Otc derivatives trading system

Most OTC derivatives are cash settled or allow for it. Such payments may be reduced by bilateral netting. Some dealers also manage settlement risks in two-way payments by specifying that counterparties pay first, before the dealer pays. Overall, except when principal is at risk as in foreign exchange transactions , most market participants see settlement risk in OTC derivatives transactions as no greater than in cash transactions, where management of settlement risk is well developed and understood. In addition, because netting practices are widely accepted, payments associated with OTC derivatives transactions are a relatively small fraction of total gross obligations for most institutions, usually around five percent and no more than 15 percent of total payments.

Increasing competition and declining spreads create pressure to rationalize middle-and back-office costs. Some small to medium-sized market participants find it more economical to subcontract middle-and back-office functions to another firm, rather than perform them in-house. For example, hedge funds often employ a prime broker that handles financing, custody, recordkeeping, and clearing. At that point, middle-office risk managers take responsibility for managing its market, credit, and operational risks.

The principles of prudent risk management are the same in OTC derivatives as in other areas: avoid concentration, know your counterparty, manage maturity, and mark-to-market. Similarly, some of the same risk-management tools used for other types of exposures can be used for OTC derivatives as well. This section provides a general overview of the risk management considerations surrounding OTC derivatives, including those that are particular to OTC derivatives positions.

For example, standard VaR models ignore the confluence of credit and market risk, which is a key consideration for OTC derivatives exposures.

When the exposure is highly leveraged, even small market moves can give rise to large changes in credit exposure. In a five-year interest-rate swap, a basis point change in rates can increase credit exposure by basis points of notional principal. Modeling of market risks is more advanced than modeling of credit exposures including counterparty exposures in OTC derivatives.

A few dealers also explicitly mark to market the credit risk in their swap books, and some use instruments such as corporate bonds or credit derivatives to hedge counterparty risk in OTC derivatives exposures. As the market for credit derivatives develops further, it may provide timely market estimates of credit risk for these purposes. One of the key concepts of counterparty credit risk in a derivatives contract is potential future exposure PFE , or the amount potentially at risk if a counterparty defaults see Box 3.

Consider a German securities firm that buys a put option on a U. If the U. Moreover, if the drop in the price of the U. Payments may be made more frequently on riskier exposures for example, monthly or quarterly rather than semiannually.

Market participants pay close attention to the maturity of their exposures, in part because exchange-traded hedging instruments generally have short maturities. Exposures tend to be concentrated at short maturities see Table 3. Collateral is a particularly important tool for managing counterparty risks in OTC derivatives markets. Dealers indicated that 45 percent of collateral arrangements involved other banks and broker dealers; 20 percent involved hedge funds; another 20 percent involved corporations usually end users ; 8 percent involved central banks and supranational agencies; and the remaining 7 percent involved counterparties such as private individuals.

In general, collateral is used much more intensively in some countries particularly the United States than others. Collateral is operationally demanding: an active dealer might mark-to-market , transactions every day. Collateral positions are usually marked-to-market daily, though dealers do not always make daily collateral calls.

Other terms that vary are the use of one-way versus two-way collateral whether only one party, or both, potentially posts collateral and rehypothecation the reuse of collateral. ISDA plans to consolidate these into a single core document that addresses the operational and economic aspects, with annexes that cover purely legal aspects. The complexity of OTC derivatives contracts gives rise to operational risks, including the aforementioned clearing and settlement risks and a variety of others.

The relationship of the price of the derivative to the underlying security and to related hedging instruments can be quite complicated, and major dealers employ teams of highly skilled quantitative analysts to study and manage these relationships. Nonetheless, even sophisticated institutions and well-developed and liquid markets are subject to model risk. For example, the relationships among sterling interest-rate swaps, interest-rate options, and swaptions broke down in , owing to structural developments that the models did not capture. Sharp losses during periods of market turbulence have led to an increased focus on counterparty credit risk in OTC derivatives.

This credit risk includes current and potential exposure. Potential future exposure PFE is the maximum, the average, or some percentile for example, the 95th percentile of the distribution of exposure that might be attained in the future. This distribution based on simulated future paths for die price of the underlying asset is known as an exposure profile. The exposure profile and PFE depend importantly upon the key characteristics of the underlying cashflows, particularly their maturity.

For example, exposure tends to rise with maturity because the potential drift in the price of the underlying security also increases with maturity the diffusion effect. At the same time, the remaining maturity of the contract, and the number of future payments that might be at risk, decrease with the passage of time the amortization effect.

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For contracts where principal is exchanged, the exposure profile usually rises continuously until maturity; for others, such as interest rate swaps, the exposure profile is usually hump-shaped. A simple example can illustrate the principle of exposure profiles and PFE. In practice, calculating the PFE on even this simple swap is complicated, because changes in both the level and shape of the yield curve can give rise to large changes in the value of the swap, and because the yield curve evolves over time in a complicated way.

To simplify, suppose that 1 the yield curve is initially flat, and remains flat—short-term and long-term interest rates are always exactly the same; 2 interest rates follow a simple process: they start at 12 percent; thereafter, every year, interest rates either increase by one percentage point, decline by one percentage point, or remain unchanged.

The valuation of the swap is then very simple; at each point in time, the floating-rate leg is priced at par, and the fixed-rate leg is priced as if it were a fixed-rate bond with a 12 percent coupon. At inception and expiration, the swap is worth zero, since the interest rates on the floating paying and fixed receiving legs are the same and the cashflows are identical.

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The table shows the evolution of interest rates and the value of the swap. If interest rates fall, the value of the swap to the fixed-rate receiver rises for the same reason that the price of a fixed-rate bond rises , creating credit exposure to the counterparty. The maximum exposure is at the lowest level of interest rates that can be attained; the diffusion effect means that interest rates can fall further in years that are farther from inception.

Comparing a ten-year swap gives a perspective on the importance of maturity see the second panel of the table. Operational risks are difficult to quantify and manage using tools like the ones used for other risks. In practice, most operational risks are managed by limiting and reserving against exposures that seem vulnerable to operational risks, and by strengthening back-office systems and automating the trade-capture process. As noted above, operational risks associated with the early part of the trade-capture cycle are viewed as manageable by major market participants.

As a result, much of the focus has turned to other operational risks that crop up later—particularly legal risks see Box 3. The legal risks associated with the use of collateral have been the subject of much recent discussion.

Collateral offers substantial protection for swap transactions that are subject to U. For example, there are important questions about the enforceability of collateral arrangements in some jurisdictions. OTC derivatives are more lightly regulated than exchange-traded derivatives, so it is not surprising that OTC derivatives transactions have given rise to a number of legal disputes. A recent study found that 76 percent of derivatives cases filed in U. Bankers Trust United States, : This is often viewed as among the first decisions bearing on the OTC derivatives markets, though the judge who ruled made it clear that his decision was meant to apply only to the specific arrangements at hand.

In the event.

BT owed it a fiduciary duty under these arrangements, and that BT had failed to perform this duty in the context of these swaps; 2 the agreements violated various provisions of, among other things, the Commodity Exchange Act CEA and Ohio law. It also ruled that the swap agreements were exempt from the CEA and that the ch0ice of law provision in the swap agreements which specified that New York law would govern the agreements precluded claims under Ohio law. Ultra Vires: Hazell vs. During —89, the local authorities of the London borough of Hammersmith and Fulham entered about swaps and swap derivatives transactions totalling some 6 billion in notional amounts, almost all speculative rather than hedging transactions.

The U. The decision effectively voided numerous other transactions undertaken by U. Counsel for SG insisted that the crisis in Russia relieved them of their obligations. As of mid—, the case had not yet been concluded. Deutsche Bank sent ANZ a notice that the City of Moscow had made payments on a loan from Daiwa Bank one day late, providing as evidence an article from International Financing Review and noting that the terms of the loan from Daiwa included no grace period. The court concluded that ANZ was bound to the letter of the agreement and found in favor of Deutsche Bank.

Peregrine Fixed Income At issue was whether language in ISDA documentation should be interpreted as specifying that the credit standing of the non-defaulting counterparty should betaken into account in valuing terminated swaps. Some legal experts considered that, if the court found that the amount Robinson owed PFI should be reduced, numerous other ISDA-documented swaps transactions could have been sharply revalued.

In May , The U. Market participants have taken a number of steps to address these operational risks. Considerable effort has been devoted to formalizing and standardizing or commoditizing the framework for OTC derivatives transactions, so that traders and back-office personnel correctly document the terms of each trade and both counterparties understand their rights and obligations. The master agreement is a key element of this framework.

Various national organizations and business groups, such as the British Bankers Association and ISDA, have promulgated master agreements that are either used verbatim or modified. The closeout process can itself be the source of difficulties in stressed markets, however. Under standard agreements, closeout valuations require 4 or 5 market quotes for each contract, and a major derivatives desk may have thousands of contracts with a large counterparty. Legal risks are often reflected in risk management practices. For example, there may be limits on exposures to countries where legal risks are pronounced.

If there are concerns that netting may not be enforceable in a particular jurisdiction, or that enforcement may be time-consuming, exposures may be calculated on a gross basis. The risks and market practices described in this part of the paper are importantly influenced by the supervisory and regulatory environment that impinges on OTC derivatives markets. The next section describes that environment.

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Print Citation Alert off. Explore other countries and regions ». Get Code Buy. This paper also highlights the key features of modern banking and over the counter OTC derivatives markets that seem to be relevant for assessing their functioning, their implications for systemic financial risks in the international financial system, and areas where improvements in ensuring financial stability can be obtained.

The paper also describes how OTC derivatives activities have transformed modern financial intermediation and discusses how internationally active financial institutions have become exposed to additional sources of instability because of their large and dynamic exposures to the counterparty credit risks embodied in their OTC derivatives activities. In order to rebalance private and official roles, it is essential first to clarify the limits to market discipline in OTC derivatives markets, before leaning more heavily on aspects of market discipline that seem to work well in these markets.