The OTC derivatives market has been hit by a massive wave of regulatory change. Capital and margin requirements have increased, trade reporting has been mandated, and execution mechanisms are evolving. Most of all, central clearing is being imposed for many transactions. OTC Derivatives: Bilateral Trading and Central Clearing explains the new rules and the new models. It discusses the traditional bilateral market, then sets out how this will change due to mandatory central clearing and the new ways in which OTC derivatives will have to be traded, reported, and processed. The risks of OTC derivatives clearing houses are discussed in detail, as are the protections that CCPs have against these risks. The book also looks at alternatives to some of the policy decisions that have been made, showing the balance between costs and benefits of various different approaches to derivatives market stability. The book is both a detailed primer on OTC derivatives clearing and a powerful insight into post-crisis financial regulation. Key features of the book include: • A discussion of the capital rules for OTC derivatives counterparty credit risk in Basel III; • An account of OTC derivatives trade processing in both bilateral and cleared markets; • A detailed account of the risk profile of OTC derivatives CCPs; • An explanation of the risks run in various collateral segregation models; and • A comparison of various macro-prudential tools for enhancing the financial stability of OTC derivatives markets.

After the credit crisis, supervisors enacted a range of financial reforms. In particular, they radically changed the nature of the OTC derivatives market via a number of measures, notably mandatory central clearing. This book discusses the market before the crisis, explains what central clearing is, and outlines the consequences of the new rules.

Practical guidance toward handling the latest changes to the OTC derivatives market Central Counterparties is a practical guide to central clearing and bilateral margin requirements, from one of the industry's most influential credit practitioners. With up-to-date information on the latest regulations imposed after the global financial crisis, this book covers the mechanics of the clearing process and analyses the resulting consequences. Detailed discussion explains the ways in which the very significant clearing and margining rules will affect the OTC derivatives market and the financial markets in general, with practical guidance toward implementation and how to handle the potential consequences. Over-the-counter derivatives were blamed by many for playing a major role in the 2007 financial crisis, resulting in a significant attention and dramatic action by policymakers, politicians, and regulators to reduce counterparty credit risk which was seen as a major issue in the crisis. The two most important regulatory changes are the mandatory clearing of standardised OTC derivatives, and the requirements for bilateral margin posting in non-standard OTC contracts. Central Counterparties is a complete reference guide to navigating these changes, providing clarification and practical advice. Review the mitigation of counterparty credit risk with the historical development of central clearing Clarify the latest regulatory requirements imposed by Dodd-Frank, EMIR, Basel III and more Learn the mechanics of central clearing, with special attention to complex issues such as margin calculations, the loss waterfall, client clearing and regulatory capital rules Gain insight into the advantages and disadvantages of clearing and bilateral margin requirements, and the potential issues that arise As the clearing and margining mandates are phased in, the associated costs will be severe enough to dramatically shift the topology of the financial markets and transform the nature of risk. Central Counterparties provides the information, clarification and expert insight market practitioners need to get up to speed quickly.

To mitigate systemic risk, some regulators have advocated the greater use of centralized counterparties (CCPs) to clear Over-The-Counter (OTC) derivatives trades. Regulators should be cognizant that large banks active in the OTC derivatives market do not hold collateral against all the positions in their trading book and the paper proves an estimate of this under-collateralization. Whatever collateral is held by banks is allowed to be rehypothecated (or re-used) to others. Since CCPs would require all positions to have collateral against them, off-loading a significant portion of OTC derivatives transactions to central counterparties (CCPs) would require large increases in posted collateral, possibly requiring large banks to raise more capital. These costs suggest that most large banks will be reluctant to offload their positions to CCPs, and the paper proposes an appropriate capital levy on remaining positions to encourage the transition.

The financial crisis of 2007–2009 exposed the weaknesses of the global over-the-counter (OTC) derivatives market such as limited transparency regarding risk exposures, poor counterparty risk management practices, and the risk of contagion arising from interconnectedness in this market. In the aftermath of the financial crisis, regulators introduced worldwide legislative and regulatory changes aimed at increasing the transparency and stability of the financial markets. In this book, Dr. Olga Lewandowska explores those novel regulatory solutions and their impact. The main focus is on central counterparty (CCP) clearing that became mandatory for OTC derivatives under the new regulatory paradigm. In four research papers, she analyzes CCP from different risk perspectives and based on four diverse research methods. Her book offers a comprehensive assessment of the risk-reduction potential of the CCPs, their implications for the financial markets, and the practical challenges in the implementation of the recent financial market reforms.

The reform program for the over-the-counter (OTC) derivatives market launched by the G-20 nations in 2009 seeks to reduce systemic risk from OTC derivatives. The reforms require that standardized OTC derivatives be cleared through central counterparties (CCPs), and they set higher capital and margin requirements for non-centrally cleared derivatives. Our objective is to gauge whether the higher capital and margin requirements adopted for bilateral contracts create a cost incentive in favor of central clearing, as intended. We introduce a model of OTC clearing to compare the total capital and collateral costs when banks transact fully bilaterally versus the capital and collateral costs when banks clear fully through CCPs. Our model and its calibration scheme are designed to use data collected by the Federal Reserve System on OTC derivatives at large bank holding companies. We find that the main factors driving the cost comparison are (i) the netting benefits achieved through bilateral and central clearing; (ii) the margin period of risk used to set initial margin and capital requirements; and (iii) the level of CCP guarantee fund requirements. Our results show that the cost comparison does not necessarily favor central clearing and, when it does, the incentive may be driven by questionable differences in CCPs' default waterfall resources. We also discuss the broader implications of these tradeoffs for OTC derivatives reform.

New regulatory data reveal extensive price discrimination against non-financial clients in the FX derivatives market. The client at the 90th percentile pays an effective spread of 0.5%, while the bottom quarter incur transaction costs of less than 0.02%. Consistent with models of search frictions in over-the-counter markets, dealers charge higher spreads to less sophisticated clients. However, price discrimination is eliminated when clients trade through multi-dealer request-for-quote platforms. We also document that dealers extract rents from captive clients and market opacity, but only for contracts negotiated bilaterally with unsophisticated clients.