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Regulating Financial Derivatives

Clearing and Central Counterparties

Alexandra G. Balmer

This book puts forward a holistic approach to post-crisis derivatives regulation, providing insight into how new regulation has dealt with the risk that OTC derivatives pose to financial stability. It discusses the implications that post crisis regulation has had on central counterparties and the risk associated with clearing of OTC derivatives. The author offers a novel solution to tackle the potential negative externalities from the failure of a central counterparty and identifies potential new risks arising from post crisis reforms.
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Index

Alexandra G. Balmer

accountability 76, 192

adverse selection 55, 151, 165–6, 195, 203

information asymmetry and 168, 169, 172–5, 200, 202

AIG 28–9, 32, 33–4, 37, 153, 167, 198

AIG Financial Products (AIGFP) 33, 34

arbitrage 20

regulatory 52, 78, 82, 86, 90, 109, 121–2, 132, 146, 148, 183, 205, 206

Aristotle 15

asymmetry, information 55, 168, 172, 176, 177

adverse selection and 168, 169, 172–5, 200, 202

CCP resolution plan 138

bail-outs 33, 34, 35, 36, 37, 70, 143–4, 153, 163, 167, 189, 192, 196, 198, 201

Bank of England 180

Bank for International Settlements (BIS) 78

bank(s) 115–16, 147, 148, 166, 171, 177

central see separate entry

clearing members 44, 55, 156, 184

clearinghouses 57, 60

collateral demand 161

deposit guarantee schemes 193

fair market value 174

financial crisis (2007–2009) 31, 33, 178

licence 101, 150

linkage risk 184, 185–6

Barings Bank 34–5

Basel Committee on Banking Supervision (BCBS) 65, 71, 82

Basel II 31

Basel III 161

margin requirements 52

Bear Stearns 33

Black Monday (19 October 1987) 179

Bloomberg 67

Born, Brooksley 70, 199

Bretton Woods System 66–7

Brexit 144–7, 148, 149

Buffett, Warren 2

Bush, George W. 76

Caisse de Liquidation (Paris) 172

call options 25

capital reserves 31, 34

CCP default fund 191–3, 196, 205, 206

benefits 193

possible implementation 194–5

central banks 75–6, 84, 102, 119–20, 135, 137, 138, 142, 143, 177, 190–191, 202, 206

Bank of England 180

European System of (ESCB) 101, 105, 135, 177–8, 200

Federal Reserve 31, 34, 35

central securities depositories (CSDs) 80–81

Chicago Board of Trade (CBOT) 58

Clearing Corporation 58–9

Chicago Eggs and Butter Board (later Chicago Mercantile Exchange) 59, 122

Chicago’s International Monetary Market 67

clearing 38–64, 148–51, 205, 206

auctions 47, 53, 55–6, 62, 74, 117

central counterparty or clearinghouse 38–41

collateral collection 47–53, 63, 186, 188, 200, 202–3, 205

default fund 51, 53, 54–5, 59, 62, 64, 102, 104, 114, 144, 162, 163–4, 170, 178, 184, 190, 196, 198, 199, 201, 202, 203, 205

EU reform 101–5, 120, 122, 128, 131, 144, 203

initial margin 48, 49, 51, 54, 59, 63–4, 101–2, 158, 162, 178, 185, 199, 202, 205

margin and derivatives 51–3

segregation 48–9, 54, 102, 128

US reform 115, 122

variation margin 46, 48, 49–50, 53, 54, 59, 63–4, 144, 158, 162, 178, 184–5, 199, 202, 205

default resolution 53–6

waterfall mechanism 54–5, 103–4, 164, 190, 202

definition 39–40

financial stability see clearing and financial stability

for-profit CCPs 61, 164, 172, 179–83, 200

international reform agenda 77, 80–81, 82, 83–4, 86

clearing eligibility 78–80, 85

LCH.Clearnet (LCH) 36, 37, 40, 54, 61–3, 150–151, 164, 195, 198, 199

Brexit 145–6, 147

margins 178, 203, 205

SwapClear 41–2

Swiss CCP SIX x-clear 160

origins of 57, 202

derivative clearinghouses 58–60

recent developments 60–61

ownership, CCP 165, 179–83, 200, 202

reform in European Union 90–91, 93–110, 113, 118–23, 148–51, 203

CCP default 105, 106, 122–3, 125, 130–131, 132–45, 149, 188–9, 191, 196, 202, 204, 205

CCP interoperability 101–2, 160–161

CCPs: systemically important/relevant 95, 114, 133, 141, 143–4, 178, 188, 196, 201

counterparties affected 96–9

establishing CCP 100–101, 106

impact of reform 155, 156–7, 160–161

implementation timeframe 105–6, 118

initial margin 101–2

minimum CCP capital 101, 177, 178, 200

qualified derivatives 99–100

reforming EMIR 125–32

risk management 94–5, 101–5, 144, 157

small non-financial counterparties 97, 106, 126, 127, 128

reform in United States 107–17, 118, 120–122

CCP default 116–17, 122

CCP interoperability 114

counterparties affected 111

establishing CCP 114

implementation timeframe 117

qualified derivatives 111–13

risk management 115–16

regulators’ (over-)reliance on CCPs 203–4

specifics of 43, 199, 202–3

collateral collection see above

default resolution 53–6, 103–4

exchange-traded versus bilateral derivatives 43–4

member selection 44

netting 40, 45, 46–7, 55, 59, 83, 157–62, 186, 193, 195, 198, 199

novation 39, 44–6, 58, 63, 156, 186

review 57

standardisation 47

transparency and reporting 56–7, 105

strengthening CCPs 206

summary 63–4

clearing and financial stability 152–4, 195–6

alternative solution 189–95

best current solution 189–91

new approach 191–5, 196

default management 162–9

clearing of CDS 167–9

skin in the game 164–5, 180

valuation errors 165–7

impact of reform 154–5

default management 162–9

netting 157–62

transparency 155–7

netting 157–62

CCP interoperability agreements 159–61

collateral demand 161–2

systemic risk and CCPs 169–70

adverse selection and information asymmetry 172–5, 200

alternative solution 189–95

CCP authorisation requirements 177–83

linkage risk 184–6, 196

moral hazard 175–7

ownership, CCP 179–83

regulatory fragmentation 183–4

risk concentration 170–172, 195

shareholders vs clearing members 181–2

stress-testing 178–9

too-big-to-fail 177, 186–9

client clearing 44, 49, 54, 61, 105

collateralised debt obligations (CDO) 32

Committee on Payments and Market Infrastructures (CPMI, formerly CPSS) 40–41, 65, 77, 82

financial market infrastructures 80–81

Commodities Clearing House (Kuala Lumpur) 172

commodity traders 97

contagion 53, 54, 55, 100, 142, 176, 189

corporate governance 34

counterparty risk 35–6, 39–40, 41, 43, 44

CDS without clearing 45–6

central counterparty (CCP) 45, 48, 61, 186

for-profit CCPs 181

post-crisis reform: EU 95, 98, 118

credit default swaps (CDS) 27–30, 32–4, 37, 70, 198

clearing of 167–9, 199

counterparty risk without clearing 45–6

ISDA 73–4

credit derivatives 26–30, 67

credit rating agencies 23, 58

European Union 92

financial crisis (2007–2009) 32

credit risk 16, 17–18, 26, 29, 33, 48, 58

ISDA 73

currency derivatives 67

defaulter-pays principle 53, 163, 191

definitions

central counterparty and clearinghouse 40–41

derivative 13–14

democratic legitimacy 66, 76

deregulation 67, 70–71, 74, 79, 111, 121, 147–8, 199

difference contracts 25, 68

domino effect 170–171

due diligence 98, 176

Durbin, M 28

economies of scale 58, 158

economies of scope 58, 158

European Banking Authority (EBA) 93, 135, 177–8

European Insurance and Occupational Pensions Authority (EIOPA) 93

European Securities and Market Association (ESMA) 90, 92–4, 96, 99, 100, 101, 103, 105, 110, 113, 115, 118, 122, 155, 157, 203

Board of Supervisors 150

capital, retained earnings and reserves of CCP 177–8

CCP recovery and resolution 135, 136, 138, 142

European System of Central Banks (ESCB) 101, 105, 135, 177–8, 200

European Union 76, 86, 89–90, 189, 196

Brexit 144–7, 148, 149

CCP default 105, 106, 122–3, 125, 130–131, 132–45, 149, 188–9, 191, 196, 202, 204, 205

additional financial resources 143–4

cascade of loss distribution 140–141

draft Regulation 133–5

early intervention 138–9

‘failing’ CCP 141

recovery and resolution plan 135, 136–8

resolution 139–43

Resolution Authority 135–6

state-funded bail-out 143–4

third countries 144–5, 149–50

Commission 77, 86, 94, 113, 119–20, 124–5, 127, 130–131, 185

credit default swaps (CDS) 167

definition: central counterparty and clearinghouse 41

deposit guarantee schemes 193

ESMA see European Securities and Market Association

European Systemic Risk Board (ESRB) 88, 93, 157

Financial Transaction Tax 194

MiFID I 72, 91–2, 174

minimum CCP capital 101, 177, 178, 200

national differences 203

ownership, CCP 180

post-crisis regulation 88–92, 94–5, 107–10, 113, 118–23, 130–132, 148–51

BRRD 105, 106, 134, 150

CCP default 105, 106, 122–3, 125, 130–131, 132–45, 149, 202

CCP interoperability 101–2

CCPs: systemically important institutions 95, 114, 133, 141, 143–4, 149

counterparties affected 96–9

EMIR 89, 90–91, 92, 93, 95–107, 109–10, 113, 114, 115, 117, 119–20, 121, 122, 124–32, 136, 149, 150, 157, 169, 177–8, 184, 199, 203

establishing CCP 100–101, 106

implementation timeframe 105–6, 118

MiFID II 91–2, 99, 126, 148

MiFIR 92, 148

qualified derivatives 99–100

risk management 94–5, 101–5, 131–2, 144, 157

small non-financial counterparties 97, 106

supervision 90, 92–4, 101, 105, 118, 122, 131–2, 146, 157, 203–4

pre-crisis regulation 71–2, 74

reforming the reform 124–5, 156

CCP recovery and resolution 132–45, 191, 196, 202, 204, 205

EMIR 125–32

regulations: directly applicable 91

Second Company Law Directive 150

State aid 142, 143

United States 89, 107–10, 113, 120–122, 145, 146, 148, 183, 199, 205

exchange-traded derivatives 21–2, 23, 36, 37, 68, 152, 153, 195

clearing: bilateral derivatives versus 43–4

European Union 127, 128–9

MiFID I 72

futures contracts 25

options 25

exchanges 58–9

origin of 58

recent developments 60–61

extraterritoriality 1, 98, 108–10, 146, 149

fair-value accounting/mark-to-market 50, 51–2, 165–7

Fannie Mae 32

Federal Reserve System 34, 35

interest rates 31

financial crisis (2007–2009) 28–33, 53–4, 63, 71, 74, 85, 153, 178

AIG 28–9, 32, 33–4, 37

G-SIFIs 83

LCH.Clearnet (LCH) 36, 37, 40, 54, 61–3, 150–151, 164, 198

lessons from 34–6, 37, 122

see also international reform agenda

financial derivatives 24–6

forwards/futures 24–5, 29

options 24, 25–6

swaps 24, 26

financial stability see clearing and financial stability

Financial Stability Board (FSB) 65, 73–4, 132

international reform agenda 75, 77–8, 83–4, 183

progress report 154–5

post-crisis reform: EU 106–7

Financial Transaction Tax (EU) 194

fines 129

for-profit CCPs 61, 164, 172, 179–83, 200

foreign exchange forwards 24

forwards/futures 24–5, 29

fragmentation 110, 121, 132, 134, 146, 158, 162, 183–4, 197, 204, 205

Freddy Mac 32

futures clearinghouses 57

G7 75

G10 41

G20 65, 75–7, 78, 85, 86, 88, 89, 90, 118, 121, 144, 148, 149, 183, 187, 189, 198, 204

game theory 173

Giancarlo, CJ 107, 119, 148

global systemically important financial institutions (G-SIFIs) 83, 170

gold standard 66

Goldman Sachs 33

Greenspan, Alan 70

haircuts 53, 84, 103, 120, 172, 185

hedge funds 44, 156

hedging 16–17, 19–20, 36, 58, 80, 149, 198

credit default swaps (CDS) 29

credit risk 16, 17–18

forward contracts 24

market risk 16, 17, 18

risks from 18

Hong Kong Futures Exchange 172, 187

in the money 17

incorporation, place of 115

information 115, 203–4

asymmetry 55, 168, 172, 176, 177

adverse selection and 168, 169, 172–5, 200, 202

CCP resolution plan 138

CCP resolution and recovery 138, 139

clearing 56–7, 157, 168, 182

exchanges 21–2

over-the-counter 23

insolvency 16, 17–18, 27

central counterparty (CCP) 45, 123, 133, 140, 169, 190, 201

insurance companies 178

insurance fund, CCP 193–4, 196

benefits 193

possible implementation 194–5

insurance regulators 28, 32

interconnectedness 4–5, 6, 7, 90, 118–19, 133, 135, 137, 144, 159, 169, 175, 184–6, 188, 190, 192, 193, 194, 201

interest rate swaps 22, 26, 29, 67, 110

LCH.Clearnet (LCH) 54, 62

interest rates 31

International Monetary Fund (IMF) 51, 76, 77

International Organisation of Securities Commissions (IOSCO) 65, 77, 78

determining clearing eligibility 78–80

financial market infrastructures 80–81

margin requirements 52

non-centrally cleared OTC derivatives 81–2

international reform agenda 75, 85–7

first results 77–8

determining clearing eligibility 78–80

financial market infrastructures 80–81, 86

further developments 81–3

margin requirements 84–5

national regulators 84

recovery and resolution 83–4

G20 65, 75–7, 78, 85, 86, 88, 89, 90, 118, 121, 144, 148, 149, 183, 187, 189, 198, 204

origin 75–7

International Swaps and Derivatives Association (ISDA) 28, 65, 67, 76

‘Big Bang Protocol’ 74

Codes 72

Master Agreements 72–3, 74–5, 117–18, 158

intra-group transactions 80, 96, 98, 127, 128

Irwin v. Williar 68

jump-to-default risk 167, 199

key findings 197–204

Lamfalussy Report (2001) 71

Larosière Report (2009) 90

LCH.Clearnet (LCH) 36, 37, 40, 41–2, 54, 61–3, 150–151, 164, 195, 198, 199

Brexit 145–6, 147

margins 178, 203, 205

Swiss CCP SIX x-clear 160

legal risk 40

ISDA 73

Lehman Brothers 33, 34, 36, 37, 38, 40, 54, 61–3, 150, 162–3, 164, 178, 198

liquidity 18–19, 20, 21, 22, 23, 28, 36

central counterparty (CCP) 45, 47, 55, 61, 171, 172, 181, 184, 186, 190

insurance fund 194, 196

financial crisis (2007–2009) 29, 34

international reform agenda 79

post-crisis reform 163, 206

EU 95, 102, 103, 105, 110, 119–20, 121, 131, 135, 137, 143, 144, 157, 161, 169, 189

US 110, 112, 121

spiral 53

long party 24, 25

Long Term Capital Management 34–5, 70

margin(s) 48, 59, 62, 163, 172, 176, 184, 188, 190, 196, 198, 199, 201, 202, 203, 205

call 50

derivatives and 51–3

EU reform 101–2, 103–4

initial 34, 48, 49, 51, 54, 59, 63–4, 83, 84, 85, 101–2, 158, 162, 178, 185, 199, 202, 205

international reform agenda 77, 82–3, 84–5

US reform 115, 116

variation 46, 48, 49–50, 53, 54, 59, 63–4, 83, 84, 144, 158, 162, 178, 184–5, 199, 202, 205

mark-to-market 50, 51–2, 165–7

market abuse 57

market risk 16, 17, 18, 23, 29, 58, 60

clearing 39–40, 48

hedging 16, 17, 18

Merrill Lynch 33, 34

Metallgesellschaft 34–5

moral hazard 55, 195, 200, 201, 202, 205, 206

CCP default fund 192, 193, 196

emergency credit lines to CCPs 163, 177

EU 188, 189, 205

CCP under resolution 144

CCPs and access to central bank liquidity 120

default fund 203

mandating central clearing 169, 175–7

margin collection 52

selection of CCP members 151

skin in the game 165

too-big-to-fail 187, 191

US

CCP default 116

Morgan Stanley 33

mortgage-backed securities (MBS) 32

nationalism 183

netting 40, 45, 46–7, 55, 59, 83, 157–62, 186, 193, 195, 198, 199

bilateral 43

ISDA 73

New York International Commercial Exchange 67

Nixon, Richard 66

novation 39, 44–6, 58, 63, 156, 186

Obama, Barack 108

operational risk 16, 29

banks 31

clearing 39–40, 48

options 24, 25–6, 29

Orange County Pension Fund 34–5

OTC Derivatives Supervisors Group (ODSG) 78

out of the money 17

over-the-counter derivatives 22–3, 36–7, 38, 66, 69

AIG 33

clearing: exchange-traded versus 43–4

credit derivatives 28

forward contracts 24

opacity 35–6

options 25

swaps 26

see also clearing; pre-crisis regulation; reform agenda, international

ownership, CCP 165, 179–83, 200, 202

pension funds 34, 96, 98, 126, 131, 150

pre-crisis regulation 65–7

European Union 71–2, 74

national 67–8

United States 68–71, 74, 85

non-governmental 72–5

priority

creditor 47

pro-cyclicality 52, 85, 103, 120, 131, 144, 159, 167, 172, 184

proportionality 97, 125, 178

protectionism 107, 121, 183

purpose of derivatives 15–16

arbitrage 20

hedging 16–17, 19–20, 36, 58, 80, 149, 198

credit default swaps (CDS) 29

credit risk 16, 17–18

forward contracts 24

market risk 16, 17, 18

risks from 18

speculation 18–20

put options 25

quantitative easing 161

reference entity 17

reform agenda, international 75, 85–7

first results 77–8

determining clearing eligibility 78–80

financial market infrastructures 80–81, 86

further developments 81–3

margin requirements 84–5

national regulators 84

recovery and resolution 83–4

G2065, 75–7, 78, 85, 86, 88, 89, 90, 118, 121, 144, 148, 149, 183, 187, 189, 198, 204

origin 75–7

regulatory analysis

clearing and financial stability see separate entry

objectives of reform 152–4

regulatory arbitrage 52, 78, 82, 86, 90, 109, 121–2, 132, 146, 148, 183, 205, 206

reporting 56–7, 74, 77, 78

EU 90, 98, 106, 126, 128–30, 148–9, 150, 156–7

Reuters 67

risk management 4, 8–9, 23, 34, 62, 78, 80, 191, 195, 201, 204, 205, 207

AIG 29, 34

CCP insurance fund 194

CCP’s burden of 202–3

clearing: techniques of 38, 41–57, 170, 187–8, 196, 198, 199, 202, 205

cost vs risk 182–3

default management 165

for-profit corporations 61, 180–181

linkage risk 184–6

post-crisis reform 169

EU 94–5, 101–5, 131–2, 144, 157

US 115–16

purpose of derivatives 15

too-big-to-fail 187–8

Roman law 44–5

Rubin, Robert 70

Russia 31

securities differentiated from derivatives 14

securities settlement systems (SSSs) 80–81

securitisation 31–2

settlement risk 39–40

short party 24, 25

size of market 13, 22, 23, 28, 30, 64, 71, 75, 158

subprime mortgages 31

soft law 65–6, 85, 93, 198

speculation 2–3, 18–20, 36, 65, 66, 80, 198

credit default swaps (CDS) 29

credit derivatives 28

forward contracts 24

United States 68, 74, 112, 113, 199

spill-over effects 8, 52

standardisation 47, 52, 58, 65, 67, 82

Chicago Board of Trade (CBOT) 58

European Union 99

exchange-traded derivatives 21, 36

Financial Stability Board (FSB) 77–8

IOSCO 79

ISDA Master Agreements 72–3

State aid 142, 143

stress-testing 51, 118, 169, 178–9, 199, 200

subprime lending 30–33

Summers, Larry 70

survivors-pay principle 163–4

SwapClear 41–2

swaps 24, 26, 29, 70

currency 67

foreign exchange 113

interest rate 22, 26, 29

Sweden 41

Switzerland 147

CCP SIX x-clear 160

systemic risk 2, 4, 36, 38–9, 42, 46, 63, 64, 87, 153–4, 200, 201, 205, 206

CCPs and 169–70, 190, 198, 201, 207

adverse selection and information asymmetry 172–5, 200

alternative solution 189–95

CCP authorisation requirements 177–83

linkage risk 184–6, 196

moral hazard 175–7

regulatory fragmentation 183–4

risk concentration 170–172, 195

too-big-to-fail 177, 186–9

credit default swaps (CDS) 167–8

default resolution 55

European Union 88, 93, 94, 96, 97, 114, 125, 149

interoperability agreements 160–161

Financial Stability Board (FSB) 77

G2076

interoperability agreements 160–161, 162

macro-prudential policy and 6–10, 170

margins 52, 53, 198

netting 157–8, 195, 198

origins of clearing 60

post-crisis soft law standards 66, 85

United States 70–71, 88, 112, 114

taxation

EU: Financial Transaction Tax 194

Telekurs 67

time horizon and counterparty risk 35

too-big-to-fail 77, 83, 96, 105, 116, 119, 141, 177, 186–9, 190, 191, 192, 193

trade repositories (TRs) 56–7, 77, 78, 81, 156

European Union 90, 92–3, 100, 115, 127, 129–30, 156–7

trading derivatives 20–21

exchange-traded derivatives 21–2, 23, 25, 36, 37

over-the-counter derivatives see separate entry

transaction costs 59, 73

transparency 36, 115

central counterparty (CCP) 40, 47, 56–7

European Union 134, 156–7

EMIR 90, 105, 115, 125, 126

MiFID II 91

impact of reform 155–7

price 47, 68

Trump, Donald 147–8

types of derivatives 24

comparative summary 29–30

credit 26–30

financial 24–6

forwards/futures 24–5, 29

options 24, 25–6, 29

swaps 24, 26, 29

underlying assets 14, 15, 68

United Kingdom 71

Brexit 144–7, 148, 149

United States 25, 64, 189, 191, 201, 207

Black Monday (19 October 1987) 179

Chicago Board of Trade (CBOT) 58

Clearing Corporation 58–9

Chicago Eggs and Butter Board (later Chicago Mercantile Exchange) 59, 122

Chicago’s International Monetary Market 67

Commodity Exchange Act (CEA) 69, 71, 112, 114

Commodity Futures Modernization Act (CFMA) 65, 68, 70–71, 199

Commodity Futures Trading Commission (CFTC) 69, 70, 71, 107, 108–9, 111–12, 113, 114, 115, 119, 122, 148, 199

credit default swaps (CDS) 167

Dodd-Frank Act 201026, 108–9, 111–13, 114, 115, 116, 117, 121, 147, 198–9

European Union 89, 107–10, 113, 120–122, 145, 146, 148, 183, 199, 205

Federal Deposit Insurance Corporation 116–17

Financial Stability Oversight Council 88, 116

gold standard 66

New York International Commercial Exchange 67

over-the-counter derivatives 22, 26, 37

ownership, CCP 180

post-crisis order 75, 85, 86, 89, 107–17, 118, 120–122, 147–8

CCP default 116–17, 122

CCP interoperability 114

counterparties affected 111

establishing CCP 114

implementation timeframe 117

qualified derivatives 111–13

risk management 115–16

SIDCOs 114

pre-crisis regulation 68–71, 74, 85

Securities and Exchange Commission (SEC) 71, 109, 112, 113

valuation 61, 82, 174, 175, 200

errors 165–7

mark-to-market 50, 51–2, 165–7

Volcker Rule 115–16

weather derivatives 67, 69

World Bank 76