Analysis of the performance guarantee mechanism of overseas OTC derivatives transactions

Editor's note: In order to thoroughly implement the spirit of the Central Financial Work Conference and the Several Opinions of the State Council on Strengthening Supervision and Risk Prevention and Promoting the High-quality Development of the Capital Market, and solidly promote the high-quality development of the securities industry, the China Securities Quotation Investment Education Base has launched the special topic of "Risk Prevention and Development Promotion" to share the exploration and practical achievements of OTC derivatives in strengthening the risk prevention and control capabilities of the securities industry, doing a good job in five major articles, and providing high-quality services for economic and social development.

Authors: Fang Peng and Niu Wenhui, both working in the equity derivatives business line of CITIC Securities

summary

After the 2008 global financial crisis, G20 leaders agreed at the Pittsburgh meeting in United States on a plan to reform the OTC derivatives market, some of the key goals of which include: all standardized OTC derivatives should be cleared through a central counterparty; Raising margin requirements for non-centrally cleared derivatives transactions, etc. As a member of the G20, the mainland has also actively promoted the relevant reform process. The purpose of this article is to analyze the current performance guarantee mechanism of overseas OTC derivatives, especially non-centrally cleared derivatives transactions, and to draw on the experience of overseas markets to put forward suggestions that are conducive to the long-term and stable development of derivatives trading in mainland China.

introduction

After the 2008 global financial crisis, G20 leaders agreed at their meeting in Pittsburgh, United States, on the regulation of the OTC derivatives market, proposing four core reforms aimed at reducing systemic financial risks:

1. All standardised OTC derivatives transactions should be traded through exchanges or electronic platforms, where appropriate;

2. All standardised OTC derivatives transactions should be cleared through a central counterparty;

3. OTC derivatives contracts should be reported to the Central Trading Database;

4. Derivatives transactions that are not centrally cleared shall be subject to margin requirements that are higher than the standard of the exchange.

One of the main directions of this reform is to improve the performance guarantee system for OTC derivatives trading, so that it can better cover the risks brought by OTC derivatives. This article will put forward suggestions for improving the domestic performance guarantee mechanism on the basis of reviewing overseas OTC derivatives transactions, especially the performance guarantee mechanism for non-centrally cleared OTC derivatives transactions.

Introduction to the performance guarantee mechanism of overseas centralized clearing of OTC derivatives

▍ Mode overview

Under the centralized clearing model, OTC derivatives clearing is similar to that of on-exchange products: the central counterparty is responsible for clearing, and through contract rollover, that is, a contract with the same amount and opposite direction is carried out with both parties. The central counterparty acts as a buyer for all sellers and a seller for all buyers, assuming counterparty credit risk, such as CME ClearPort, ICE Clear Credit, etc.

▍Margin requirements

In April 2012, the Payment and Clearing Systems Committee of the Bank for International Settlements (CPSS) and the International Organization of Securities Commissions (IOSCO) issued a new Financial Market Infrastructure Standard (PFMI), which proposes the central counterparty standards in capital, risk management, margin and operation management for the central counterparty clearing in the OTC derivatives market, which has become an important reference for the implementation of supervision in various countries. The central counterparty generally determines the margin requirements of the clearing member based on the potential future risk exposure, such as the SPAN (Standard Portfolio Analysis of Risk) scheme.

▍Pattern features

While the central counterparty provides portfolio margin services for OTC derivatives settlement and reduces systemic risks, there are also problems such as the contradiction between contract standardization and OTC transaction personalization, and the high cost of on-exchange infrastructure construction that cannot fully support business innovation and development. Therefore, the development process of overseas centralized clearing of OTC derivatives transactions is usually a process of promoting on-exchange clearing after the OTC trading varieties are gradually practiced, matured and standardized. The centralized clearing model is suitable for markets where the derivatives market is relatively mature and the business model and varieties are relatively stable.

At present, the overseas market mainly promotes the centralized clearing of interest rate, exchange rate and credit derivatives transactions, especially the relatively simple structure of swap products, and has not yet put forward clear centralized clearing requirements for equity and commodity derivatives transactions.

Introduction to the performance guarantee mechanism of overseas non-centrally cleared OTC derivatives

▍ Mode overview

In the decentralized clearing model, market participants act as counterparties to each other, carry out transactions, and one or both parties to the transaction are cleared, reconciled, and settled separately. The advantage of this model is that the transaction is highly free and efficient, and both parties can independently confirm the performance guarantee and other transaction-related matters, while the disadvantage is that the two parties to the transaction expose the credit risk of the other party.

Before the outbreak of the financial crisis in 2008, there were almost no regulatory requirements for such transactions, but after the outbreak of the financial crisis, international organizations and national regulatory authorities have strengthened the supervision of non-centralized clearing derivatives transactions and increased the requirements for performance guarantees.

▍Regulatory principles

The Basel Committee and the International Organization of Securities Commissions (IOSCO) have set out a number of key principles for the performance guarantee mechanism for non-centrally cleared derivatives transactions:

1. All OTC derivatives transactions that are not cleared by a central counterparty should be subject to an appropriate margin regime.

2. All financial firms and systemically important non-financial entities engaged in non-centrally cleared OTC derivatives transactions are required to exchange initial and variable margin based on counterparty credit risk.

3. The margin collection standard should be consistent among all trading entities and fully reflect the future risk exposure (initial margin) and current risk exposure (variable margin) of the portfolio.

4. Margined assets should be highly liquid and should be available at appropriate discounts to ensure that they retain their value in adverse market conditions.

5. The parties to the transaction shall exchange the initial margin. Initial margin should not be charged on a net basis. Initial margin, when held, should ensure insolvency isolation for both parties to the transaction.

6. Margin requirements should be implemented gradually over an appropriate period of time to ensure that the transition costs associated with the new framework can be effectively managed.

▍ Business practices

1. Dealer capital requirements

Regulatory commissions in various countries generally believe that the counterparty risk of non-centrally cleared derivatives transactions is significantly higher than that of centrally cleared derivatives transactions. As a result, both Basel III and the Basel Committee's credit exposure standards issued in April 2014 set provisions to increase the costs and thresholds for dealers to conduct non-centrally cleared derivatives transactions.

Taking the 2014 credit risk exposure standard as an example, according to the formula for calculating the capital adequacy ratio: capital adequacy ratio = capital ÷ (asset × risk weight), for non-centrally cleared OTC derivatives transactions, the risk weight needs to be calculated according to the higher risk weight, and if the central counterparty meets the standard proposed by the International Organization of Securities Commissions, the risk weight can be adjusted to zero. A higher risk weight means that dealers will reduce their capital adequacy ratio when they carry out non-centrally cleared derivatives transactions, and they need to increase their capital reserves.

2. Who does the margin rule apply to

For non-centrally cleared derivatives transactions, regulators in various countries generally believe that the core purpose of margin rules is to control the systemic risks brought by OTC derivatives to the financial system. As long as either party to the transaction does not pose significant systemic risk to the financial system, the relevant transaction is not covered by margin requirements. For example, non-systemically significant non-financial institutions (often classified by their transaction size or liquidation threshold) are generally considered to have little or no systemic risk in their transactions.

3. Initial Margin Requirement

The Basel Banking Committee and the Organization of International Securities Commissions (OSCO) have mandated that the amount of initial margin should reflect the exposure to extreme but real stress scenarios and should reflect an estimate of the loss in the value of the derivative at a 99% single-tail confidence level over a 10-day period. Entities with a cumulative average trading size lower than the specified threshold can be exempted from the initial margin requirement.

4. Variable Margin Requirements

For variable margin, the Basel Banking Committee and the International Organization of Securities Commissions require that, in order to mitigate adverse liquidity shocks and effectively reduce counterparty credit risk, the amount of variation margin exchanged between the parties must be sufficient to fully cover the mark-to-market exposure of non-centrally cleared derivatives transactions and be included in netting arrangements.

5. Relevant content of credit support attachments

In non-centrally cleared derivatives transactions, ISDA agreements or other similar documents are usually signed between counterparties to regulate the clearing operations of future transactions. Take the ISDA agreement as an example, which is accompanied by a Credit Support Annex (CSA), in which the details of the performance security will be specified in detail, such as the validity of the agreement, the form of the performance security, the type of collateral, the remortgage limit, the period for calculating the amount of collateral, etc. The following is an introduction to some of the important provisions of the CSA, as well as the common specific provisions of these terms in foreign countries.

(1) Legal form of performance guarantee

The forms of performance guarantee of derivatives are mainly divided into pledge and transfer performance guarantee. The former is similar to a pledge of cash or rights under domestic law. The pledgor can pledge cash, securities, etc. as collateral to guarantee its debts under the OTC derivatives transaction. The latter is to use the performance guarantee as part of the settlement mechanism for OTC derivatives transactions, and combine the performance guarantee with the debt arising under the derivatives master agreement for netting.

In the process of implementing the above-mentioned initial margin and variable margin requirements by the regulatory authorities in various countries, for the initial margin, the parties to the transaction usually choose a pledged performance guarantee, that is, to ensure that the receiver can control the future risk exposure of the contract, and at the same time, to prevent the risk brought by the bankruptcy of the receiver to the transferor; Variable margin usually chooses transferable performance security, that is, to ensure that the recipient can make full use of and use the performance security to cover the current contract risk exposure and improve transaction efficiency.

(2) The type of performance guarantee

In order to ensure that financial institutions can provide sufficient collateral while maintaining strong liquidity, the Basel Committee did not limit collateral to the most liquid assets such as cash and government bonds, but also gave some examples of eligible collateral that meets the main regulatory principles (liquidity and security), including high-quality corporate bonds, high-quality guaranteed bonds, major stock index constituents, gold, etc. This practice is also intended to be in line with the common practice of centralized liquidation.

Suggestions on the development of the performance guarantee mechanism for domestic derivatives trading

▍Gradually improve the performance guarantee mechanism for domestic derivatives trading

At present, the domestic OTC derivatives market is still in a relatively early stage. As of the end of 2023, the notional principal amount of OTC derivatives of mainland securities has exceeded RMB 2.3 trillion. In order to promote the steady and healthy development of the OTC derivatives market, the mainland should learn from the experience of mature international markets and combine the structural characteristics of domestic participants to establish a high-quality performance guarantee mechanism. Clarify the regulatory principles of the performance guarantee mechanism for derivatives trading in mainland China, including but not limited to:

1. To maintain the regulatory bottom line of no systemic risk, dealer management is the key, and dealer capital requirements are the core. Inappropriate requirements for dealer access and performance security may trigger credit events such as dealers' inability to pay settlement payments as agreed, triggering a chain reaction and creating systemic risks.

2. Establish an effective, transparent and fair derivatives market. On the premise of fully considering the role of transferable performance guarantee in promoting market efficiency and practical needs in the initial stage of development, we will further deepen the development of mechanisms such as transaction report databases, third-party valuation, and on-exchange clearing, and jointly build an effective, transparent and fair derivatives market.

▍Based on the goal of preventing systemic risks, improve the standards of traders and the management requirements of performance guarantees

From overseas experience, derivatives transactions often require dealers to use their balance sheets to absorb hedging or contract losses in order to achieve the goal of diversifying or managing risks. Dealers are essentially credit and capital intermediaries for derivatives trading, which requires high capital reserves.

A financial institution with a small net capital, as a derivatives dealer, can easily collect several times or even more than ten times of its own capital (net capital). In the case of a large number of transferable performance guarantees, a large amount of investment or hedging transactions will be made using the performance security products submitted by the client. Once the market changes and the dealer has a hedging loss, its net capital is not enough to fully absorb the loss, so it can only occupy the performance security products submitted by other customers, resulting in risk overflow, similar to the situation that dealer A is unable to pay the settlement payment of dealer B, causing dealer B to be unable to pay the subsequent settlement payment of other dealers and even the settlement payment of the customer.

In order to prevent the credit risk of traders, it is recommended that the regulatory authorities take multiple measures to further optimize the regulatory measures and requirements:

1. Further improve the risk control index system mechanism with net capital and liquidity as the core of the proxy derivatives traders. Derivatives dealers on behalf of clients should establish a unified net capital risk management system, and further refine the net risk control indicators for derivatives trading, so as to strengthen the assessment of the trader's risk carrying capacity and liquidity. The size and type of derivatives transactions carried out by traders with low net capital scale and poor risk resistance should be restricted.

2. Restricting dealers with insufficient net capital from receiving transferable performance security. Different from the pledged performance guarantee, the transferable performance guarantee is essentially part of the netting mechanism, and the transferee can freely use the performance security after receiving the performance security. If it is not properly managed, liquidity risk will occur, which can easily lead to risk transmission and systemic risk.

3. In order to standardize the implementation standards of traders, it is recommended that the industry implement a demonstration mechanism for the management of performance guarantees, guide dealers to establish standardized management processes for collateral value assessment, mark-to-market, risk mitigation and disposal, and put forward certain requirements for the personnel and systems for dealers to invest in the management of performance guarantees.

▍Based on the principles of market efficiency, fairness and transparency, gradually develop the industry infrastructure required for derivatives trading

As an important part of the risk prevention and control mechanism of derivatives trading, the performance guarantee mechanism does not exist alone, and needs to develop and interact with other industry infrastructures together to build a stable, healthy and resilient derivatives market:

1. It is recommended to further develop the depth and breadth of the transaction report database, enrich the content of data submission and refine the granularity, so as to lay the foundation for subsequent industry innovation and risk prevention and control mechanisms.

2. Considering the non-public and personalized characteristics of derivatives trading, it is recommended to further promote the development of a third-party valuation mechanism for derivatives contracts to ensure the transparency and fairness of derivatives trading contracts and prevent risks such as benefit transfer.

Compared with the relatively stable derivatives trading markets in developed countries in Europe and the United States, the OTC derivatives business in mainland China is still in the early stage of development. For relatively standardized derivatives transactions such as interest rates and exchange rates, we will guide the centralized clearing of OTC derivatives transactions to continuously reduce systemic risks. For other non-standardized derivatives transactions, focus on the implementation of basic measures such as strengthening the net capital risk management of dealers, improving the performance guarantee mechanism, and formulating the framework of the performance guarantee agreement, and under the condition that the infrastructure such as the transaction report database system and the third-party valuation mechanism is gradually complete, through the collection and collation of submitted data, summarize the mature practices of the industry, and form a comprehensive derivatives trading market operation and supervision mechanism of "effective market development, transparency and fairness, and prevention of systemic risks".

Disclaimer: The information in this article is for investor education purposes only and does not constitute any investment advice to investors, and investors should not substitute their independent judgment or make decisions based solely on such information. The information in this article is intended to be accurate and reliable, but the accuracy or completeness of such information is not guaranteed, and no liability is accepted for any loss or damage that may arise from the use of such information.