Jaimini Bhagwati on ways to better manage and restrict default risk stemming from derivatives markets
One of the causal reasons for the financial sector meltdown in the US was the unbridled use of over-the-counter (OTC) derivatives. This appears to have led to misconceptions about systemic risk engendered by OTC markets. It is particularly surprising that leading economists are mistaken about the difference between the nominal size of OTC derivatives and corresponding credit exposures. For instance, Andrew Sheng commented in his brilliant talk in Delhi on February 7, 2009 that “if you had a swap of say $100 million with Lehman’s (and if your exposure is) $2.4 million (and) if Lehman defaulted (your) loss would be $100 million not $2.4 million”. This is factually incorrect since a swap party’s loss in the case of a counterparty default is the credit exposure, or $2.4 million in Sheng’s example.
Derivatives are either traded on exchanges (eg options, futures) or are customised over-the-counter (OTC) products such as currency and interest rate swaps, credit default swaps (CDSs) etc. Effectively, the buyers and sellers of exchange-traded derivatives are exposed to the exchange and vice-versa but not to each other. By contrast, the two sides to OTC derivatives transactions are directly exposed to each other’s credit risk. OTC markets have evolved over time and currently contracts are marked to market and collateral has to be posted with custodians. The amount of collateral is a fraction of net exposure and depends on the credit rating of the party which needs to post collateral. That is, a higher proportion of the exposure has to be posted if the rating is lower. All derivatives contracts start off with zero market value. It is only with movements in interest and exchange rates, bond and stock indices etc over time that contracts move in favour of one or the other counterparty.
The table above shows that the nominal value of outstanding OTC derivatives at the end of 2008 was $592 trillion and this was more than hundred times the credit exposure of $5 trillion. In comparison, at the end of 2008 the nominal value of outstanding exchange-traded derivatives amounted to $57.9 trillion, or about 10 per cent of the nominal OTC market. However, unlike OTC markets there is no significant credit exposure for exchange-traded derivatives since margins have to be posted on a daily basis. Of course, the exchange is exposed to counterparties during intra-day trading hours.
OTC contracts are relatively non-transparent, frequently highly-leveraged and provide higher profit margins for financial intermediaries than exchange-traded derivatives. It follows that banks market OTC derivatives aggressively. As many would recall, this led to some end-users of OTC products filing lawsuits against investment banks; examples include Procter and Gamble versus Bankers Trust, Gibson Greetings, Orange County. Several Indian corporates have also disingenuously complained that they did not understand the underlying risk in the leveraged OTC derivatives they had contracted with banks.
In the case of AIG it had underwritten CDSs on securities derived from mortgage-backed assets. As the US housing market sank so did the value of these securities, which were insured by AIG as the seller of CDSs. Consequently, the credit exposure of CDS counterparties to AIG ballooned up and this coupled with AIG’s rating downgrade meant that AIG was suddenly required to make large collateral payments. As AIG had not set aside commensurate capital for the huge volume of CDSs it had sold, it would have defaulted on its payment commitments without US government funding support.
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Clearly, therefore, default risk builds up if parties to OTC contracts are inadequately capitalised. In terms of reforming OTC markets, we could try to replace OTC contracts with exchange-traded derivatives. In fact, the cash flows of interest rate and currency swaps can be replicated with interest rate and currency futures. However, the problem is that liquidity in exchange-traded derivatives drops off sharply after a year or so and these markets cannot be customised to meet the specific needs of end-users.
In comparison, OTC markets allow maturities to stretch to several decades and products can be tailored to meet the specific hedging or speculation needs of clients. Ideally, regulators should not stand in the way of innovation exemplified by OTC contracts. The difficulty is that if one of the OTC parties is not in a position to meet its obligations under its contracts and is too big to fail, as in the case of AIG, governments have to provide the required capital. Currently, regulators are discussing how best to set up central counterparty clearing (CCPs) for OTC products. An alternate mechanism to limit default risk could be that once OTC contracts are settled, these have to be registered with exchanges and margins posted as for all exchange-traded derivatives.
| OUTSTANDING OVER-THE-COUNTER (OTC) & EXCHANGE-TRADED DERIVATIVES | ||||
| (In $ trillion) | Dec-2006 | Dec-2007 | Jun-2008 | Dec-2008 |
| OTC Derivatives | ||||
| Notional Value | 418.1 | 595.3 | 683.7 | 592 |
| Gross Credit Exposure | 2.0 | 3.3 | 3.9 | 5.0 |
| Exchange-Traded Derivatives | ||||
| Notional Value | 69.4 | 79.1 | — | 57.9 |
| Source: Bank for International Settlements Quarterly Review, June 2009 Futures Industry Association | ||||
In 2007-2008, there was a sense in Indian regulatory circles that Participatory Notes (PNs) enable holders to take anonymous, highly-leveraged bets on economic variables and also evade taxes. And, towards the end of 2007 it was suspected that leveraged PNs pushed the Sensex beyond 20,000. While there were differences of opinion among commentators, there was unease that non-transparent PN activity causes undue volatility in Indian equity markets. Presently, the market value of FII investments in Indian stocks is of the order of $160 billion—a small fraction of global FII pension and other funds. Consequently, even if FIIs face losses in India they could decide to liquidate positions if stop-losses on PNs were to kick in. One way to address this small yet potentially destabilising risk is for Indian regulators to stipulate that FIIs should provide a formal undertaking that their PNs only involve India-based exchange-traded derivatives and no OTC contracts.
To summarise, to better manage and restrict default risk stemming from derivatives markets: (a) OTC derivatives trades in India and elsewhere need to be booked through central clearing mechanisms or registered with exchanges; and (b) the derivatives components in Participatory Notes contracted by FIIs should be restricted to derivatives traded on Indian exchanges.
The author is the Indian Ambassador to the European Union, Belgium and Luxembourg. Views expressed are personal