactions conducted on exchanges. The clearinghouse then operates across both markets. Since clearinghouses offer credit, intertemporal incentives are needed to ensure settlement. When liquidity costs increase, concerns about default lead to a tightening of liquidity provision.     

Leverage Choice and Credit Spreads when Managers Risk Shift

We model the debt and asset risk choice of a manager with performance‐insensitive pay (cash) and performance‐sensitive pay (stock) to theoretically link compensation structure, leverage, and credit spreads. The model predicts that optimal leverage trades off the tax benefit of debt against the utility cost of ex‐post asset substitution and that credit spreads are increasing in the ratio of cash‐to‐stock. Using a large cross‐section of U.S.‐based corporate credit default swaps (CDS) covering 2001 to 2006, we find a positive association between cash‐to‐stock and CDS rates, and between cash‐to‐stock and leverage ratios.     

Who Transfers Credit Risk? Determinants of the Use of Credit Derivatives by Large US Banks

Abstract

Credit derivatives enable banks to transfer selected credit risks to third parties. An empirical model is developed for the motivation for bank participation in credit derivative markets and, conditional on participation, the factors that determine the volume of business transacted. Participation appears to be closely related to bank size, but there is only limited evidence that entry barriers related to franchise value or past experience in dealing in derivatives are important. There is evidence that banks use credit derivatives as part of their overall risk management strategy. However, the use of credit derivatives does not appear to be influenced by the extent of managerial share ownership.     

The Usefulness of Derivative-related Accounting Disclosures

The Financial Accounting Standards Board attempts to improve reporting and disclosure of derivative transactions through SFAS Nos. 105, 107, and 119. These statements require recognition of gains or losses on trading purpose derivatives, and disclosure of notional principal amounts, credit exposures, and fair values of trading and nontrading derivatives. Using a multiple regression model, this study investigates the relevance of these disclosures to stock returns for a sample of large banks. All derivatives-related disclosures, except for notional principal amounts, are found to contain new information not incorporated in market beta and earnings. These results support the Board's derivative disclosure requirements.     

Deriving value or risk? Determinants and the impact of emerging market banks’ derivative usage

This paper examines the determinants of the emerging market banks’ derivative usage and the impact of derivative usage on bank value, total risk and bank stability. Our empirical evidence first suggests that derivative usage is driven primarily by net interest margin, bank concentration and institutional strength. In addition, although derivative usage appears to reduce emerging market bank value, it does not affect total risk. Moreover, emerging market banks can reduce bank instability using derivatives. Our findings have important implications for investors and policy makers focusing on emerging derivatives markets.     

FINANCIAL INNOVATIONS IN LEVERAGED COMMERCIAL LOAN MARKETS

In the last decade, three innovations in commercial loan-based securities and derivative have enabled institutional investors to access commercial loan markets on leveraged terms : collateralized loan obligations (CLOs); loan-based total return swaps; and leveraged loan-based structured notes (LLSNs). These innovations have been driven by a combination of structural changes in the banking industry, enhanced technology for securitizations, reformed banking regulations, and the advent of credit derivatives.
Besides providing new investment opportunities for institutional investors, these recent innovations in loan markets also promise to reinforce the existing trend in banking away from financial intermediation and toward information intermediation. Such a trend, the authors argue, is helping to ensure the long-run viability of commercial banks. By transforming loan assets in the ways described in this article, banks can generate fee income instead of interest income (thus limiting their capital requirements and interest rate and credit exposures) while still exploiting their comparative advantage in credit analysis and monitoring.     

Bank capital (requirements) and credit supply: Evidence from pillar 2 decisions

We analyze how time-varying bank-specific capital requirements affect bank lending to the non-financial corporate sector as well as banks' balance sheet adjustments. To do so, we relate Pillar 2 capital requirements to a comprehensive corporate credit register coupled with bank and firm balance sheet data. Our analysis consists of three components. First, we investigate how capital requirements affect the supply of bank credit to the corporate sector, both on the intensive and extensive margin, as well as for different types of credit. Subsequently, we document how bank and firm characteristics as well as the monetary policy stance impact the relationship between bank capital requirements and the supply of credit. Finally, we examine how time-varying bank-specific capital requirements affect banks' balance sheet composition.     

Secondary Trading Costs in the Municipal Bond Market

Using new econometric methods, we separately estimate average transaction costs for over 167,000 bonds from a 1‐year sample of all U.S. municipal bond trades. Municipal bond transaction costs decrease with trade size and do not depend significantly on trade frequency. Also, municipal bond trades are substantially more expensive than similar‐sized equity trades. We attribute these results to the lack of bond market price transparency. Additional cross‐sectional analyses show that bond trading costs increase with credit risk, instrument complexity, time to maturity, and time since issuance. Investors, and perhaps ultimately issuers, might benefit if issuers issued simpler bonds.     

The Behavior of Stock Prices Around Institutional Trades

All trades executed by 37 large investment management firms from July 1986 to December 1988 are used to study the price impact and execution cost of the entire sequence (“package”) of trades that we interpret as an order. We find that market impact and trading cost are related to firm capitalization, relative package size, and, most importantly, to the identity of the management firm behind the trade. Money managers with high demands for immediacy tend to be associated with larger market impact.     

Regulatory Soft Interventions in the Chinese Market: Compliance Effects and Impact on Option Market Efficiency

Securities Laws in China are administered by the China Securities Regulatory Commission (CSRC). The CSRC has great flexibility in administering securities laws since the committee represents the will of the state. Under the state‐controlled financial system, the CSRC works closely with state‐controlled financial firms and suggests, but does not mandate, actions to be taken in the equity market, especially during periods of extreme market stress. These suggestions, or soft interventions, have been used to block trades associated with short sales, significantly reducing short‐sales volume. With daily and intraday data, we investigate the impact of these interventions on put‐call parity and implied volatilities. There is overwhelming evidence of increased deviations from put‐call parity and changes in implied volatility after soft interventions. Our results are robust after allowing for bid‐ask spreads, taxes, transaction costs, and difference‐in‐differences comparisons with control securities in the Hong Kong market.