The large volumes of notionals and market values in OTC (rates and credit) derivatives markets have spurred a regulatory enhancement of risk buffers at banks. However, an IMF working paper by Li Lin and Jay Surti points out that no commensurate prescriptions apply to the two monopolistic central counter parties (CCPs) that clear a large share of the OTC derivatives market. This bears the risks that CCPs could become a medium of regulatory arbitrage of even systemic pressure.

Capital Requirements for Over-the-Counter Derivatives Central Counterparties, IMF WP 13/3
http://www.imf.org/external/pubs/ft/wp/2013/wp1303.pdf

The paper gives some important metrics of size of the market: “The volume of business activity in the OTC derivatives markets—aggregated across all products— stood at almost six times global banking assets and between nine-to-10 times global economic activity at end-2011. Markets for hedging and trading specific types of risks are correspondingly large also, with the smallest, credit derivatives, having outstanding gross notional amounting to more than ¼ of global banking assets. The market value of outstanding OTC derivatives contracts, while a fraction of global banking and economic activity, is substantially more volatile than either.”

The OTC market involves large banks and central counterparties:Systemically important banks’ (SIBs) are dominant players in the OTC derivatives markets. U.S. SIBs’ OTC derivatives exposures are large relative to, and in two cases, larger than their balance sheets. Even when netting out the value of cash collateral and accounting for offsets arising from bilateral master netting agreements, the market value of these exposures constitute a significant proportion of their overall trading assets…”

“Trading in the OTC derivatives markets is bilateral, either between dealers or between a dealer and its client. However, a very significant volume of contracts is re-traded with central clearing counterparties (CCPs) via a process called novation or clearing, wherein the CCP becomes a buyer to one counterparty and seller to the other. A majority of OTC-interest rate contracts are cleared and the percentage of OTC credit default swaps (CDS) that are cleared, while not yet comparably large, has been growing remarkably fast since the inception of the crisis.”

“The global market structure of the provision of clearing services is monopolistic within a number of risk or product classes. Global clearing of OTC-interest rate products occurs almost exclusively through the SwapClear subsidiary of the U.K. CCP LCH.Clearnet. And, global clearing of OTC-CDS is dominated by the CCP InterContinental Exchange‘s (ICE) U.S. and U.K. subsidiaries, ICE Clear Credit and ICE Clear Europe….More than ⅓ of outstanding gross notional in the OTC-interest rates market is cleared, and hence, given its market share, the size of SwapClear’s business—whether measured by notional or market value—is very large. The volume of cleared credit derivatives is substantially smaller, albeit the rate of growth in clearing of the erstwhile nascent single-name (SN) contracts has been very impressive, with cleared gross notional outstanding doubling each year over the last three years.”

“The market power of these major CCPs creates necessary conditions for them to be globally systemic financial institutions. Since the lion’s share of these CCPs’ risk exposures is to the largest global banks, this also makes them especially effective shock transmitters. The post-crisis commitment of the G20 countries to mandate clearing of all standardized OTC derivatives trades will, in the absence of a change to the market structure of global clearing services, serve to exacerbate the global systemic importance of these CCPs.”

“Their pre-funded risk buffers are perhaps the most important component of the risk management framework….Their importance in the risk management framework derives in no small part from the fact that contingency arrangements….are susceptible to wrong-way risk; i.e., the risk that the value of such contingent arrangements falls at the same time as the financial risks that they are designed to protect against are realized.”

“While standard setting bodies have upgraded the principles for regulation and supervision of financial market infrastructures including for CCPs, the standards—particularly those applying to advanced models and techniques for calculating risk buffers—are far from the level of detail and prescription that characterizes the new standards agreed by the Basel Committee on Banking Supervision (BCBS) for banks using advanced internal models to capitalize their risk exposures.”

Cross asset-class netting risk
“The most important [model input for capital requirements] is the definition of the netting set used to determine a CCP’s outstanding exposures. We find that a widening of netting sets facilitated by use of model-implied correlations and bases between (the market values of) derivatives instruments that map into different risk factor classes; (e.g., maturity or currency), considerably eases capital requirements. Using instead a methodology akin to the Basel 2.5 standardized approach, wherein netting sets are defined only up to a risk factor class, results in a first-order increase in the margin and the default fund requirements.”

Default and tail risk
“CDS contracts are characterized by discrete increases in loss experience when a default event occurs during a period of stressed markets. For CCPs clearing OTC-CDS, a departure from risk tolerance metrics that limit losses up to tail events towards metrics that limit losses in the tail can materially increase capital requirements. Calibrating returns, their volatility and market liquidity parameters on a stress period basis—similar to the stressed Value-at-Risk (VaR) capital charge against banks’ market risk exposures—significantly increases a CCP’s required margin and default fund.”

“There may be considerable benefits from prudential authorities adopting a more prescriptive approach that identifies acceptable risk tolerance metrics and sets a perimeter within which CCPs may calibrate key parameter inputs into their risk models. This process is already substantially further advanced for banks. Given banks’ dominant role in the market for OTC derivatives clearing, as the CCPs’ counterparties, there is a risk of providing them regulatory arbitrage opportunities if prudential standards for the same financial risks are different for banks and for CCPs.”