Policy Perspectives on OTC Derivatives Market Infrastructure

In our paper Policy Perspectives on OTC Derivatives Market Infrastructure (Federal Reserve Bank of New York Staff Report No. 424), we address market design weaknesses in the over-the-counter (OTC) derivatives market that were identified through the crisis, and discuss how the New York Fed and other regulators could improve the structure of this market.

In the wake of the recent financial crisis, OTC derivatives have been blamed for increasing systemic risk. Over-the-counter derivatives markets are said to be complex, opaque, and prone to abuse by market participants who would take irresponsibly large amounts of risks. Although OTC derivatives were not a central cause of the crisis, we find that weaknesses in the infrastructure of derivatives markets did exacerbate the crisis. As a result of failures of risk management, corporate governance, and management supervision, some market participants took excessive risks using these instruments. The complexity and limited transparency of the market reinforced the potential for excessive risk-taking, as regulators did not have a clear view into how OTC derivatives were being traded. If used responsibly, however, over-the-counter derivatives provide important risk management and liquidity benefits to the financial system as well as non-financial corporations and other market participants.

While new legislation is also needed, regulators have not waited for legislation to demand improvements in the infrastructure of these markets, and have worked in concert with other market participants and policymakers to this end for the past several years. Some of the major accomplishments of this effort include the following:

• Regulators insisted that market participants create a central repository to log all credit derivatives trades. Before 2005, there was no central source of credit derivatives trade information, making it difficult to manage lifecycle events. In addition to facilitating the processing of various lifecycle events, in late 2008, this central repository became a key source of credit derivatives data for regulators and the general public.
• Regulators set stringent targets and deadlines for dealers to reduce their backlogs and increase both automation and processing efficiency for OTC derivatives. In 2005, immature infrastructure and lack of automation had led to long processing lags between the times at which trades are executed and the times at which they become legally matched contracts. The processing lags and backlogs of legally uncertain trades have been largely eliminated for credit derivatives and dramatically reduced for other types of OTC derivatives.
• Regulators solved a collective action problem by asking market participants to fully adhere to an industry created protocol that ensured that all parties would henceforth be aware of the identities of their counterparties at all times. In 2005, a client of a dealer would commonly assign its trades to other dealer counterparties through a process known as novation, without all parties being informed of the assignment. This led to a lack of awareness by dealers of the identities of their ultimate counterparties, resulting in trade-match failures and breaks in payment flows.
• Regulators mandated participation in a settlement mechanism that ensured orderly settlement of CDS for defaulted reference entities.  These improvements to CDS market design enabled the market to handle record levels of bankruptcies. Market participants committed to use an auction process that allows parties to settle CDS contracts without the need to deliver bonds. The auction determines a settlement price for the bond that leaves most parties indifferent between settling the CDS through physical delivery of bonds in return for cash, and settling in cash only for the net value. In the past 12 months, the market has successfully settled 50 CDS corporate credit events. In the preceding three-year period there was an average of only three such CDS settlement events per year.
• Regulators demanded that banks increase their use of portfolio compression to collapse superfluous positions, thus reducing the associated counterparty risk and cutting the market’s aggregate notional amount of CDS trades in half. Before 2007, active market participants typically held large simultaneous long and short CDS positions referencing the same underlying borrower. These redundant positions posed significant unnecessary counterparty exposure and offered no material economic benefit.
• Regulators required major market participants to adhere to at least daily monitoring of the values of their OTC derivatives portfolios with each other. Dealers had been inconsistent in their approaches to monitoring and managing the counterparty risks of their OTC derivatives positions, including their frequency of exchange of collateral.

Despite the significant recent improvements in market infrastructure outlined above, the infrastructure for OTC derivatives still poses systemic risks. The New York Fed plans to address the problems in the OTC derivatives market by advocating for improvements in counterparty risk management, especially central clearing and robust collateralization, while preserving the market’s incentives for product innovation and customization, so that market makers continue to contribute to economic growth by developing financial products that improve the allocation of risk and enhance market liquidity. The New York Fed encourages the use of exchanges and electronic trading platforms, as well as post-trade price transparency, in order to promote market efficiency. There will remain a population of customized derivatives that are more suitably negotiated or risk-managed bilaterally. Whether or not derivatives contracts are traded or cleared centrally, there must be high standards for collateral arrangements, operational infrastructure, and transparency.

Regulation and other improvements in the market should not overemphasize one risk-reducing element of the market design without giving consideration to how that individual component fits together with the rest of the market infrastructure. The various components must function robustly on their own and synchronously. Regulation must encourage improvements that are holistic and employ a long-term vision of how the OTC derivatives market infrastructure affects the entire financial system. The New York Fed will encourage market participants to set and meet corresponding targets, and will contribute to the design of supporting regulations.

The full paper is available for download here.