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Key Issues in Derivatives Reform

Rena S. Miller
Analyst in Financial Economics
December 1, 2009

Submitted to :- Prof. Simmi Khurana

Submitted by :- Vikesh Kumar Jha

PG09-118

Summary
Financial derivatives allow users to manage or hedge certain business risks that arise from
volatile commodity prices, interest rates, foreign currencies, and a wide range of other variables.
Derivatives also permit potentially risky speculation on future trends in those rates and prices.
Derivatives markets are very large—measured in the hundreds of trillions of dollars—and they
grew rapidly in the years before the recent financial crisis. The events of the crisis have sparked
calls for fundamental reform.
Derivatives are traded in two kinds of markets: on regulated exchanges and in an unregulated
over-the-counter (OTC) market. During the crisis, the web of risk exposures arising from OTC
derivatives contracts complicated the potential failures of major market participants like Bear
Stearns, Lehman Brothers, and AIG. In deciding whether to provide federal support, regulators
had to consider not only the direct impact of those firms failing, but also the effect of any failure
on their derivatives counterparties. Because OTC derivatives are unregulated, little information
was available about the extent and distribution of possible derivatives-related losses.
The OTC market is dominated by a few dozen large financial institutions who act as dealers.
Before the crisis, the OTC dealer system was viewed as robust, and as a means for dispersing
risk throughout the financial system. The idea that OTC derivatives tend to promote financial
stability has been challenged by the crisis, as many of the major dealers required infusions of
capital from the government. Derivatives reform legislation before Congress would require the
OTC market to adopt some of the practices of the regulated exchange markets, which were able
to cope with financial volatility in 2008 without government aid. A central theme of derivatives
reform is requiring OTC contracts to be cleared by a central counterparty, or derivatives clearing
organization. Clearinghouses remove the credit risk inherent in bilateral OTC contracts by
guaranteeing payment on both sides of derivatives contracts. They impose initial margin (or
collateral) requirements to cover potential losses initially. They further impose variation margin
to cover any additional ongoing potential losses. The purpose of posting margin is to prevent a
build-up of uncovered risk exposures like AIG’s. Proponents of clearing argue that if AIG had
had to post initial margin and variation margin on its trades in credit default swaps, it would
likely have run out of money before its position became a systemic threat that resulted in costly
government intervention. Benefits of mandatory clearing include greater market transparency, as
the clearinghouse monitors, records and usually confirms trades. Clearing may reduce systemic
risk, by mitigating the possibility of nonpayment by counterparties. There are also costs to
clearing. Margin requirements impose cash demands on “end users” of derivatives, such as
nonfinancial firms who used OTC contracts to hedge risk. H.R. 3795, different versions of which
were ordered to be reported by the House Committees on Financial Services and on Agriculture,
and Title VII of the Senate Committee on Banking, Housing and Urban Affairs’ comprehensive
financial reform proposal provide exemptions from mandatory clearing for certain categories of
market participants. If exemptions are too broad, then systemic risks, as well as default risks to
dealers and counterparties, may remain. The bills seek to balance the competing goals of
reducing systemic risk and preserving end users’ ability to hedge risks through derivatives,
without causing those derivatives trades to become too costly. This report analyzes the issues of
derivatives clearing and margin and end users, and it discusses the various legislative approaches
to the enduser issue. This report will be updated as events warrant.
General Background
Derivative contracts are an array of financial instruments with one feature in common: their
value is linked to changes in some underlying variable, such as the price of a physical
commodity, a stock index, or an interest rate. Derivatives contracts—futures contracts, options,
and swaps—gain or lose value as the underlying rates or prices change, even though the holder
may not actually own the underlying asset.
Thousands of firms use derivatives to manage risk. For example, a firm can protect itself against
increases in the price of a commodity that it uses in production by entering into a derivative
contract that will gain value if the price of the commodity rises. A notable instance of this type of
hedging strategy was Southwest Airlines’ derivatives position that allowed it to buy jet fuel at
low fixed price in 2008 when energy prices reached record highs. When used to hedge risk,
derivatives can protect businesses (and sometimes their customers as well) from unfavorable
price shocks. Others use derivatives to seek profits by betting on which way prices will move.
Such speculators provide liquidity to the market—they assume the risks that hedgers wish to
avoid. The combined trading activity of hedgers and speculators provides another public benefit:
price discovery. By incorporating all known information and expectations about future prices,
derivatives markets generate prices that often serve as a reference point for transactions in the
underlying markets. Although derivatives trading had its origins in agriculture, today most
derivatives are linked to financial variables, such as interest rates, foreign exchange, stock prices
and indices, and the creditworthiness of issuers of bonds. The market is measured in the
hundreds of trillions of dollars, and billions of contracts are traded annually.
Derivatives have also played a part in the development of complex financial instruments, such as
bonds backed by pools of other assets. They can be used to create “synthetic” securities—
contracts structured to replicate the returns on individual securities or portfolios of stocks, bonds,
or other derivatives. Although the basic concepts of derivative finance are neither new nor
particularly difficult, much of the most sophisticated financial engineering of the past few
decades has involved the construction of increasingly complex mathematical models of how
markets move and how different financial variables interact. Derivatives trading is often a
primary path through which such research reaches the marketplace.
Since 2000, growth in derivatives markets has been explosive (although the financial crisis has
caused some retrenchment since 2008). Between 2000 and the end of 2008, the volume of
derivatives contracts traded on exchanges, such as futures exchanges, and the notional value of
total contracts traded in the over-the-counter (OTC) market grew by 475% and 522%,
respectively. By contrast, during nearly unprecedented credit and housing booms, the respective
value of corporate bonds and home mortgages outstanding grew by 95% and 115% over the
same period.
Market Structure and Regulation
Although the various types of derivatives are used for the same purposes—avoiding business
risk, or hedging, and taking on risk in search of speculative profits—the instruments are traded
on different types of markets. Futures contracts are traded on exchanges regulated by the
Commodity Futures Trading Commission (CFTC); stock options on exchanges under the
Securities and Exchange Commission (SEC);and swaps (and some options) are traded OTC, and
they are not regulated by anyone.
Exchanges are centralized markets where all the buying interest comes together. Traders who
want to buy, or take a long position, interact with those who want to sell, or go short, and deals
are made and prices reported throughout the day. In the OTC market, contracts are made
bilaterally, typically between a dealer and an end user, and there is generally no requirement that
the price, the terms, or even the existence of the contract be disclosed to a regulator or to the
public. Derivatives can be volatile contracts, and the normal expectation is that there will be big
gains and big losses among traders. As a result, there is a problem of market design. How do the
longs know that the shorts will be able to meet their obligations, and vice versa? A market where
billions of contracts change hands is impossible if all traders must investigate the
creditworthiness of the other trader, or counterparty. The way this credit risk—often called
counterparty risk—is managed is a key element of the current reform proposals.
The exchanges deal with the issue of credit risk through a clearinghouse. Once the trade is made
on the exchange floor (or electronic network), it goes to the clearinghouse, which guarantees
payment to both parties. The process is shown in Figure 1. Traders then do not have to worry
about counterparty default: the clearinghouse stands behind all trades. How does the
clearinghouse ensure that it can meet its obligations?
Clearing depends on a system of margin, or collateral. Before the trade, both the long and short
traders have to deposit an initial margin payment with the clearinghouse to cover potential
losses. Then at the end of each trading day, all contracts are repriced, or “marked to market,” and
all those who have lost money (because prices moved against them) must post additional margin
(called variation or maintenance margin) to cover those losses before the next trading session.
This is known as a margin call: traders must make good on their losses immediately, or their
broker may close out their positions when trading opens the next day. The effect of the margin
system is that no one can build up a large paper loss that could damage the clearinghouse in case
of default: it is certainly possible to lose large amounts of money trading on the futures
exchanges, but only on a “pay as you go” basis.
Figure 1. Derivatives Market Structures: Exchange and Over-the-Counter (OTC)

In the OTC market, as shown in the right side of Figure 1, there is a network of dealers rather
than a centralized marketplace. Firms that act as dealers stand ready to take either long or short
positions, and make money on spreads and fees. The dealer absorbs the credit risk of customer
default, while the customer faces the risk of dealer default. In this kind of market, one would
expect the dealers to be the most solid and creditworthy financial institutions, and in fact the
OTC market that has emerged is dominated by two or three dozen firms—very large institutions
like JP Morgan Chase, Goldman Sachs, Citigroup, and their foreign counterparts. Before 2007,
such firms were generally viewed as too well diversified or too well managed to fail; since 2008,
they are more likely considered too big to be allowed to fail. In the OTC market, some contracts
require collateral or margin, but not all. There is no standard practice: all contract terms are
negotiable. A trade group, the International Swaps and Derivatives Association (ISDA) publishes
best practice standards for use of collateral, but compliance is voluntary.
The terms “collateral” and “margin” are similar—both are forms of a down payment against
potential losses to guard against a counterparty’s nonpayment—but technically they are not
interchangeable. A margining agreement requires that cash or very liquid securities be deposited
immediately with the counterparty. After this initial deposit, margin accounts are marked to
market, usually daily. In the event of default, the counterparty holding the margin can liquidate
the margin account. By contrast, collateral arrangements usually require the counterparty to
perfect a lien against the collateral.6 The range of assets allowable under a collateral agreement
is usually wider than what is allowed under margining arrangements. Settlement of collateral
shortfalls tends to be less frequent than under margining arrangements.
Because there is no universal, mandatory system of margin, large uncollateralized losses can
build up in the OTC market. The best-known example in the crisis was AIG, which wrote about
$1.8 trillion worth of credit default swaps guaranteeing payment if certain mortgage-backed
securities defaulted or experienced other “credit events.” Many of AIG’s contracts did require it
to post collateral as the credit quality of the underlying securities (or AIG’s own credit rating)
deteriorated, but AIG did not post initial margin, as this was deemed unnecessary because of the
firm’s triple-A rating. As the subprime crisis worsened, AIG was subjected to margin calls that it
could not meet. To avert bankruptcy, with the risk of global financial chaos, the Federal Reserve
and the Treasury put tens of billions of dollars into AIG, the bulk of which went to its derivatives
counterparties.

Derivatives Reform
The AIG case illustrates two aspects of OTC markets that are central to derivatives reform
proposals. First, as noted above, AIG was able to amass an OTC derivatives position so large
that it threatened to destabilize the entire financial system when the firm suffered unexpected
losses and the risks of default to AIG derivatives counterparties grew. In a market with
mandatory clearing and margin, in which AIG would have been required to post initial margin to
cover potential losses, there is a stronger possibility that AIG would have run out of money long
before the size of its position reached $1.8 trillion.
Second, because OTC contracts are not reported to regulators, the Fed and the Treasury lacked
information about which institutions were exposed to AIG, and the size of those exposures.
Uncertainty among market participants about the size and distribution of potential derivatives
losses flowing from the failure of a major dealer was a factor that exacerbated the “freezing” of
credit markets during the peaks of the crisis, and made banks unwilling to lend to each other.
A basic theme in the derivatives reform proposals before the 111th Congress is to get the OTC
market to act more like the exchange market—in particular, to have bilateral OTC swaps cleared
by a third-party clearing organization. There are some widely recognized benefits to clearing:
• Reduction of counterparty risk—collateral or margin collected by the clearinghouse prevents
risk build-ups that could trigger systemic disruptions, and
• Transparency—because information on trades and positions is centralized in the clearinghouse,
regulators will know who owes what to whom, improving the ability to respond to a crisis. In
addition, as price information becomes public, dealer spreads should narrow, reducing the costs
of hedging and other transactions. At the same time, there are costs associated with a clearing
regime that requires all participants to post margin. Firms that use derivatives to hedge business
risks take positions that move in the opposite direction to the underlying market. In the example
of Southwest Airlines, imagine that energy prices had dropped sharply, instead of rising as they
actually did. The reduced fuel costs would have been good for the airline’s bottom line, but its
derivatives position would have lost money, and had the contracts been cleared, it would have
had to post margin to cover those losses. Such losses would not threaten the firm’s solvency,
because it would still be effectively paying a price for fuel that allowed it to operate at a profit.
However, the margin demands could have created liquidity problems. In the current debate, “end
users” of OTC derivatives argue that the costs of posting margin may prevent them from
hedging, leaving them exposed to greater business risks.

End Users
The derivatives proposals put forward by the Obama Administration, the House Committees on
Agriculture and Financial Services, and the Senate Banking Committee all include exemptions
from clearing requirements intended to avoid placing burdensome costs on end users of
derivatives. End user is not a term defined in statute. In general, it refers to any OTC derivatives
counterparty that is not a dealer, although in the current debate it sometimes appears to refer
primarily to nonfinancial firms that use derivatives to hedge the risks of their businesses. How
much of the OTC market do they account for?

Figure 2. OTC Swap Counterparties

June 2009
non financial services
10%

financial institutions dealers

56% 34%

Source: Bank for International Settlements.

Notes: Includes OTC interest rate, foreign currency, and equity contracts

The Bank for International Settlements publishes data on counterparties in several OTC markets.
As of June 2009, 34% of OTC contracts were between reporting dealers, 56% were between
dealers and other financial institutions, and the remaining 10% involved dealers and nonfinancial
entities (see Figure 2). Thus, nearly two-thirds of OTC derivatives involve an end user. If all end
users are exempted from the requirement that OTC swaps be cleared, the market structure
problems raised by AIG still remain. That is, if individual dealer firms that retain large amounts
of credit risk get into trouble, the government will continue to face an unsatisfactory choice:
allow the dealer to fail, and risk panic and cascading failures among interconnected dealers and
counterparties, or provide a taxpayer bailout, with the undesirable consequence of reducing
incentives for private parties to manage risk prudently. Derivatives reform legislation seeks to
strike a balance. Although the primary goal is to eliminate the problem of derivatives dealers that
are too big or too interconnected to fail, the bills provide exemptions for end users whose
derivatives positions are intended to hedge business risk and who are not thought to pose
systemic risk. The bills differ in the way they define classes of market participants who are to be
subject to the mandatory clearing requirement (as well as other forms of regulation) and in the
way the exemptions are structured.

Safeguards Applicable to Uncleared OTC Swaps

If end-user exemptions are too broad, some portion of the systemic risks posed by the
unregulated OTC markets will remain. In recognition of this, the bills provide additional
safeguards against the impact of defaults by traders (or dealers) in uncleared swaps. One such
safeguard was mentioned above—swap dealers and MSPs will be subject to capital requirements
to cushion them against the impact of derivatives losses. Another has to do with the imposition
of margin requirements on uncleared contracts.
The bills direct the regulators to impose initial and variation margin requirements on contracts
that are not cleared through a derivatives clearing organization. Again, a range of exemptions
would apply to certain end users:
• Under the House Financial Services bill, imposition of such margin requirements is optional for
swaps when one of the counterparties is not a swap dealer or an MSP. Any such requirements
must provide for use of noncash collateral.
• Under the House Agriculture Committee bill, there is no explicit authority to impose margin
requirements on swaps with end users.
• The Senate Banking Committee proposal permits regulators to exempt uncleared swaps from
margin if one of the counterparties is not a swap dealer or an MSP, using the swap as a hedge in
accordance with generally-accepted accounting principles (GAAP), and predominantly engaged
in nonfinancial activities. Such exemptions would require the additional approval of the systemic
risk regulatory agency. Regulators may permit the use of noncash collateral, if consistent with
swap market integrity and financial system stability.

Author Contact Information

Rena S. Miller
Analyst in Financial Economics
[email protected], 7-0826