Margin models used by LCH, CME for Rates clearing and the main difference between two is explained shortly and precisely. Most of the CCPs use historical Var simulation with differing parameters to calculate the Max probable loss which equates to margin payment.
Brazil Bovespa came with model completely different which takes into account funding and liquidity risk as well and not just Mtm risk (ie VaR).
The different models
- VaR (5 year, 5 day, 99%)
- SwapClear VaR (10 year, 5 day, ES)
- Eurex “Prisma” cross-product
- Bovespa Core
With the new regulations, clearing is mandatory for OTC derivatives. Not every bank and financial and non-financial institution will become direct member of CCP clearing house because of high fees (default fund fees). So the small banks and financial/non financial participants in OTC market will be looking out and will opt for Clearing Member/Bank who will provide OTC Clearing as service, without the high membership fees.
Ultimately the banks will be looking for clearing members who can help them sail through the regulations, and not let them bother with all the additional rules. They are not looking for price arbitration, or choose a product off the shelf. Clients are buying something that is brand new and they want to know how it works, how the regulatory environment is changing, and how they’ll be affected
Thus Client clearing the new business is born, which is provided by big banks who are direct members of clearing house and who will be providing OTC clearing as service. As of today the market is in its very early stages. There is only probably max 10 firms in Europe who has the capability to provide client clearing service, but this number will grow, how large, depends on the market.
The OTC derivatives market is clearly very big (in trillions or more) and the margin requirements (will be in billions) if have to be met, the required collateral margin acceptable by CCP i.e cash/treasury if has to match with the market size will be very difficult. This will add a very tight squeeze on liquid cash available in the market to the extent that market can no longer function.
This is where the client clearing can come to help. The clearing members can be more lenient than the CCP in terms of acceptable collateral. Also clearing members can theoretically reduce the margin needs by cross netting the cleared and uncleared products. This market is very much still on paper and will be driven by the regulatory needs and the market reaction
The regulations are put on to standardize the OTC markets. The size of market dictates that all the regulations could not be implemented as desired, so either the size of market has to reduce or the market itself should find ways which is the usual case.
Client clearing market can help the OTC market to find a way to implement the regulations and at the same time allow the market to function in its operative ways. Well this is still starting and so wait and watch .
Cross-product margining arrangements
Clearing members could also charge clients less than the CCP’s minimum – an area in which some dealers are hoping to put clear water between themselves and the competition. Although CCPs will break-up offsets between cleared and uncleared products, some dealers promise to continue calculating client margin as though cross-product netting was still achievable.
There could be offsets across cleared products and uncleared products done bilaterally where the clearing broker is also acting as prime broker on bilateral trade. This is possible theoretically and so wait until market dictates the needs.
As the competition heats up over the days, probably there would be difference in the views from European banks and non European (US/Japanese). The European banks are known to conservative in their approach, and US banks may come up with new and interesting products/services.
Collateral for Margin
One more aspect where clearing brokers can help is if the clients dont have the right kind of assets required by CCP to be posted for Initial Margin purposes, probably clearing member can be more lenient, to allow collateral other than cash/government bonds.
CVA risk (Credit Valuation Risk)
What is credit valuation adjustment?
Credit valuation adjustment (CVA) is an adjustment made by a bank to the market value of an OTC derivative contract to take into account credit risk of the counterparty, i.e. the risk that the credit quality of the counterparty deteriorates or that the counterparty in question defaults. As such, in accounting terms, CVA is the “market value” of credit risk.
Why is CVA important
Under the proposed Basel III framework, the capital charge will be enhanced by a new charge, called the Credit Valuation Adjustment (‘CVA’) Risk Capital Charge.
This is a capital charge, whereby the bank is required to hold additional capital when entering an OTC trade. The charge is designed to cover losses arising from the fact that as the counterparty’s financial position worsens, the market value of its derivatives obligation declines, even though there might not necessarily be an actual default.
Trades that are cleared through a central counterparty (‘CCP’) will be collateralized daily, reducing any potential CVA charge, but not completely eliminating.
In a centrally cleared model, counterparty risk is reduced by each end investor facing a clearing broker, that clearing broker then facing the CCP. The exposure that the clearing broker has to the client is identical to the exposure it has to the CCP, effectively
‘passing through’ the client’s counterparty risk to the CCP.
Under current proposals, this structure may be treated as a bilateral trade between the end investor and clearing broker, and a centrally cleared trade between the clearing broker and CCP. The ‘end investor to clearing broker’ leg would attract a higher risk weighted capital charge and the ‘clearing broker to CCP’ leg would attract an additional lower risk weighted capital charge.
The charge for entering into a centrally cleared trade may therefore be higher than a bilateral trade alone, the opposite of the desired effect.
The purpose of this consultation is to gather stakeholders’ views on two specific issues in the area of counterparty credit risk, on which:
– Capitalisation of bank exposures to central counterparties (Section I) and
– Treatment of incurred credit valuation adjustments (Section II)
The EMIR consultation paper below describes the proposed solution and issues if any
The basic premise of ccp central clearing is to “eliminate” the counterparty risk of the individual banks or financial entities participating in the transaction. So on the outset this looks like central clearing should make life easier for credit risk manager
However in reality we are “shifting” the credit risk from banks and non-bank financial entities to CCPs. So instead of eliminating we have created new type of risk CCP Risk concentrated with CCPs
CCPs are not central banks, neither non-profit organisations. CCPs are private-sector, profit making entities operating in competitive environment. The default of CCP is probably almost next to impossible with the kind of controls kept in place, but still there is a possibility and should be considered by credit risk team. So exposures to CCP should be measured and monitored
CCP Exposure Measures
1. Net market value of open positions
2. Initial and variation margins posted to CCP
3. Default fund contributions (funded and unfunded)
Exposure to bilateral counterparty
One important aspect that should be monitored is the the possibility of transaction to be rejected by CCP , in which case the transaction remains bilateral despite the initial intention to clear. If the rejection is because of higher exposure you have against the bilateral party, then the trade cannot be cleared. By adding checks before submitting to CCP novation would be of no help, we cannot back-out of the transaction legally now. The necessary checks should be done in pre-deal or before signing the deal with the bilateral party
Therefore it is a very important step to be added in the operational processes of banks to monitor and ensure the exposures to the different bilateral counter-parties exists under the CCP Limits, even though the trade is novated
CCP Solvency – CDO
Assessment of CCP solvency is compared similar to CDO (Collateral Debt Obligation) problem with several tranches of protection akin to CCP default “waterfall” model
Asset Segregation Models – EMIR regulations and CFTC Regulations are having differing views. It is interesting to see so many variations to the OMNIBus model.