The synthesizing of custom financial contracts and securities is for financial services what the assembly-line process is for the
manufacturing sector. Options, futures and other exchange-traded securities are the raw “inputs” applied in prescribed combinations over time to create portfolios that hedge the various customer liabilities of financial intermediaries.
—Robert C. Merton (1992)
B
anks, derivative dealers, and other financial institutions that engage in a high volume of transactions with each other take on credit risks in the course of their daily interactions. Clearinghouse, exchanges, and derivative contracts are structural means of mitigating theses risks.Although derivatives have attracted a great deal of public attention in the last two decades, they are not a new phenomenon. For many years, traders have bought and sold pieces of paper representing pork bellies, corn, gold, or oil rather than buying and selling the commodities themselves.1 Whenever a standard unit of trade can be established, an instrument can be created to reflect this basic transaction. Derivatives are easier to deal with than the physical goods. While most futures contracts are closed out in cash before the maturity date, on occasion goods are actually delivered in accordance with the terms of the contract.
It is financial derivatives, which represent rights or options in a variety of financial instruments, that have made headlines in recent years. The overall
69
70 MANAGING CREDIT RISK
- 5,000 10,000 15,000 20,000 25,000
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Credit Derivatives
- 50,000 100,000 150,000 200,000 250,000 300,000 350,000
Interest Rate Derivatives
Credit Derivatives Interest Rate Derivatives Amounts in billions of dollars
F I G U R E 5 . 1 Growth in Financial Derivatives
Source:British Bankers Association (2006) and ISDA Market Survey (2007).
volume of trading in financial derivatives has increased from$618.3 billion in 1986 to over$285 trillion in 2006 (see Figure 5.1). The growth of interest rate derivatives has been high for some time now; more recently credit derivative growth has also started to accelerate, although still from a much lower base.
This explosive growth has created substantial risks of several kinds:
counterparty risk, settlement risk, and systemic risk, to name a few. Someone buying a stock option from a dealer depends upon the dealer to make good on what it has sold. At the same time, the seller depends upon the buyer to make the payment agreed upon.
Derivative dealers are specially organized companies that are typically affiliated with a commercial bank, or more recently, one of the megabanks.
A sizable portion of their business involves trades with other dealers. As a result, in addition to having exposure to the credit risk of their customers, these organizations are also exposed to the credit risk of other dealers.
Since the total number of dealers is limited, these risks may become quite concentrated.
When the financial derivatives market was in its infancy, dealers knew one another and felt comfortable that there was little risk of nonperfor- mance. Growth in the derivatives markets, concentrations in the bank- ing market because of consolidations, and the rapid demise of a series of major trading institutions such as Barings, Enron, and Long-Term Capi- tal Management (LTCM) have combined to create sharper awareness of
Structural Hubs 71 counterparty risk. Market participants who trade over-the-counter deriva- tives such as swaps, options, swaptions, caps, and collars are increasingly concerned about managing these risks. Indeed, the management of such counterparty risk is one of the major themes of the financial markets for the past two decades.
E X C H A N G E S
An exchange is an institutional means of reducing counterparty risk. As trad- ing has expanded in size and scope, more of that trading has been done on exchanges. The reason for this is that the exchange can set standards for par- ticipation and monitor the ongoing creditworthiness of its customers. In fact, smaller participants typically do not participate directly on the exchange but mostly through larger participants usually subsidiaries of the banks, invest- ment banks, and megabanks. Listing on an exchange—whether stock, bond, options, futures, metals, chemical, oil, and so on helps to create liquidity in the listed instrument and is one of the key factors in the huge increase in trading we have seen in recent years.
Anyone buying a contract on a futures exchange—whether an individ- ual or an institution—is required to put up margin. Because the buyer has posted margin, the seller knows that money will be available to pay for the contract. Since the seller is likewise obliged to post margin, the buyer has the same assurance about receiving the purchased goods or their monetary equivalent. The margin requirement effectively eliminates most counterparty risk between buyer and seller. The only remaining credit risk is for very short term—intraday or overnight movements in the traded instrument—where the counterparty may not be able to make the next margin call. When this oc- curs, a player relinquishes any rights to margin or to the underlying contract.
The margin requirement allows small players such as individual investors or small investment firms to trade on an equal basis with the megabanks. Many participants consider this equality of access one of the great advantages of an exchange. Another advantage of an exchange is that it standardizes the terms of contracts, thereby reducing the transaction costs.
While the calculation of margin requirements and the posting of collat- eral seem like relatively simple administrative functions, when this needs to be done thousands, even millions of times daily, a focused and specialized organizational response is required. For this reason, all major exchanges have established dedicated clearinghouses to manage these functions.
Many investment banks are joining forces to create private exchanges (typically calledtrading systems) in which private placements can take place.
This would allow the trading of unregistered U.S. securities. The advantage
72 MANAGING CREDIT RISK of such system could be phenomenal for companies outside the United States.
Many international companies view the current system as cumbersome and intrusive. An unregistered electronic exchange could be quite attractive to such companies allowing access to the financial markets in North America avoiding the need to deal with the SEC regulations.
C L E A R I N G H O U S E S
Clearinghouses are the major credit managers of the capital markets. They exist to manage the counterparty risk between institutions that do a lot of business with each other. They position themselves between buyer and seller, thereby guaranteeing that the trade will be completed. Clearinghouses set standards for membership in the clearinghouse (which can be more strin- gent than membership in the exchange), approve new members, set margin requirements that reflect the volatility of the traded instrument, and care- fully monitor the creditworthiness of the institutional players. They have massive trading systems that allow them to process every trade done on the exchange, record the buyer and seller, and book the required margin. For the major clearinghouses in the United States and Europe, this means millions of trades every day. The clearinghouses also are big players in the short -term investment markets as they have huge sums to invest on an overnight basis.
This system has been very effective in virtually eliminating credit risk from the exchange-traded markets.
Banks have also used clearinghouses to manage risk between them. New York banks, for example formed a clearinghouse to clear checks and other obligations they have to one another. Instead of exchanging millions of bits of paper and billions of dollars in cash, the banks use a clearinghouse as a central place to meet and sort out their transactions electronically as shown in Figure 5.2.
An associated clearinghouse is an important component of an exchange.
It can be a dedicated clearinghouse or one that serves a variety of markets.
LCH.Clearnet Group Limited is the prime example of ahorizontal model clearinghouse,which handles most of the trading activities in London, Paris, and several other European financial centers. As can be seen in Figure 5.2, LCH.Clearnet clears a wide variety of markets and instruments including equities, derivatives of all types, swaps and commodities, and energy. Institu- tionally, the credit risk of LCH.Clearnet substitutes for the credit risks of the multiple counterparties transacting business on the various exchanges listed in the Figure 5.2. Every trade executed on one of these exchanges spawns two trades: one between the buyer and LCH.Clearnet and the other between LCH.Clearnet and the seller. At the end of the day, LCH.Clearnet has a
Structural Hubs 73
> Euronext
> London Stock
> Exchange
> virt-x
> Euronext.liffe
> EDX London
> ICAP Electronic
Broking
> prebon.net
> eSpeed
> ETCMS
> MTS
> VIEL & Cie
Prominnofi
> SwapsWire
> SWIFTNet
Accord
> Euronext.liffe
> ICE
> ICE Futures
> Prowernext
> Energy &
Freight Brokers
> London Metal
> Exchange
Securities
Exchange-Traded Financial &
Equity Derivatives
Fixed
Income Swaps
Commodities
&
Energy
L C H . CL E A R N E T
> Euroclear UK &
Ireland Ltd
> Euroclear Belgium
> Euroclear France
> Euroclear NL
> Euroclear Bank
> SIS
> Clearstream
International
> Clearstream
Frankfurt
> VPS
> NCSD
> Interbolsa
> Monte Titoli
> VP -
Vaerdepapincentralen
> Banque Nationale
de Belgique
> Commodities
> Cash
> DTCC
F I G U R E 5 . 2 Example of a Horizontal Model Clearinghouse Source:London Clearinghouse (2007).
perfectly matched book of contracts and thus incurs no market risk. How- ever, LCH.Clearnet is now exposed to the risk of their clearing members, who in turn are exposed to the counterparty risk of their own customers.
Figures 5.3 and 5.4 illustrate how a clearinghouse provides a structural hedge for a member.
Figure 5.3 depicts of the operation of the trading in the absence of the clearinghouse. Dealer A is long two contracts with dealers B and F, and short two contracts with dealers C and E. Because the short positions exactly offset the long positions, dealer A is market neutral, that is, immune to changes in the market value of the positions. But dealer A is exposed to the credit risk of either B and C or E and F because one of these pairs will owe money to A if there is a market move up or down. In Figure 5.4, dealer A is again in market neutral, but a clearinghouse has been interposed between A and the other dealers. In this case, the clearinghouse assumes the credit risk of the counterparties: If the market moves against B and C,
74 MANAGING CREDIT RISK
Dealer B 1 Long
Dealer C 1 Long
Dealer F 1 Short
Dealer E 1 Short Dealer
2 Long 2 Short
Dealer A is exposed to position risk from either
B & C or E & F
F I G U R E 5 . 3 Exposure without a Clearinghouse
Dealer B 1 Long
Dealer C 1 Long
Dealer F 1 Short
Dealer E 1 Short Dealer
2 Long 2 Short
Dealer A is unaffected by market moves.
The clearinghouse assumes the position risk.
Dealer F 1 Short
F I G U R E 5 . 4 Exposure with the Clearinghouse
Structural Hubs 75 the clearinghouse covers the position as far as A is concerned. By serving as a hub, the clearinghouse eliminated the crisscrossing of credit exposure between every dealer and every other dealer. Since the exposure of the clearinghouse to each dealer is net of that dealer’s long and short positions in an instrument, the existence of the clearinghouse enlarges the liquidity of the market—enabling dealers to execute trades in greater number and dollar volume. Since the clearinghouse monitors the credit of each dealer and sets standards for their participation in the system, the dealers themselves no longer need to monitor one another. This is a more efficient arrangement.
N E T T I N G , C O L L A T E R A L , A N D D O W N G R A D E T R I G G E R S
Netting—the practice of setting off payments in one direction against those in the opposite directions—is the primary risk management technique of a clearinghouse or exchange. Netting enables market participants to get an accurate view of their exposure to other players. In reality, the flows between particular institutions are not even. Most players are comfortable accepting each other’s credit up to a certain point, but beyond this limit, they want some form of reassurance before they will engage in further business.
Reassurance typically comes in the form of collateral. If dealer A is uncomfortable when its exposure to dealer B exceeds a given threshold, dealer A may ask dealer B is post collateral as a condition for continuing to trade together. Under some circumstance, dealer B’s collateral will remain at dealer A on a permanent basis. Dealer B may also insist on collateral from dealer A. Collateralization has become a major part of derivatives trading, both on exchanges and over-the-counter markets.
The collateral requirement creates a kind of handicapping system that effectively sets limits for trading. Clearinghouses and exchanges provide the recordkeeping needed to track and mitigate counterparty risk through collateralization.
Since the value of derivatives may be highly volatile, time is a critical aspect of counterparty risk. Exchanges and clearinghouse require partici- pants to mark their portfolios to market, using the market price at the close of the business day to determine the value of each instrument they hold. In this way, margins and collateral can be adjusted on a daily basis. In recent years, in high-volume markets, this requirement has been increased to be intraday, with margin calls being made two to three times during the trad- ing day. Knowing the value of an instrument on any given day, or part of a day focuses both buyer and seller on their responsibilities to one another.
In addition, clearinghouses and exchanges have membership requirements
76 MANAGING CREDIT RISK including minimum capital, surety bonds, credit surveillance, and monitor- ing of members.
Clearinghouses also invest in huge processing systems to assure high reliability and to support massive volumes of trades. They develop pro- cedures to deal with default by a member and with market emergencies, and establish financial resources to withstand stresses from major disruptive events. They maintain relationships with regulatory bodies (who generally view them as critical components of the capital markets) and may arrange for government support in times of financial distress. They create systemic linkages with other clearinghouse to manage the risk exposures connect with them. Should their resources be depleted as a result of losses sustained, some clearinghouses have the power to impose an assessment on their members.
Time can affect counterparty’s creditworthiness. That is why structural hedgers make use of downgrade triggers. A contract between dealers typi- cally specifies that if the credit of one party is downgraded beyond a certain point, that party must post collateral in order to continue trading. This as- sures other players that money will be available to satisfy the downgraded company’s obligations.
The combination of these structural hedges—netting, margins, collater- alization, marking to market, and downgrade triggers with good old fashion close surveillance—has proven to be highly effective. The record at clear- inghouses and among dealers has been outstanding: The megabanks, clear- inghouses, and exchanges have all lost very little money because of their exposure to credit risk related to trading activities. And some very large bul- lets have been dodged in recent years—Barings, LTCM, Enron, Worldcom, Parmalat, and Amaranth are recent examples of high-volume, high-profile disasters that did not result in credit losses at clearinghouses in the United States or Europe. Even where many small players are involved, clearing- houses and exchanges have seen very few losses attributable to credit risk.
C R E D I T D E R I V A T I V E P R O D U C T C O M P A N I E S
Credit derivatives have not yet become exchange traded. Nor have any clearinghouses been created for these instruments. However, without doubt the credit derivative market has been the most innovative sector within the financial markets. The bespoke nature of the contracts, the length of the contracts and several other factors have made stymied efforts to trade credit derivatives on exchanges or to clear the trades using clearinghouses. Still the amount of credit being transferred by dealers in an increasing number of products is huge and is increasing rapidly. These products tend to be complex and there has been some difficulty finding investors whose interests
Structural Hubs 77 and mentality is to “buy and hold” the risk over the period of the transaction.
Today, when the markets create opportunities, it is not long before we see an innovation focused on what is needed. Credit derivative product companies(CDCPs) are relatively new and as yet niche segment within the credit derivatives space.
While CDCPs will use some of the structural hedging tools developed elsewhere in the marketplace, they are somewhat different breed. They may hedge their exposures, but they are a typically taking a long position in the credit. Since they are providing protection to the major dealers, they will normally have a triple-A rating from the rating agencies and will need to keep their ratings at this level. The protection they provide is executed in a swap format using international Swaps and Derivative Association (ISDA) documentation.
Thederivative product company (DPC) concept is not a new one. In- deed, DPCs can trace their origins back to the early 1990s, the focus back then was on interest rate and currency swaps. At that time, DPCs were de- veloped a means for lower-rated banks to increase their swaps positions.
As the banks improved their creditworthiness and more trading moved into clearinghouses, it seemed that the time for DPCs had passed. In 2002, how- ever, the technology was applied to credit derivatives for the first time with the launch of Primus Financial Products LLC. Since then, only four more vehicles have been launched, two of which started in 2007. Nevertheless, the concept seems to have caught on—in January 2007 Moody’s stated that it was in the process of rating 24 new CDCPs.
L I M I T A T I O N S O F S T R U C T U R A L H U B S
There are significant limitations on the application of structural hedging techniques. To begin with, they require the existence of a market sufficiently large and liquid that the value of items in every player’s portfolio can be marked to market. Prices are posted daily for corn and silver, for example, but not for corporate loans. Banks, in fact, generally resist proposals to mark their loans to market because it would make holding them in their portfolio difficult and expose their income statements to a lot of volatility. To a degree, the credit derivative market is making this issue less relevant, since prices for most big corporate names are readily available in the derivative markets. But even if the credit derivative market has provided more information, prices are still somewhat unrelated to what a loan could be purchased for in the cash markets.
In addition, netting is meaningful only where there is two-way flow between parties, in the loan market, where the bank is always the lender;
78 MANAGING CREDIT RISK netting may be relevant only to the limited extent where there is a right of offset. Some degree of netting might become possible where a company has money on deposit at the same bank from which it has taken a loan.
However, the situation is inherently more complicated than that between two derivatives settling trades with one another.
Structural hubs are inflexible systems that work best for standardized products that are traded in volume. Consequently, they will probably grow in importance as the markets mature. For some less-common types of deriva- tives, for example, these techniques may turn out to be more trouble than they are worth. In addition, transparency is critical to the establishment of clearinghouses or exchanges: Every aspect of a transaction must be per- fectly visible to regulators and other players. Transparency quickly leads to commodity-like pricing and a focus on cost efficiencies.
Clearinghouses and exchanges are complex organizations that cannot be developed overnight. It is only when concerns about credit risk exceeding a fairly high threshold that the establishment of such an institution becomes feasible. However, once an exchange has been created, it is comparatively easy to add new products and new types of players. That is why a number of futures exchanges have expanded in recent years.
Structural hubs are powerful techniques with a proven record of success.
In all probability, the coming years will see them applied to many areas where they have never been used before. As Merton (1992) notes, structural hubs are the key element in the construction of special purpose, risk-management structures out of general-purpose components. Recently we have seen this applied with CDPCs in the credit derivatives markets. We will undoubtedly see more in the future.
R E F E R E N C E S
Akorecki, A., and F. Guerrera. 2003. “Clearing House Shake-Up Proposed.”Finan- cial Times, 3 April.
Barrett, R., and J. Ewan. 2006.Credit Derivatives Report 2006. London: British Bankers Association.
Bliss, R., and C. Papathanassiou. 2006, 8 March.Derivatives Clearing, Central Counterparties and Novation: The Economic Implications. Frankfurt am Main:
European Central Bank.
Cameron, D. 2006. “Investors ‘Miss Importanace of Clearing System’.”Financial Times, 29 November.
Cohen, N. 2007. “UK Treasury Signs Up for Clearing House Membership.”Financial Times, 29 March.
The Economist. 2000. “One World, Ready or Not,”18 May.
———. 2000. “European Stock Exchanges: The X Files.” 13 July.