Exchange functions
Trading derivatives can be done bilaterally or through exchanges. An exchange is a central market where standardized contracts can be traded. Exchanges perform three primary functions: product standardization, trading venue, and reporting services.
Forms of Clearing
Clearing, margining, and netting are important counterparty risk mitigants. Clearing is the process of reconciling and matching contracts between counterparties. Margining represents both upfront funds posted to mitigate against counterparty default (initial margin), and daily transfer of funds to cover position gains and losses (variation margin). Netting refers to consolidating multiple offsetting positions between counterparties into a single payment.
The three forms of clearing include direct clearing, clearing rings, and complete clearing (i.e., central clearing). Direct clearing is a mechanism for bilaterally reconciling commitments between two counterparties. A clearing ring is a mechanism to reduce counterparty exposure between members by allowing for counterparty substitution. Complete clearing is clearing through a CCP, where the CCP assumes the obligations of clearing exchange members.
Over-The-Counter Derivatives
The main benefits of OTC derivatives include customization of terms, settlement, and documentation, which are negotiated bilaterally between two parties. Customization can be beneficial since it reduces basis risk (i.e., risk of term mismatches).
Disadvantages of OTC derivatives include counterparty risk, difficulty in unwinding trades, and novation of contracts.
Clearing is more challenging for OTC derivatives compared to exchange-traded derivatives given the generally longer maturities. OTC derivatives trades could be cleared by CCPs.
Classes of OTC Derivatives
OTC derivatives comprise of five broad classes of derivatives: interest rate, foreign exchange, equity, commodity, and credit derivatives. Interest rate derivatives comprise the largest class, followed by foreign exchange derivatives and credit derivatives.
Mitigating Risks of OTC Derivatives
Mechanisms for controlling counterparty risk include: special purpose vehicles (SPVs), derivatives product companies (DPCs), monolines, and credit derivative product companies (CDPCs).
SPVs are bankruptcy remote legal entities set up by a parent firm to shield the SPV from any financial distress of the firm. SPVs essentially alter bankruptcy rules and transform counterparty risk into legal risk. The legal risk is consolidation, or the risk that the courts view the SPV and the originating firm as the same legal entity.
DPCs are bankruptcy remote subsidiaries of firms set up to originate derivatives products sold to investors. DPCs are separately capitalized and have restrictions on their activities and margin. They are generally AAA rated where the rating depends on three criteria: (1) market risk minimization (2) parent support, and (3) credit risk and operational risk management.
Monolines are highly-rated insurance companies that provide financial guarantees, or “credit wraps” to investors. CDPCs are akin to DPCs, but with a business model that is closer to that of a monoline.
