Commission staff working paper accompanying the Commission Communication - Ensuring efficient, safe and sound derivatives markets {COM(2009) 332 final} {SEC(2009) 914 final}
Date: 2009-07-03
Institutions: European Commission
Subjects: EU Member State, EU programme, bankruptcy, credit, economic recession, exchange of information, fixing of prices, impact study, supplies contract

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COMMISSION OF THE EUROPEAN COMMUNITIES 

Brussels, 3.7.2009 
SEC(2009) 905 final 

COMMISSION STAFF WORKING PAPER 

Accompanying the  

COMMISSION COMMUNICATION 

Ensuring efficient, safe and sound derivatives markets 

{COM(2009) 332 final} 
{SEC(2009) 914 final} 

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Executive summary .................................................................................................................... 3 

TABLE OF CONTENTS 

1. 

2. 

2.1. 

2.2. 

2.3. 

2.4. 

3. 

3.1. 

3.2. 

3.3. 

3.4. 

3.5. 

4. 

4.1. 

4.2. 

4.3. 

4.4. 

4.5. 

Introduction .................................................................................................................. 4 

Derivatives markets: function, structure and risks....................................................... 6 

Function of derivatives................................................................................................. 6 

Market structure ........................................................................................................... 7 

Transparency ................................................................................................................ 9 

Risk and risk mitigation ............................................................................................. 11 

Different Types of OTC Derivatives: Risk characteristics and current Risk 
Management measures ............................................................................................... 19 

Credit default swaps................................................................................................... 20 

Interest rate derivatives .............................................................................................. 29 

Equity Derivatives...................................................................................................... 32 

Commodity derivatives .............................................................................................. 35 

Foreign exchange derivatives..................................................................................... 37 

Effectiveness of current risk mitigation measures ..................................................... 41 

Credit default swaps................................................................................................... 41 

Interest rate swaps ...................................................................................................... 42 

Equity derivatives....................................................................................................... 42 

Commodity derivatives .............................................................................................. 43 

Foreign exchange derivatives..................................................................................... 43 

Bibliography............................................................................................................................. 45 

Glossary.................................................................................................................................... 47 

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EXECUTIVE SUMMARY 

The main findings of this Staff Working Paper are the following: 

•  Derivatives and complex products, negotiated mainly in over-the-counter (OTC) markets, 
have come to the forefront of the policy debate during the financial crisis. However, OTC 
derivative vary substantially among different market segments.  

•  In terms of market infrastructures, some market segments, such as interest rate derivatives 
and  foreign  exchange  derivatives,  are  mature  and  have  strong  market  infrastructures  and 
risk management systems in  place, even though the coverage of these systems should be 
expanded.  Other  segments,  such  as  equity  derivatives,  are  less  mature  and  have  less 
developed infrastructures in place.  

•  In terms of risk characteristics, the early focus on credit default swaps was justified in view 
of  its  binary  and  discontinuous  pay-out  structure,  concentrated  dealer  market  structure, 
difficulty of valuing the rights and obligations contained in the contract, especially for the 
less  liquid  single  name  part  of  the  market,  lack  of  solid  risk  management  measures  and 
disproportionate dimension of the derivative market with respect to the underlying market. 
Most other OTC derivatives appear less risky, as pay-out structures are more continuous in 
nature  (e.g.  interest  rate  swaps,  foreign  exchange  derivatives,  equity  derivatives),  the 
market  more  disperse  (e.g.  interest  rate  swaps,  foreign  exchange  derivatives,  equity 
derivatives,  commodity  derivatives),  the  underlying  markets  more  liquid  and  the 
underlying  risks  more  observable  (e.g.  foreign  exchange,  interest  rate  swaps,  equity 
derivatives),  risk  management  measures  sometimes  more  solid  (e.g.  interest  rate  swaps, 
foreign  exchange  derivatives)  and  electronic  systems  more  developed  (e.g.  credit  default 
swaps, interest rate swaps).  

•  Even so, much can be done to strengthen these market segments so as to ensure financial 
stability.  CCP  clearing  is  the  most  effective  way  of  reducing  credit  risk  and  is  broadly 
feasible  in  all  market  segments.  But,  for  CCP-eligible  products,  to  increase  the  use  of 
CCPs  further  in  the  EU,  safe,  sound  and  common  requirements  are  necessary.  Although 
CCP  clearing  can  grow  substantially  to  cover  large  parts  of  OTC  derivatives,  it  cannot 
apply to all OTC derivatives as the necessary prerequisites are not always in place and not 
easily  applicable.  It  is,  therefore,  also  important  to  improve  product  and  market 
standardisation, strengthen bilateral collateral management and ensuring central storage of 
contract details.  

•  In addition, the crisis and the role played by some OTC derivative market segments require 
a deeper discussion on how to reconcile the clear value played by OTC derivative markets 
–  satisfying,  as  they  do,  the  demand  for  flexible  and  bespoke  derivative  contracts  to 
manage  specific,  non-standard  risks  –  with  an  a  priori  societal  preference  for  transparent 
trading venues, as public and standardised as possible for the purpose of risk assessment 
and price determination.  

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1. 

INTRODUCTION 

The  ongoing  financial  crisis  has  brought  unprecedented  regulatory  attention  to  over-the-
counter (OTC) derivatives markets and to the way in which credit risk has been transferred. 
Indeed, one of the root causes of the crisis may be traced back to the misuse of the techniques 
that were developed to transfer credit risk (securitisation and credit derivatives). While some 
of the problems related to securitisation and to the excessive risk transfer and risk mispricing 
have  already  been  addressed  by  the  recent  review  of  the  Capital  Requirement  Directive1 
(CRD), the risks inherent in Credit Default Swaps (CDS) and other types of OTC derivatives 
have  not.  Their  use  and  their  impact  on  financial  stability  generated  the  current  political 
debate and are analysed in this report.  

The  near-collapse  of  Bear  Sterns  in  March  2008,  the  default  of  Lehman  Brothers  on  15 
September  2008  and  the  bail-out  of  AIG  on  16  September  highlighted  the  fact  that  OTC 
derivatives in general and credit derivatives in particular carry systemic implications for the 
financial market. 

By their nature, OTC markets are markets for professional investors and are thus not directly 
accessible to the general public. As professional investors were deemed sophisticated enough 
to  manage  the  risks  inherent  in  the  OTC  market,  the  latter  has  been  accorded  fairly  light 
regulatory  treatment.  However,  the  recent  financial  crisis  has  illustrated  that  professional 
investors not always understand the risks they face and the consequences of those.  

The bilateral nature of this market makes it opaque to parties outside a particular transaction. 
In addition, the level of concentration in the market in terms of participants tends to be high2. 
Moreover,  as  the  price  determined  in  the  derivatives  markets  may  be  used  to  calculate  the 
price of other instruments, its opaque nature may affect other market segments. In the credit 
default swaps (CDS) market, for example, the prices of these instruments have a direct impact 
one the financing costs a firm faces. Furthermore, even if not directly accessible to the general 
public,  the  instruments  traded  in  the  OTC  market  may  ultimately  affect  retail  investors 
through  other  products  or  via  professional  investors.  Finally,  as  the  major  financial 
institutions  tend  to  participate  in  most  (if  not  all)  the  segments  of  this  market,  the  level  of 
interconnection  (and  hence  the  spill-over  effects)  between  these  various  segments  are 
extremely high3. 

These  characteristics  proved  to  be  the  Achilles  heel  of  the  OTC  market  during  the  current 
crisis  and  might  have,  absent  prompt  and  forceful  intervention  from  governments,  wrecked 
havoc to the financial system. The three institutions mentioned above were important players 
in the OTC derivatives market, either as dealers or users of OTC derivatives, or both4. Whilst 
the trouble they experienced originated outside the OTC derivatives markets and was initially 

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4 

COM/2008/0602 final - COD 2008/0191 amending Directives 2006/48/EC and 2006/49/EC as regards 
banks  affiliated  to  central  institutions,  certain  own  funds  items,  large  exposures,  supervisory 
arrangements, and crisis management. 
Although it may vary significantly from one segment to another. 
The same can also be said in terms of interconnectedness between OTC and regulated markets. In fact, 
it would appear that during this crisis the hit taken by regulated markets due to trouble on OTC markets 
was substantial (their liquidity was used by banks to sell instruments in order to either obtain collateral 
or cover the losses in the OTC markets).  
So much so that two of them were bailed out by the US government in fear of systemic repercussions in 
case of their default. The third one (Lehman), while not recognised as such before its default, proved to 
be systemically important as well. 

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confined to a small segment of the OTC market (i.e. credit derivatives)5, their crucial role in 
virtually  all  the  segments  of  the  OTC  derivative  market  (in  the  case  of  Lehman  and  Bear 
Stearns)  had  a  negative  spill-over  effect  for  the  entire  OTC  market.  The  opaqueness  of  the 
market prevented, on the one hand, other market participants from knowing exactly what the 
exposures of their counterparties were to these three entities (the events in the credit default 
swaps market after Lehman’s bankruptcy are a point in case), which resulted in mistrust and 
the drying up of liquidity in the inter-bank money market. It also prevented regulators from 
being able to identify early the risks building up in the system, the extent to which risks were 
being concentrated in a handful of institutions and consequently the effects that their default 
would  have  for  financial  stability.  The  light  regulatory  coverage  of  the  market  exacerbated 
this  problem  as  supervisors  did  not  have  sufficient  information.  Even  in  case  they  had 
sufficient  information,  one  could,  argue  that  the  lack  of  proper  regulatory  coverage  might 
have deprived public authorities of an effective policy response. 

Whilst  the  current  crisis  brought  an  unprecedented  amount  of  scrutiny  on  the  OTC  market, 
this does not mean that no regulatory attention was directed towards this market. For example, 
the  Committee  on  Payment  and  Settlement  Systems  (CPSS)  published  a  report  on  the  risks 
inherent  in  OTC  derivatives  markets  and  the  tools  used  by  the  industry  to  mitigate  them 
already  in  19986.  Also,  in  the  past  few  years,  regulatory  attention  had  been  increasingly 
focused on decreasing the risks inherent in the OTC market. For example, the adoption of the 
Financial Collateral Arrangements Directive (FCD) contributed significantly to improvement 
of collateral treatment in the OTC derivative markets by granting protection of the collateral 
provided and for netting and close-out netting agreements. 

Furthermore, actions have been taken by public authorities in order to increase the safety of 
OTC derivatives markets by improving their operational efficiency. Although necessary, the 
crisis  has  amply  illustrated  that  these  latter  efforts  are  by  themselves  insufficient  and  that 
more  needs  to  be  done  to  ensure  that  OTC  derivative  markets  do  not  pose  a  threat  to  the 
financial system. Supervisors, regulators and policymakers around the world have started to 
notably  focus  on  strengthening  the  vital  risk  management  function  of  central  counterparty 
(CCP) clearing.  

On 17 October 2008, Commissioner McCreevy called for i) a systematic look at derivatives 
markets  in  the  aftermath  of  the  lessons  learned  from  the  financial  crisis,  and  ii)  concrete 
proposals as to how the risks from credit derivatives can be mitigated.7 On 2 December 2008 
the Council supported, as a first step and as a matter of urgency, the creation of one or more 
European  CCP  clearing  capacities  in  OTC  derivatives  markets,  and  encouraged  coherence 
with parallel initiatives at global level.8 On 18 December 2008 the ECB's Governing Council 
confirmed that  "there was a need for at least one European CCP for credit derivatives and 
that,  given  the  potential  systemic  importance  of  securities  clearing  and  settlement  systems, 
this infrastructure should be located within the euro area".9 Finally, on 2 April 2009 the G20 
declaration on strengthening the financial system promoted the standardisation and resilience 

5 

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9 

The  downfall  of  all  three  institutions  was  due  to  their  direct  or  indirect  exposure  to  the  sub-prime 
mortgages  market.  In  the  case  of  Bear  Sterns  and  Lehman  Brothers,  their  exposure  was  through 
collateralised debt obligations (CDOs) backed by sub-prime mortgages they held on their books. In case 
of AIG, the exposure was through CDS that the latter had sold on those CDOs. 
CPSS (1998). A follow-up report was published in 2007. 
McCreevy, C. (2008). 
Economic and Financial Affairs Council (2008). 
ECB (2008). 

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of  credit  derivatives  markets,  in  particular  through  the  establishment  of  central  clearing 
counterparties subject to effective regulation and supervision.10 

To  ensure  a  solid,  coherent  and  consistent  policy  response,  the  Commission  in  its 
Communication of 4 March11 committed to deliver, on the basis of a report on derivatives and 
other  complex  structured  products,  appropriate  initiatives  to  increase  transparency  and  to 
address any financial stability concerns. The Communication12, this Staff Working Paper and 
the  Consultation  Document13  that  outlines  the  options  contained  in  the  communication  in 
further detail and accompanies them with questions are a first response to that commitment. 
As outlined in the Communication, this will feed into a detailed impact assessment exercise, 
which will help the Commission to shape its approach.14 

This report is structured as follows. Chapter 2 outlines how derivative contracts work and the 
role they have played during the financial crisis. Chapter 3 focuses on OTC derivatives and 
assesses the (i) market structure, (ii)  market  infrastructure, (iii) level of standardisation, (iv) 
risk  characteristics  and  (v)  risk  mitigation  instruments  currently  used  (with  a  particular 
emphasis  on  multilateral  CCP  clearing  vs.  bilateral  clearing  by  means  of  collateral).  The 
assessment is done for the main OTC derivative asset classes: interest rate derivatives, credit 
derivatives,  foreign  exchange  derivatives,  equity  derivatives  and  commodity  derivatives. 
Chapter 4 detailed the level of risk associated with each OTC derivatives market segment and 
the level of effectiveness of current risk mitigation measures.  

2. 

DERIVATIVES MARKETS: FUNCTION, STRUCTURE AND RISKS 

This  chapter  outlines  the  basic  concepts  related  to  the  function  of  derivatives,  the  overall 
market structure, the level of transparency in the market, the major risks entailed and existing 
ways of mitigating these risks.  

2.1. 

Function of derivatives 

2.1.1.  What are derivatives 

Derivatives are financial instruments whose value is derived from the value of an underlying 
asset  or  market  variable.  The  main  types  of  derivatives  are:  forwards,  futures,  options  and 
swaps.  

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G20 (2009).  
European Commission (2009a). 
European Commission (2009b). 
European Commission (2009c). 
This is consistent with recent amendments to the Capital Requirement Directive (CRD), as adopted in 
first  reading  by  the  European  Parliament  on  6  May  2006.  Recital  (19b)  states:  "In  order  to  ensure 
financial  stability,  the  Commission  should review  and  report on  measures  to  enhance transparency of 
OTC markets, to mitigate the counterparty risks and more generally to reduce the overall risks, such by 
clearing of credit default swaps through central counterparties. The establishment and development of 
CCPs in the EU subject to high operational and prudential standards and effective supervision should be 
encouraged.  The  Commission  should  submit  its  report  to  the  European  Parliament  and  the  Council 
together with any appropriate proposals, taking into account of parallel initiatives at the global level as 
appropriate." and, 

Article 156 (review clause) states: "By 31 December 2009 the Commission shall review and report on measures 
to enhance transparency of OTC markets, including the credit-default swap (CDS) markets, such as by 
clearing through central counterparties (CCPs), and shall submit this report to the European Parliament 
and the Council together with any appropriate proposals." 

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A forward is a contract whereby two parties agree to exchange the underlying asset at a pre-
determined point in time in the future at fixed price. Therefore, the buyer agrees today to buy 
a  certain  asset  in  the  future  and  the  seller  agrees  to  deliver  that  asset  at  that  point  in  time. 
Futures are standardised forwards traded on-exchange. 

An option is a contract that gives the buyer the right, but not the obligation, to buy (call) or 
sell  (put)  the  underlying  asset  at  or  within  a  certain  point  in  time  in  the  futures  at  a  pre-
determined  price  (strike  price)  against  the  payment  of  a  premium,  which  represent  the 
maximum  loss  for  the  buyer  of  an  option.  Therefore,  differently  from  forwards  and  futures, 
options  settle  only  if  exercised  and  will  be  exercised  only  if  in-the-money,  i.e.  if  the  strike 
price is lower/higher than the current market price for a call/put. 

Under  a  swap  agreement  two  counterparties  agree  to  exchange  one  stream  of  cash  flow 
against another on a notional principal amount. The different types of swaps agreements are 
explained in chapter 3. 

2.1.2.  The use of derivatives 

Broadly,  derivatives  can  be  used  for  hedging,  speculating  and  arbitrage  purposes.  With  a 
hedge, an investor can protect himself against risk he is exposed to. Risk that can be hedged 
with derivatives can be movements in market variables (e.g. exchange and interest rate, share 
and commodity prices) as well as credit risk. 

Derivatives  can  also  be  used  to  speculate  on  the  movement  of  a  market  variable  or  on 
creditworthiness. Speculators add liquidity to the market by taking a view on the direction of 
the movement; what is often called as taking a bet, can of course be called taking risk. Since 
there are two parties to a derivative deal, a speculator needs to find someone who holds the 
opposite view or would like to transfer a particular risk. 

Finally, derivatives can be used for arbitrage. An arbitrage opportunity is the exploitation of 
price  differences  between  markets.  Derivatives  can  be  combined  to  replicate  other  financial 
instruments, thus they can be used to "connect" markets by eliminating pricing inefficiencies 
between them. 

Derivatives  thus  play  a  fundamental  role  in  price  discovery.  For  example,  they  provide  the 
market's view on future developments in market variables. They may also provide a view on 
the default risk of a reference entity, on a company or a sovereign borrower, or of a particular 
segment  of  the  credit  market.  Thereby,  derivatives  allow  for  pricing  of  risk  that  might 
otherwise be difficult to price because the underlying assets are not sufficiently traded.  

2.2.  Market structure 

Derivative  contracts  can  either  be  traded  in  a  public  venue,  i.e.  a  derivatives  exchange,  or 
privately  over-the-counter  (OTC),  i.e.  off-exchange.  OTC  derivatives  markets  have  been 
characterised  by  flexibility  and  tailor-made  products.  This  satisfies  the  demand  for  bespoke 
contracts tailored to the specific risks that a user wants to hedge. Exchange-traded derivative 
contracts, on the other hand, are by definition standardised contracts.  

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Chart 1: The size of derivatives markets: on- and off-exchange 

$trn

Exchanges

Exchanges - Europe

OTC

800

700

600

500

400

300

200

100

0
Jun-98

Jun-99

Jun-00

Jun-01

Jun-02

Jun-03

Jun-04

Jun-05

Jun-06

Jun-07

Jun-08

Note: The figure shows the notional amounts outstanding in on- vs. off-exchange market segments in USD trillions in 1998-2008. The trends 
shows  outstanding  amounts  worldwide,  where  European  exchanges’  market  share  is  shown  separately  (no  similar  geographic  breakdown 
exists in OTC data). Source: Bank for International Settlements (BIS). 

While derivatives were initially mostly traded in public venues, today the bulk of derivatives 
contracts  is  traded  OTC  (roughly  85%  of  the  market  in  terms  of  notional  amounts 
outstanding). The OTC market has expanded quickly in recent years, but decreased in 2008 
for the first time since monitoring started in 1998. 

Whether  a  derivative  contract  is  standardised  or  bespoke  determines  how  the  market  has 
structured the delivery of trade and post-trade chain functions: 

•  Trade execution: Trade execution occurs when two counterparties agree to a transaction. 
On-exchange,  orders  are  matched  automatically  on  derivative  exchanges'  order  books. 
OTC  execution  may  take  a  variety  of  forms,  depending  on  contracts'  standardisation  and 
market preference, e.g. occurring by phone or electronically on "private" exchanges  (e.g. 
inter-dealer  networks).  Electronic  trading  has  increased  rapidly  in  recent  years,  driven  in 
part  by  the  advent  of  hedge  funds,  which  have  different  trading  needs  compared  to  e.g. 
corporates.  

•  Trade  confirmation:  After  the  execution,  the  terms  of  the  trade  need  to  verified 
(affirmation) and confirmed. On-exchange, this occurs automatically within the exchange's 
matching  system.  As  regards  OTC,  the  most  standardised  (vanilla)  OTC  contracts  use 
electronic  affirmation  and  confirmation  third-party  services  (e.g.  Markit  Wire,  DTCC's 
Deriv/SERV etc).  

•  Clearing: Contrary to equity markets, where the post-trade aspects (e.g. exchange of cash 
and transfer of ownership) are completed quickly (less than 2/3 days), derivative contracts 
involve long-term exposure, as derivative contracts may last for several years. This leads to 
the  build-up  of  huge  claims  between  counterparties,  with  of  course  the  risk  of  a 
counterparty  defaulting.  Clearing  is  the  function  by  which  these  risks  are  managed  over 
time.  On-exchange,  clearing  is  done  on  a  Central  Counter-party  (CCP).  OTC,  clearing  is 
mostly done bilaterally between the parties involved but increasingly on a CCP. In view of 

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the key role of risk in derivative markets, the issue of clearing and risk management more 
widely are treated more in depth in section 4. 

Dealers  play  an  important  role  in  OTC  derivative  markets,  acting  both  as  prime  brokers 
(counterparty  risk  taker  and  leverage  provision)  and  market  maker  (product  structuring  and 
liquidity provision). To be an effective dealer requires scale and reach. Accordingly, there are 
strong forces pushing  for a centralised dealer structure. The crisis has somewhat altered  the 
balance  between  dealers  though,  with  clients  becoming  reluctant  to  use  only  one  prime 
broker, instead preferring to split business among a few prime brokers.  

2.3. 

Transparency  

While  exchange-traded  derivatives  leave  a  transparent  trail  in  terms  of  positions,  prices  and 
exposures,  in  the  mostly  OTC  market  for  derivatives,  information  available  to  market 
participants and supervisors is limited. In the preceding sections, it has been emphasised that 
neither  market  participants  nor  supervisors  had  a  complete  view  of  the  market.  More 
transparency to regulators, mainly on positions, might improve the resilience of the financial 
system.  The  situation  is  described  in  the  first  part  of  this  section.  In  addition,  transparency 
might  also  improve  market  efficiency  (in  particular  through  price  transparency)  helping 
detecting possible market abuses (through transaction reporting) and reducing frictional costs 
in the market. These latter aspects are dealt with in the second and third part of this section. 

2.3.1.  Transparency on positions 

The  main  providers  of  market  survey  data  are the Bank for International Settlements  (BIS), 
International Swaps and Derivatives Association (ISDA) and the British Bankers Association 
(BBA),  covering  the  broad  categories  of  derivatives.  The  US  Comptroller  of  the  Currency 
(OCC)  quarterly  publishes  data  from  US  commercial  banks  received  through  regular 
reporting.  Some  service  providers  in  the  derivative  market,  for  example  clearinghouses  or 
electronic trade confirmation platforms, also collect information. For CDS, the DTCC Trade 
Information  Warehouse  (TIW)15,  began  publishing  aggregated  data  in  autumn  2008  (see 
section 3.1.5). 

However, each of the abovementioned sources provides only a partial picture of the market. 
Only  the  OCC  provides  positions  of  particular  a  group  of  institutions  (commercial  banks), 
which are aggregated by types of derivative instruments (e.g. CDS, interest rate swaps etc.). 
Similarly,  the  TIW  breaks  down  the  data  on  CDS  by  reference  entity,  but  does  not  provide 
data on exposures of single institutions. Publicly available information, on which the market 
could form a view on possible counterparty risk correlations, is therefore incomplete. 

Information on positions that supervisors receive from financial institutions is more complete, 
as long as the financial institutions are located within their respective jurisdiction. However, 
since  derivative  trading  is  global,  supervisors  may  currently  be  unable  to  get  a  complete 
picture  of  counterparty  exposures  of  a  particular  institution  in  a  timely  fashion.  In  addition, 
they  may  also  be  unable  to  identify  the  level  of  concentration  of  holdings  of  a  particular 
instrument.  Their  access  to  private  service  providers,  such  as  the  TIW,  but  also  to  portfolio 
reconciliation  services  (those  offered  by  e.g.  Markit  and  TriOptima,  see  section  2.4.1.3)  is 
currently  on  a  case-by-case  basis.  CCPs  naturally  collect  position  data  in  their  respective 
market on at least a daily basis, which is provided to the primary regulator. Currently, little 
data is provided to the public apart from the total open interest in the CCP. 

15 

The  DTCC  is  the  Deposit  Trust  and  Clearing  Corporation,  which  is  the  US  Central  Securities 
Depository and Clearing House for equities and bonds. 

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However,  the  Federal  Reserve  Bank  of  New  York  has  recently  established  a  group  of 
supervisors to detail their information needs in the CDS market, in order to define consistent 
reporting obligation for CCPs and for central data repositories. 

2.3.2.  Transparency on prices 

Prices  (bid-ask  spreads)  are  generally  available  to  OTC  market  participants  via  interdealer 
brokers  or  from  dealers  to  clients  in  response  to  request  for  quotes.  Data  vendors  also 
distribute  consensus  prices16  on  the  basis  of  the  information  provided  by  their  contributors. 
Post-trade  transparency  on  traded  prices  is  limited.  As  mentioned  above,  the  prices 
determined  in  the  derivatives  market  are  particularly  relevant  as  a  reference  price  for  the 
particular risk traded. For example, the CDS price, as an indicator for default risk, affects the 
refinancing  cost  faced  by  firms.  In  this  context,  wider  availability  of  post-trade  information 
has been raised several times.  

On a public trading venue, where standardised products are traded, information on prices is 
fully  transparent  to  both  public  and  regulators.  As  proved  by  the  Markets  in  Financial 
Instruments  Directive  (MiFID)  for  equities,  a  level  playing  field  between  trading  venues  is 
established if they are all subject to appropriate transparency requirements.  

Extensive  analysis  and  consultation  has  been  carried  out  in  recent  years  on  whether  more 
transparency  of  trading  activity  also  in  non-equity  markets  is  required.  There  are  valid 
arguments both in favour and against. While market participants, infrastructure providers and 
regulators  tend  to  agree  that  an  adequate  picture  of  ongoing  and  past  trading  activity  is 
necessary, they disagree on the adequacy of existing arrangements and the need for regulatory 
intervention.  

On  the  one  hand,  in  conditions  of  disproportionate  disclosure  requirements  in  less  liquid 
markets, dealers would be discouraged from committing capital to trading, and the benefits of 
the relevant financial instruments would be foregone. On the other, some  participants could 
benefit from more transparency in order to reduce the information asymmetry in favour of the 
major  dealers.  With  the  crisis,  this  opacity  in  OTC  derivative  markets  has  become  a  major 
concern for regulators and market participants. CESR is currently revising the level of price 
transparency available in structured finance products and credit derivatives market.  

2.3.3.  Transaction reporting 

Transaction reporting to supervisors has the primary purpose of preserving market integrity. 
Article  25(3)  of  MiFID  requires  investment  firms  to  report  all  transactions  in  any  financial 
instruments admitted to trading on a regulated market to the competent authority (including 
exchange-traded derivatives and listed structured products), wherever these transactions take 
place  (regulated  market,  multi-lateral  trading  facility  (MTF)  or  OTC).  This  means  that 
transactions  in  OTC  derivatives  and  other  complex  products  if  these  are  not  admitted  to 
trading on a regulated market are exempt from these requirements. 

CESR  has  recently  mandated  a  Task  Force  to  analyse  the  possibility  to  both  collect  and 
exchange reports in some OTC derivatives with the objective to help detect cases of market 
abuse. As these OTC financial instruments which are not listed mirror instruments admitted to 
trading on regulated markets they can equally be used for market abuse.  

16 

Consensus  prices  are  average  of  the  price  at  which  a  contributing  dealer  is  willing  to  trade  or  have 
traded a particular contract, without differentiation between the two. 

EN 

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Based on the preliminary analysis carried out17, there may be a need to extend the scope of 
Article  25  to  include  OTC  derivative  instruments  whose  underlying  financial  instrument  is 
admitted  to  trading  on  a  regulated  market  (including  corresponding  depositary  receipts). 
Although  Recital  45  of  MiFID  allows  Member  States  to  apply  transaction  reporting 
obligations to financial instruments that are not admitted to trading on a regulated market, the 
collection  of  transaction  reports  of  OTC  derivative  instruments  is  currently  not  mandatory. 
Most Member States appear to support changing this. 

2.4. 

Risk and risk mitigation 

Derivative contracts bind counterparties together for the duration of the contract. The duration 
varies  depending  on  product  type  and  market  segment,  ranging  from  e.g.  a  few  days 
sometimes in FX derivatives to several decades for certain interest rate derivative contracts.  

Throughout the duration, counterparties build up claims against each other, as the rights and 
obligations  contained  in  the  contract  evolve  with  the  underlying  that  the  contract  is  derived 
from.  This  gives  rise  to  counterparty  credit  risk,  i.e.  the  risk  that  the  counterparty  may  not 
honor its obligations under the contract. As outlined above, it is difficult to value this risk in 
view of the opaque nature of OTC derivatives markets.  

Clearing is the function by which this risk is managed. Clearing can either occur at bilateral 
level between the two counterparties to a particular trade or at multilateral level, by means of 
a Central Counter-party (CCP) becoming the counterparty to all other counterparties.  

2.4.1.  Bilateral clearing 

Under bilateral clearing, the two counterparties typically conduct their trading relations under 
a  Master  Confirmation  Agreement  (MCA)  that  sets  the  main  contractual  parameters 
governing their trading relationship. This agreement may have a Credit Support Annex (CSA) 
that outlines how the two counterparties agree to manage their respective credit exposures to 
each  other.  The  CSA  applies  to  all  OTC  derivatives  transactions  concluded  between  the 
parties to the CSA.  

2.4.1.1.  Principles of bilateral collateral provisioning 

The  underlying  principle  is  that  both  parties  will  mark-to-market  (MTM)  contracts  so  as  to 
monitor the evolution of their residual value.  

Should the MTM process show that one party has built up a claim on the counterpart it is then 
entitled to ask its counterparty for collateral in order to mitigate the risk that the counterparty 
may not eventually honor its obligation or may default during the lifetime of the contract. 

Collateral is typically provided in cash (see below). Cash is exchanged on a net basis, i.e. a 
single net cash value is calculated for the overall OTC derivative portfolio between the two 
counterparties  in  question.  Each  counterparty  therefore  benefits  from  cross-margining  (i.e. 
build-up of claims in one derivative market segment compensated by build-up of liabilities in 
another).  Other  types  of  collateral  include  securities,  letters  of  credit,  guarantees  and 
commodities. 

17 

Call for Evidence on the Technical Standards to Identify and Classify OTC Derivative Instruments for 
TREM, CESR's Transaction Reporting Exchange Mechanism, 2 February 2009 

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2.4.1.2.  Practice of bilateral collateral provisioning 

The dominant source of the nature and extent of bilateral collateral is ISDA's margin surveys. 
This section is based on the numbers provided by ISDA. However, the Commission services 
cannot  judge  the  solidity  of  these  numbers,  as  no  information  is  available  about  the 
methodology  for  calculating  the  numbers.  They  should  accordingly  be  considered  as 
indicative only. 

ISDA’s “Margin Survey 2009” documents that in 2008, reported collateral amounted to $2.6 
trillion.  As  the  survey  is  based  on  reports  from  a  sub-set  of  market  participants,  ISDA 
estimates  that  the  overall  amount  of  collateral  in  circulation  amounted  to  $4  trillion.  ISDA 
further  documents  that  151,000  collateral  agreements  were  in  place.  Of  these,  the  large 
majority (57%) are concluded under New York law, while around 28% are concluded under 
English law.  

According to ISDA, the use of collateral has grown over the years. The corresponding figures 
for 2000, the first year a survey was carried out, estimated the amount of collateral at $200bn 
and documented 12,000 collateral agreements.  

ISDA  argues  that  the  amount  of  credit  exposure  that  is  covered  by  collateral  has  grown,  as 
documented  by  the  graph  below  and  it  claims  that  it  now  amounts  to  66%  overall.  Above 
average  is  fixed  income  (71%),  on  average  is  credit  and  below  average  are  commodities 
(47%), FX (48) and equity (52).  

It  is  interesting  to  note  that  for  CDS,  the  asset  class  that  has  been  subject  to  the  brunt  of 
regulatory attention, the level of collateral, as share of credit exposure, has remained flat since 
2006.  This  may  indicate  that  while  absolute  amounts  of  collateral  may  have  increased 
substantially, the credit exposure has increased even more. 

Cash  is  the  dominant  source  of  collateral,  amounting  to  84%  of  collateral  received  in  2008 
and 83% of collateral delivered. Government securities are the second source of collateral (9 
and  15%  respectively).  Other  sources  are  e.g.  corporate  bonds,  letters  of  credit  and 
commodities. 

Chart 2: Credit exposure covered by collateral, 2003-2009 

Percent of exposure, full sample 

80

70

60

50

40

30

20

10

0

Fixed income

FX

Equity

Metals

Energy

Credit

2003

2004

2005

2006

2007

2008

2009

Source: ISDA (2009) 

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2.4.1.3.  Portfolio reconciliation 

Collateral  is  based  on  firms’  internal  trade  documentation  and  mark-to-market  estimates. 
These  may  be  more  or  less  solid.  Overall,  managing  collateral  with  a  wide  variety  of 
counterparties may be challenging. To assist firms in their collateral management processes, 
third party vendors provide reconciliation services (e.g. TriOptima).  

Table 1: Current use of portfolio 
reconciliation services 

Portfolio  reconciliation  facilitates  the  bilateral  collateral 
management  process.  In  2008  all  major  dealers  have 
to  reconcile  all  OTC  derivatives  between 
started 
themselves  and  major  counterparties,  most  on  a  daily 
basis.  Reconciliation  covers  the  whole  portfolio:  trade 
population,  key  financial  terms  (e.g.  notional,  bought  or 
sold…)  and  mark-to-market  value  (i.e.  a  counterparty's 
effective  measure  of  risk  of  a  particular  contract).  If 
disputes  arise,  reconciliation  provides  processes  for 
resolving  them.  Overall,  it  allows  counterparties  to 
monitor credit exposure more effectively. ISDA’s survey 
found that while a large share of survey respondents use 
reconciliation services (80%), only some reconcile on a daily basis while some only do it in 
case of disputes.  

Use reconciliation services 

Source: ISDA (2009). 

Reconcile monthly 

Reconcile weekly 

Reconcile daily 

Use/timing 

As needed 

Share (%) 

80 

31 

20 

6 

4 

• 

• 

• 

• 

2.4.1.4.  Potential weakness of bilateral clearing 

Overall,  collateral  is  only  an  effective  insurance  against  credit  exposure  if  (i)  exposure  is 
calculated  frequently,  (ii)  collateral  is  effectively  exchanged  in  a  timely  manner  and  (iii)  it 
offers  a  comprehensive  insurance  against  overall  potential  counterparty  credit  exposure. 
Bilateral clearing, while essential, is associated with a number of potential weaknesses in all 
these respects: 

•  First,  bilateral  clearing  fundamentally  relies  on  each  party's  internal  'risk  engine',  i.e. 
approach  to  and  method  for  assessing  the  current  value  of  and  risk  associated  with  the 
constituent  components  of  its  OTC  derivatives portfolio.  These  risk  engines  are  essential 
parts of a bank's competitive advantage and while the broad contours may be similar each 
bank has a slightly different approach to risk assessment. Overall, the crisis has highlighted 
the difficulty of designing models that adequately measure the market risk.18 It is therefore 
not  unlikely  that  disputes  may  arise  between  counterparties  as  regards  the  MTM  value 
associated  with  a  particular  contract  and  the  corresponding  collateral  obligation  it  gives 
rise  to.  This  risk  is  further  amplified  by  the  fact  that  the  CSA  does  not  detail  the  risk 
valuation  method  to  be  employed  between  the  parties  in  any  significant  detail.  Disputes 
therefore  do  arise,  particularly  over  differences  in  parameters  (e.g.  frequency  of  MTM, 
curve  calculations…)  and  these  take  time  to  resolve.  Portfolio  reconciliation  is  useful  in 
this respect, as it makes potential differences in MTM values transparent and may as well 
offer ways of facilitating the resolution of disputes. 

•  Second, while the ambition is for the collateral cycle to mirror the valuation cycle, practice 
differs. While daily valuation and (close-to-daily) exchange of collateral is the norm for the 
major  market  making  dealers,  the  frequency  falls  substantially  as  one  moves  down  to 
second  and  third  tier  institutions.  Weekly  and  even  monthly  valuation  and  exchange  of 
collateral continues to be an existing market practice.  

18 

See e.g. The High-level Group on Financial Supervision chaired by Jacques de Larosière (2009).  

EN 

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•  Third, collateral is generally based on mark-to-market values only. It does not incorporate 
the potential cost of replacing the contract in the market should the original counterparty 
default (i.e. the future replacement cost). 

•  Fourth, the level of collateral that is effectively provided often also takes into account the 
perceived credit quality of the counterparty. The source for assessing that quality is credit 
ratings.  Typically,  if  the  counterparty  has  a  high  credit  rating,  effective  collateral  levels 
may be reduced. The crisis has amply illustrated the deficiency of ratings and the negative 
effects this has on the bilateral collateral model has been illustrated by AIG. Credit default 
swaps issued by AIG Financial Products were for long exempt from providing full levels 
of collateral, thanks to (i) the parent company AIG's high rating, and (ii) the fact that AIG 
only  sold  CDS  on  "super-senior"  security  tranches.  However,  as  the  financial  crisis  took 
off in 2007, AIG and the super-senior CDS were gradually downgraded, which triggered 
significant collateral calls that AIG found it increasingly hard to meet.  

•  Fifth, as illustrated above, collateral coverage is not comprehensive. While collateral now 
covers  66%  of  credit  exposure  overall,  more  than  one  third  of  credit  exposures  remain 
uncollateralised.  While  the  overall  rate  of  exposure  covered  by  collateral  is  significantly 
higher  compared  to  a  decade  ago,  the  universal  upward  trend  has  been  broken  in  recent 
years, with growth in effective coverage having stalled (CDS) if not reversed (equity, FX). 
Moreover,  the  collateral  numbers  reported  by  ISDA  are  simple  averages  based  on 
respondents' average figures.19  

•  Sixth, and more broadly, bilateral clearing as well as the overall risk management approach 
set by each institution is vulnerable to competing intra-institutional considerations, such as 
the  quest  to  maximize  commercial  opportunities  and  associated  profits.  The  crisis  has 
highlighted  the  difficulty  for  institutions  to  uphold  a  conservative  approach  to  risk  in  a 
competitive  market  environment.  This  differs  from  multilateral  clearing,  where  the  risk 
management function is carried out by a CCP, i.e. an institution whose sole focus is risk 
reduction.  

Chart 3: Bilateral vs. CCP clearing 

Bilateral clearing
Web of of counterparty exposure
Complex collateral movements
Potential domino effect of one dealer default

•
•
•

CCP clearing

•
•
•

Hub and spoke with central guarantor
All collateral moves to/from CCP
CCP capitalised to withstand dealer default

19 

In other words, they are not weighted by the size of the respondent institution. It is accordingly difficult 
to  assess  whether  the  overall  figures  are  representative,  as  the  figures  reported  by  a  second  tier 
institution  weigh  as  much  as  those  of  a  major  market  making  dealer.  Intuitively,  larger  institutions 
should find it easier to manage the collateral process. Informal numbers do indeed suggest that some of 
the larger institutions have collateral in excess of the survey figures reported by ISDA. 

EN 

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•  Finally,  bilateral  clearing  requires  management  of  numerous  clearing  relationships  (with 
all counterparties), necessitating investments in systems and man-power. The very nature 
of the complex bilateral network this gives rise to makes it difficult, if not impossible for 
an institution to understand its own credit exposure in view of its counterparties' exposure 
to  each-other  let  alone  assessing  the  cascading  implications  of  the  default  of  a 
counterparty.  

2.4.2.  CCP clearing 

Moving from bilateral to central clearing by using one or several CCPs is the most immediate 
way of addressing the limitations outlined in the previous section. CCP clearing is associated 
with significant benefits, but requires a certain number of market characteristics for it to work. 

With  central  clearing,  trading  partners  remain  to  be  found  on  a  bilateral  basis.  However,  a 
central counterparty (CCP) changes the terms of trade in two ways: First, it allows netting of 
exposures in a multilateral way, namely with all participants in the CCP (which is organised 
by asset class). Second, it is a mutual insurance against default of one of the participants. 

After  two  parties  have  agreed  on  a  trade,  the  CCP  steps  into  each  trade  by  acting  as  a 
counterparty to each side (the trade is "novated"). The obligations of each of the two trading 
partners are now  vis-à-vis  the CCP,  hence each party's  exposure  in  this  market  is  now  with 
one and the same party, which can net them out. Moreover, the CCP can value each trade and 
hence exposure on a daily basis. 

There is often a debate on whether it is better to have one or more CCPs in any given market. 
There  are  reasons  on  both  sides.  Economic  theory  argues  that  from  the  point  of  view  of 
efficiency a single CCP is optimal (though only in the short run). However, from a safety and 
competition point of view a market structure with more than one CCP is preferable.  

2.4.2.1.  Benefits of CCP clearing 

As explained above, in bilateral OTC trades, parties post collateral to each other in order to 
reassure themselves (partly) that the counterparty will honour the contract. This may happen 
at  the  inception  of  the  contract  ("initial  margin")  as  well  as  during  its  lifetime  ("variation 
margin"). In a CCP, both types of collateral are posted centrally. This has two benefits. First, 
since  exposure  is  in  net  terms,  i.e.  of  each  party  against  the  CCP,  collateral  is  also  netted 
multilaterally. Second, by collecting collateral centrally, the amount of collateral available in 
case of a default among the participants is quite large. In addition, to be allowed for trading on 
a CCP platform, an upfront deposit has to be made ("default fund"). This provides additional 
protection in case of a default. Thus, by collecting collateral centrally and by asking for the 
upfront  deposit,  a  CCP  is  well-insured  against  default  –  as  are  the  trades  to  which  it  has 
become  a  party.  Since  posting  collateral  means  economically  a  (partial)  funding  of  a  trade 
even in a bilateral OTC transaction, the pooling of collateral in a CCP implies that each trade 
becomes well funded. By the same token, in case of a default of one participant, recourse is 
made  to  that  pool  of  collateral,  which  mutualises  the  cost  of  default.  It  is  this  mutual  pre-
funding of risk that prevents cascades of counterparty defaults. 

The CCP can make adjustments rapidly when the risk position in that market changes. This is 
in contrast to bilateral relationships, where only the risk position of direct trading partners can 
be  observed  by  market  participants  and  thus  an  overall  change  of  exposure  on  a  particular 
asset class may go unnoticed for a long while. 

EN 

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In view of this, the advantages of using a CCP can be grouped as follows:20  

•  First, it allows risk mitigation and mutualisation of losses. This is a fundamental qualitative 
difference  with  bilateral  collateral  provisioning.  Risk  mitigation  is  guaranteed  by 
multilateral  netting,  by  novation  (i.e.  the  process  through  which  the  original  bilateral 
contract  is  replaced  by  two  contracts  between  the  CCPs)  and  by  robust  margining 
procedures and other risk management controls that render the CCP the most creditworthy 
counterparty. Margins are effective, initial margins are always calculated irrespectively of 
the  counterparty  of  the  trade,  future  replacement  cost  is  duly  taken  into  account  and 
exposures are generally fully collateralised on a daily basis. Furthermore, a CCP is better 
placed  than  single  counterparties  of  a  bilateral  transaction  to  absorb  the  failure  of  a 
member. Through the design of clearing members' margining and collateral requirements, 
CCPs  reduce  the  probability  of  immediate  propagation  to  solvent  members  of  the  losses 
incurred by the insolvent one. In addition, the CCPs ability to mutualise losses enables it 
absorb defaults far better than any individual participant in bilateral clearing. 

•  Second,  it  has  a  positive  effect  on  market  liquidity.  Provided  that  the  CCP  clears  a 
sufficient  number  of  asset  classes,  the  usage  of  a  CCP  for  OTC  derivatives  may  allow  a 
member to free capital for other purposes, as less collateral should be required, thanks to 
multilateral  netting,  payment  netting  and  possible  cross-margining  arrangements  with 
exchange-traded contracts, all resulting in increase of liquidity. 

•  Third,  it  solves  disruptive  information  problems.  When  a  major  player  in  bilaterally-
cleared  derivatives  markets  fails,  it  is  not  immediately  apparent  to  the  remaining  market 
participants  who  are  absorbing  the  losses,  how  big  they  are  and  how  the  failed  firm's 
counterparties  are  affected.  The  effects  of  this  uncertainty  can  be  devastating  on  market 
confidence, as illustrated by Bear Sterns, Lehman and AIG. This uncertainty is mitigated 
by  a  CCP  that  has  effective  means  of  allocating  losses  and  no  incentive  to  use  the 
information it holds for its own profits. This neutrality alleviates the information concerns 
of market participants.  

•  Fourth,  using  a  CCP  increases  operational  efficiency.  As  the  counterparty  of  all  trades  a 
CCP establishes the margin and collateral requirements for all the participants, centralises 
the necessary calculations, mark-to-market open contracts and collect or pay the respective 
amounts in automated ways, reducing disputes and increasing efficiency. 

•  Finally, it allows regulatory capital savings since it is considered a zero risk counterparty. 

CCPs  have  proven  to  be  resilient  even  under  stressed  market  conditions  as  the  one  we  are 
facing today and showed their ability to ensure normal market functioning in case of failure of 
a  major  market  player  (e.g.  LCH.Clearnet's  successful  unwinding  of  the  interest  rate  swap 
positions  left  open  following  the  default  of  Lehman  Brothers,  as  further  documented  in 
chapter 3.2).  

2.4.2.2.  Costs and savings related to CCPs 

Traditionally, firms carry out cost-benefit analysis on whether or not to use CCP clearing in 
any given OTC derivative asset class. Firms' potential savings from using CCP can largely be 
summarised into two sources:  

•  Economic  capital  savings:  compared  to  bilateral  clearing,  multilateral  clearing  offers 
significant  additional  netting  benefits.  Furthermore,  under  the  Basel  II  Capital  Adequacy 

20 

Bliss, R. and C. Papathanassiou (2006) 

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framework,  a  zero  risk  weighting  is  attributed  to  counterparty  credit  risk  exposures  on 
derivatives  contracts  that  are  outstanding  with  a  CCP,  provided  that  the  CCP  fully 
collateralises its exposures with all participants on a daily basis21.  

•  Operational savings: due to centralised collateral management. More efficient centralised 

processes reduce the operational risks and the costs associated with them.  

The costs involved in using a CCP primarily relate to the contribution to the CCP's various 
safeguards (i.e. initial margin, variation margin, default fund) and to a lesser extent the need 
to  invest  in  infrastructure  connecting  to  the  CCP.  Moreover,  a  CCP  improves  transparency, 
which redistributes informational advantages among market participants, to the disadvantage 
of those currently enjoying an information advantage (i.e. major OTC derivatives dealers).  

Traditionally,  market  participants  have  valued  the  CCP  proposition  where  (i)  they  trade  in 
large notional size, (ii) the market is volatile, and (iii) the products sufficiently standardised.  

2.4.2.3.  Prerequisites for CCP clearing 

There are a number of prerequisites for CCP clearing to be used, broadly related to liquidity, 
trade process standardisation and contractual standardisation. More specifically: 

•  The  trade  flow  throughout  the  trading  and  post-trading  chain  should  be  sufficiently 
standardised  to  allow  a  CCP  to  step  in  after  a  transaction  is  concluded.  Electronic  trade 
confirmation largely facilitates this process.  

•  The  price  discovery  venues  need  to  be  transparent  and  robust  so  as  to  facilitate  risk 

valuation in e.g. mark-to-market processes.  

•  Broad  fungibility  so  as  to  enable  novation  and  netting.  This  requires  minimum  levels  of 
industry-wide standardisation of main legal parameters contained in contracts (e.g. ISDA). 
But the level of required standardisation may vary, as illustrated by interest rate swaps and 
credit default swaps. The former are relatively standardised as regards contract definition, 
but remain highly bespoke in some of the main parameters (e.g. rates covered, tenor, etc). 
This tailor-made nature has not precluded CCP clearing, as the continuous risk profile of 
the instrument allows clearing of contracts with different terms. CDS, on the other hand, 
needed a standardisation in the contract terms to facilitate CCP clearing and, as outlined in 
section  3.1.4,  new  contractual  and  market  conventions  have  been  put  in  place.  For  other 
market  segments,  e.g.  equity  derivatives,  even  the  contractual  documentation  is  not  yet 
standardised.  Therefore,  substantial  work  needs  to  be  done  before  such  markets  are 
amenable to a broad uptake of CCP clearing.  

2.4.2.4.  CCP market structure 

There are several factors to take in to account when considering whether clearing should be 
channelled through a single CCP or through multiple CCPs:22 

(1) 

Efficiency.  The  CCP  clearing  function  is  characterised  by  economies  of  scale  and 
scope.  Hence,  a  single  CCP  may  make  economic  sense  in  terms  of  static  gains  (i.e. 
reducing  costs).23  However,  in  terms  of  dynamic  gains  (i.e.  innovation),  the  results 
may be more complicated. In particular, it is unclear how a single CCP will over time 

21 
22 
23 

Annex III, part 2, point 6 Directive 2006/48/EC 
Hrovatin S. et al (2009). 
Duffie, D. and H. Zhu (2009). 

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(2) 

(3) 

(4) 

manage to overcome the difficulty of creating benign conditions for innovation in the 
absence of competition, a common problem in monopolistic markets.  

Regulatory,  supervisory  and  monetary  policy  related  issues.  All  of  these  provide 
powerful arguments against the global market being served by a single CCP located in 
a single non-EU jurisdiction, no matter how efficient that outcome would be in strictly 
economic  terms.  These  concerns  become  particularly  relevant  in  a  crisis  situation  as 
the single CCP would be the single point of failure, putting all market participants at 
risk. In the absence of an effective crisis management mechanism relevant authorities 
do  not  know  how  the  burden  of  a  potential  CCP  default  would  be  shared.  Other 
concerns  relate  to  i)  the  legal  risks  associated  with  such  a  crisis  situation  and  the 
potential difficulty in accessing assets, and ii) liquidity problems affecting a particular 
currency of a different jurisdiction than that of the CCP. 

Stability.  A  CCP  does  not  eliminate  counterparty  risk.  Rather,  it  creates  a  more 
transparent way of assessing that risk and a more effective way of managing it. CCPs 
are thus critically important institutions for systemic stability in their own right. As a 
consequence,  the  efficiency  argument  in  favour  of  centralised  CCP  clearing  market 
structure  has  to  be  squared  against  the  stability  argument  which  favours  a  more 
fragmented and reliable structure.  

Cross Margining and Interoperability. Finally, there are ways of achieving the best of 
fragmentation  and  centralisation.  Issues  such  as  cross-margining  agreements  and 
interoperability  should  be  contemplated,  so  as  to  improve  the  efficiency  of  clearing 
members' capital management. 

Therefore,  as  highlighted  by  the  G20  and  de  Larosière  reports,  it  is  desirable  to  have  more 
than one CCP in order to ensure competition. 

2.4.3.  Portfolio compression 

Portfolio compression reduces the amount of overall trades and notional size of the market by 
eliminating off-setting trades. This offers significant benefits for market participants. In OTC 
derivatives,  participants  build  up  gross  positions  that  far  exceed  their  net  risk  position. 
Portfolio compression typically (i) reduces counterparty credit risk without changing the net 
market  exposure  of  an  institution,  (ii)  reduce  operational  risks  and  costs,  (iii)  reduce 
administrative costs and (iv) overall cost of capital.  

Portfolio  compression  also  offer  benefits  in  a  CCP  environment,  as  it  can  also  be  used  to 
compress  the  CCP's  portfolio.  This  facilitates  default  management:  the  smaller  and  less 
complex the defaulted party's portfolio, the easier and faster it is to manage the consequences 
of a participant's default.  

In  principle,  portfolio  compression  can  be  applied  to  all  OTC  derivatives  with  sufficient 
liquidity to motivate netting down of gross positions. In practice, it is predominantly used in 
interest rate, credit default swaps and to some extent energy swap markets. Overall, the scope 
depends on the level of standardisation: the more standardised the contract, the easier it is to 
match eligible trades and tear them up. In terms of institutional scope, it is more logical for 
market-making  institutions  sitting  on  two-way  flow  rather  than  buy-side,  which  are  either 
typically long or short.  

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3. 

DIFFERENT TYPES  OF OTC DERIVATIVES: RISK  CHARACTERISTICS  AND  CURRENT 
RISK MANAGEMENT MEASURES 

OTC  derivatives  are  generally  divided  into  five  categories:  credit  derivatives,  interest  rate 
derivatives, foreign exchange derivatives, equity derivatives and commodity derivatives. The 
graph below depicts the relative weight of these market segments in the OTC market. Most of 
the market segments are also traded on-exchange (e.g. equity and commodity derivatives).  

This chapter  provides  a detailed description of  the  market  structure  of  each  of  these  market 
segments.  Each  section  outlines  the  specific  function  provided  by  derivatives  in  this  market 
segment, the market structure, the infrastructure and level of standardisation in place or under 
development,  the  specific  risk  characteristics  and  existing  risk  mitigation  instruments.  The 
final  section  contains  an  overall  assessment  of  the  effectiveness  of  existing  risk  mitigation 
measures.  

Chart 4: OTC derivative market segments 

Notional amounts outstanding, USD trillion, December 2008 

41,868

49,753

6,494

4,427

Foreign exchange contracts

Interest rate contracts

70,742

Equity-linked contracts

Commodity contracts

Credit default swaps

Unallocated

418,678

Source:  BIS (2009)

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Table 2: Overall market structure and infrastructure of different OTC derivative 
segments 

Market 

Trading 

Products 

Trade execution 

Trade confirmation 

Clearing/ 
settlement 

Credit 

OTC 

CDS 

Rates 

Exchange 

Futures on short 
term interest 
rates and 
government 
bonds 

OTC 

IRS 

FX 

Exchange 

OTC 

Futures and 
options 

Spots and 
options 

Commodities  Exchange 

Futures 

Interdealer: Creditex, 
ICAP... 

Dealer to client: MAX 

DTCC Deriv/Serv 

ICE Trust US 

Markit Wire 

BClear 

T-Zero 

Eurex, Liffe, CME 

Exchange trading 
matching systems 

Eurex Clearing, Liffe 
Clear, CME Clearing 

Interdealer: ICAP, 
Tullet 

Dealer-client: 
TradeWeb, BBG 

CME 

Markit Wire 

SwapClear 

Trade Express 

Exchange trading 
matching systems 

CME Clearing 

Interdealer: EBS, 
TFS-ICAP, Reuters 

Dealer-client: FXAII 

Swift 

CLS 

CLS 

CME, Liffe, ICE, 
LME 

Exchange trading 
matching systems 

CME Clearing, Liffe 
Clear, ICE Clear, 
LCH.Clearnet 

OTC 

Physical trades, 
structured trades 
and swaps 

EBS, LME Select, 
Trayport, Bloomberg 
Chat 

Energy: e-confirm 
(ICE), EFET 

ICE Clear Europe, 
CME Clearport 

Metal: e-confirm, 
SWIFT 

Equity 

Exchange 

OTC 

Futures and 
options 

Options, 
structured trades 
and swaps 

Eurex, Liffe, CBOE 

Exchange trading 
matching systems 

Eurex Clearing, Liffe 
Clear, OCC 

ICAP, TFS, Tullet 

Markit Wire 

BClear 

3.1. 

Credit default swaps 

This  section  focuses  on  credit  default  swaps  (CDS),  the  most  common  type  of  credit 
derivative.  

3.1.1.  Nature of contracts 

A CDS is a contract between two counterparties under which the protection buyer will pay an 
annual fee (on a quarterly basis) to the protection seller until the maturity date of the contract 
or until a credit event occurs on the reference entity. In the latter case, the protection buyer 
must deliver bonds or loans of that reference entity for the amount of the protection (notional 
value of the contract) to the protection seller and receives the par value in return.  

A  CDS  insure  against  a  credit  event  occurring  on  a  single  reference  entity  ("single  name"), 
which can be a company or a sovereign, or on a portfolio of such entities, for example through 
an index. Such an index is constructed to reflect the performance of a segment of the credit 
market,  for  example  large  European  companies  with  relatively  good  credit  ratings 
("investment grade").  

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Credit  events  for  CDS  are  typically:  i)  bankruptcy,  ii)  failure  to  pay,  and  iii)  restructuring. 
CDS contracts are governed by a ISDA Master Agreements and those on European reference 
entities  are  usually  transacted  under  the  English  Law,  whereas  those  on  North  American 
reference entities are usually under the New York Law. 

Euro denominated CDS are generally transacted for €5 or 10 million of notional and 5 or 10 
years  of  maturity.  Accordingly,  in  case  of  €10m  notional  sold  at  100bp,  the  buyer  of 
protection will pay €100,000 per year until maturity  or until a credit event on the underlying 
reference entities occurs, in which case he will receive €10m in return for the bonds or loans 
to be delivered.  

3.1.2.  Market structure 

According  to  ISDA,  the  total  notional  amount  outstanding  of  CDS  was  equal  to  USD  38.6 
trillion at the end of 2008, down from $54 trillion in mid-2008 and from $62.2 trillion by the 
end of 2007.24 According to data from DTCC's Trade Information Warehouse (TIW), which 
claims to cover roughly 90% of the market and publish weekly data, on 22 May 2009 the total 
gross notional outstanding was equal to $29 trillion, divided in $15.4 trillion in single names 
contracts, $9.7 trillion in indices, $3.9tn in tranches. Of the outstanding amounts recorded by 
the  DTCC,  $24.2  trillion  were  due  to  dealer-to-dealer  transactions.  The  total  gross  notional 
amount outstanding is reduced to $2.5 trillion if considered in net terms.  

The difference between gross and net can be easily explained by one example. Assuming that 
A sells $10m protection to B, B to C, C to D. A is a net seller of $10m and D a net buyer of 
$10m  protection.  Therefore,  the  net  exposure  is  $10m  and  the  gross  $30m.  However,  the 
gross exposure is particularly relevant in terms of overall risk because B and C though having 
a net position are exposed to both legs of the transaction. Therefore, the counterparty risk is 
measured  by  gross  rather  than  by  net  exposures.  This  explains  the  appeal  of  portfolio 
compression services, particularly as regards credit default swaps.25 

24 
25 

ISDA (2009a).  
According to TriOptima, a company offering a portfolio compression service called triReduce, in 2008 
they eliminated $30.2tn in notional by reducing gross to net. The largest part of this reduction is in CDS 
indices which are much more standardised. See chapter 2.4.3 for further details on trade compression. 

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Chart 5: The European share of the global CDS market 

Index and index tranche products
Value of all contracts, per-trade basis

7%

Approximate currency split
CDS settled by CLS, 2007

2%

CDX US

iTraxx EU

Other

52%

39%

41%

USD

Euro

Other

59%

Sources:  DTCC and ECB

The European dimension of CDS markets is significant, in terms of number of single names 
contracts, 37% are written on European corporates (the majority) or European Sovereigns26. 
The  corresponding  number  for  North  American  single  names  contracts  amounts  to  51%  of 
total  CDS  on  single  names.  Of  the  European  contracts,  the  large  majority  (80.9%)  is 
denominated  in  euro,  18.8%  and  the  rest  in  GBP  and  other  currencies.  For  US  reference 
entities, 7.8% of the total outstanding is denominated in Euro. As for the indices, 41% of the 
total outstanding is on iTraxx European products, 52% on North American CDX and 7% on 
other products. Considering the total split per currency of the CDS settled by CLS in 2007, 
39% was in Euro, 59% in USD and 2% in other currencies.  

3.1.3.  Risk characteristics 

Like other OTC derivative markets, credit derivatives markets are built on products that bind 
together  institutions  and  markets  in  ways  that are difficult to  understand and survey both at 
institutional  and  systemic  level.  While  CDS  are  relatively  small  compared  to  other  OTC 
derivatives markets, they are particularly significant in terms of risk: 

•  Banks’ CDS exposures relative to total assets have increased significantly in recent years. 
CDS  markets  are  closely  linked  to  securities  markets  and  CDS  markets  are  highly 
concentrated. 

•  Their  pay-off  is  discontinuous.  In  normal  times,  selling  protection  is  an  attractive 
proposition. For sure, the seller of protection assumes a risk of having to pay out the full 
amount of the insurance if the reference entity defaults, but he may expect, with a certain 
degree of confidence, that in most cases no payment will need to be made. In the meantime 
he earns a continuous stream of revenue from the buyer of protection. The discontinuity in 
the  payoff  profile  and  the  fact  that  in  most  cases  the  underwriter  suffers  no  loss,  have 
transformed  CDS  from  being  a  hedging  instrument  to  a  popular  revenue-generating 
instrument. The extreme risk associated with this discontinuous pay-off characteristic has 
been  amply  exposed  by  the  crisis.  For  example,  by  the  second  quarter  of  2008  AIG  had 
sold  approximately  $307bn  CDS  for  'regulatory  capital  forbearance'  reasons  to  European 
firms. By the end of year, AIG had suffered losses in excess of $30bn on these CDS while 

26 Data as end of March 2009. 

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only  earning  $157m  during  the  first  half  of  2008.27  AIG's  problems  were  not  isolated, 
which validates a 2004 finding by McKinsey that many firms entered the CDS market "on 
the cheap"; lured by high revenues but unwilling to make the necessary investments in risk 
management capabilities.28 

•  Contracts are non-fungible. This is the reason behind the great counterparty risk embedded 
in  CDSs  and  explains  the  big  disproportion,  underling  above,  between  notional  amount 
outstanding and net exposure. Because of non-fungibility, market participants that wish to 
close  a  position  can  only  do  so  by  going  back  to  the  original  counterparty  (usually  a 
dealer). This gives the dealer a certain amount of market and hence pricing power. Market 
participants  could  also  achieve  the  same  economic  effect  by  entering  into  an  opposite 
position  with  a  different  counterparty;  while  this  would  effectively  eliminate  the  risk 
related  to  the  instrument  itself,  it  would  not  eliminate  counterparty  risk  (if  one  of  the 
counterparties defaulted, the hedge would be undone). 

•  The  market  is  opaque.  Compared  to  interest  rate  swaps,  where  risks  are  well  understood 
and contracts rely on widely available and tested macro-economic data for their pricing, it 
is  more  difficult  to  evaluate  risk  for  CDS.29  The  data  needed  to  evaluate  risk  is  of 
microeconomic  nature  (e.g.  firms'  balance  sheets),  which  is  more  scarce  and  often  less 
authoritative.  The  lack  of  authoritative  data  combined  with  the  zero-sum  game 
characteristic outlined above is also conducive to volatility, as the price of protection varies 
depending on the perceived healthiness of the underlying reference entity.  

•  As  highlighted  by  the  Turner  Review,  CDS  prices  systematically  understate  risk  in  the 
upswing  and  understate  it  in  the  downswing.  Unrestricted  CDS  trading  can  accordingly 
make the price of credit more volatile, which at the extreme can even trigger credit default 
events.  Such  events  create  significant  disruption  costs  on  the  real  economy.  This  is 
particularly dangerous when the object of the CDS is a bank. In view of banks' central role 
in the economy, a bank failure has particularly serious consequences for the economy.30 

3.1.4.  Market standardisation - Recent industry developments 

The  recent  market  developments  can  be  divided  in  contractual  modifications  and  CDS 
standardisation. 

3.1.4.1.  Contractual modifications 

ISDA promoted contractual modifications which entered into effect on 8th April 2009 with the 
aim  of  improving  market  standardisation.  These  contractual  modifications  relate  to:  i)  the 
establishment of determination committees; ii) the hardwiring of the auction mechanism; iii) 
rolling  effective  date.  In  adhering  to  the  protocol  (so  called  big  bang  protocol)  the  parties 
accept  the  changes  in  the  ISDA  credit  definitions  which  apply  at  global  level.  More  than 
2,000 market participants agreed to adhere to the protocol. The changes apply to both new and 
existing  transactions.  Loan  only  transactions,  U.S.  Municipal  type  transactions,  Credit 
derivatives  transactions  on  asset  backed  securities  and  back-to-back  credit  derivatives 
transactions relating to trust certificates liked to CDX indices are not covered by the protocol.  

27 
28 
29 
30 

Financial Times (2009).  
Gerken, A. and H. Karseras (2004). 
ibid.  
FSA (2009). 

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The  March  2009  Supplements  establishes  five  regional  determination  committees  (DCs):  1) 
Americas,  2)  Japan,  3)  Asia  ex  Japan,  4)  EMEA  (Europe,  Middle  East  and  Africa),  5) 
Australia-New Zeland. Each DC consist of eight global dealers voting members, two regional 
voting  members,  five  global  non-dealers  (buy-side)  voting  members  and  two  consultative 
global  dealers,  one  regional  consultative  dealer  and  one  consultative  non  dealer  as  alternate 
non voting members. The DCs make binding determinations of whether credit and succession 
events  have  occurred  and  when.  They  will  also  determine  whether  to  hold  one  or  more 
auctions and the specific terms of any auction. The purpose of the DC is to prevent a situation 
in which the two parties in a CDS contract do not agree on whether an even has taken place. 

The  hardwiring  of  the  auction  process  implies  that  physical  settlement  outside  the  auction 
process would be no longer possible. Before the entrance into effect of the big bang protocol, 
participants had the option to participate or not in an auction. Since the auction process is used 
to determine the final recovery rate of a defaulted entities, the greater the participation to the 
auction, the more realistic the recovery rate is. The auction settlement process under the big 
bang protocol covers bankruptcy and failure to pay, but not restructuring. 

The  effective  date  for  all  CDS  contract  will  be  changed  to  the  current  day  less  60  days  for 
credit events and the current day less 90 days for succession events. The effective date rolls 
each  day  for  all  positions  so  that  they  mach  the  effective  date  of  new  trades.  Before  the 
entrance  into  force  of  the  Big  Bang  protocol  the  protection  began  at  T+1,  therefore  two 
opposite  trades  on  the  same  reference  entities,  same  notional  but  different  dates  could  not 
perfectly offset.  

3.1.4.2.  The restructuring credit event 

Restructuring means that in order to prevent a default of a company, bond and loan holders 
agree to worsen their terms, by e.g. a reduction in coupon or in the principal or an extension in 
maturity. This decision is binding to all holders. 

Generally  only  certain  bonds  or  loans  of  a  particular  issuer  are  restructured.  However,  the 
event  generally  affects  all  the  issuance  of  that  particular  entity,  with  the  effect  that  longer 
dated bonds or loans are typically cheaper to deliver.  

The occurrence of restructuring gives the buyer and the seller of CDS the option to trigger the 
contract  upon  that  credit  event  (if  the  credit  event  is  covered)  and  therefore  settling  it. 
However if the buyer triggers the contract, maturity limitation dates applies to the deliverable 
obligations (maturity cap). The reason for that is to reduce the value of the protection buyer's 
cheapest to deliver option (i.e. that the longer dated bonds or loans are delivered). In case it is 
the seller to trigger the contract, no maturity limitation applies. Different maturity caps apply 
depending on the convention under which the contract is concluded: 

•  Under Modified Restructuring (MR), deliverable obligations must not have a maturity date 
longer  than  the  minimum  between  30  months  after the restructuring  date  and  the highest 
maturity  of  the  restructured  bonds  or  loans.  In  any  case,  it  is  always  possible  to  deliver 
bonds or loans that mature up to the maturity date of the CDS and it is never possible to 
deliver bonds that mature more than 30 months after the maturity date of the CDS. 

•  Under  the  Modified  Modified  Restructuring  (MMR),  the  maturity  of  the  obligations  that 
may be delivered cannot be longer than the latest of the following: i) 60 months after the 
restructuring date for restructured obligations; ii) 30 months after the restructuring date for 
all obligations; iii) the CDS maturity date. 

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In  general  North  American  names  follow  a  MR  convention  and  European  names  a  MMR. 
Restructuring is not covered by CDS on CDX indices, whereas CDS on iTraxx indices follow 
a MMR convention. 

As  described  below,  under  the  new  standard,  North  American  contracts  will  trade  without 
restructuring  since  in  the  U.S.  the  restructuring  activity  is  generally  conducted  through  a 
Chapter 11 process which gives rise to a bankruptcy credit event. However, the majority of 
North American CDS single name outstanding have restructuring and even if the probability 
of  occurrence  is  low,  the  buyer  of  protection  cannot  be  asked  to  abandon  it  without  being 
compensated for the loss in protection.  

Furthermore, under Basel II CDS without restructuring are only partially (60%) recognised as 
credit mitigation instruments. Therefore, banks that fall under Basel II are less likely to accept 
the new market convention, since they will face a 40% regulatory capital charge. 

The easy solution proposed by the industry is to eliminate the partial recognition in Basel II, 
justifying that by the low value attached by the market to the restructuring clause. However, 
that  low  market  value  is  true  only  for  North  American  contracts  and  is  linked  to  the  low 
probability  of  occurrence.  In  Europe,  any  attempt  to  offer  contracts  without  restructuring 
failed because buyers want to protect against that credit event, which is much more common. 
The  reasons  for  maintaining  restructuring  in  Europe  are  therefore  not  simply  linked  to  the 
regulatory  capital  charge,  which  is  essential  to  retain  in  view  of  the  likelihood  of  the 
restructuring credit event. 

Since restructuring will be maintained in European standard contracts, CCP clearing of these 
contracts faces two challenges: 

(1) 

(2) 

The  optional  and  asymmetric  trigger,  as  described  above  both  buyer  and  seller  may 
trigger, but if the buyer triggers it faces a maturity limitation. Furthermore, the buyer 
may decide not to trigger hoping that the underlying defaults and so earning more. The 
problem of the CCP is that if triggering is selective, it does not know who to trigger on 
the  other  side.  To  solve  this  problem,  CCPs  are  devising  particular  allocation 
mechanisms to cope with selective triggering. 

The  need  to  make  a  separate  auction  for  each  different  restructuring  maturity 
limitation  date.  Since  maturity  limitation  dates  are  continuous,  this  would  require  an 
infinite number of auctions. This problem could be solved by splitting contracts into 
maturity buckets and then run separate auctions for each bucket. The current proposal, 
detailed in a term sheet released by ISDA on 19 June, foresees eight maturity buckets: 
2.5yrs,  5yrs,  7.5yrs,  10yrs,  12.5yrs,  15  yrs,  20yrs,  30yrs.  The  first  is  a  "blended" 
bucket  where  deliverable  obligations  may  have  maturity  of  no  more  than  2.5yrs  for 
non-restructured  obligations  and  no  more  than  5yrs  for  restructured.  A  pre-2.5yrs 
maturity  buckets  is  foreseen  for  MR  only.  All  the  other  buy-triggered  buckets  have 
maturity obligation of no more than that particular bucket and are valid for CDS with 
maturity dates between the bucket and the former one. All seller triggered transactions 
go in the 30yrs buckets. Furthermore, a rounding down convention is foreseen in case 
there are not deliverable obligations falling under the specific bucket and a option to 
move is given in case no auction will be run for the relevant bucket.  

In order to implement (2) and to define the role of the Determination Committees to establish 
when  a  restructuring  credit  event  takes  place  and  how  to  run  the  different  auctions,  a  new 
protocol (Small Bang) will need to be agreed by market players. Under the current schedule, 
the protocol will be published on the second week of July, with adherence period ending on 
the 24 July.  

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The restructuring credit event adds a level of complexity in the CCP clearing of CDS indices. 
In fact, while the settlement of the single name in the index affected by restructuring follows 
the process described above, the optionality of the trigger in an index has other repercussions. 
If restructuring on an index component occurs, there might be two possibilities: a) either the 
index  itself  is  trigger  and  two  indices  are  created  (one  with  the  single  name  and  another 
without); or b) only one index minus the single name is created and the trigger is exercised on 
the  single  name.  Option  a)  creates  the  problem  of  indices  proliferation  if  more  than  one 
restructuring  credit  event  affects  the  index  components.  Basically  a  combination  of  indices 
needs to be created to cater with all the possible options of single names triggered or not. This 
proliferation  is  hardly  manageable  by  CCPs  and  has  the  negative  effect  of  fragmenting 
liquidity  between  all  indices.  This  problem  may  be  solved  with  option  b),  which,  however, 
has other impacts on index tranches. According to the above mentioned term sheet, option b) 
will  be  adopted  as  a  market  convention.  Since  tranched  transactions  will  not  be  cleared  by 
CCPs for the time being, ISDA will further develop an appropriate mechanism to deal with 
tranched transactions at a later stage. 

3.1.4.3.  Standardisation of coupons 

Under the new North American convention, single names CDS will trade with a fixed coupon 
of 100bp, 500bp or both and without restructuring. It is expected that liquidity will tend to the 
closest strike to par and therefore investment grades will trade with 100bp fixed coupon and 
high yield will trade with 500bp. In Europe, as of 22 June 2009 a new market convention has 
been  adopted.  According  to  this  convention,  firms  will  trade  European  CDS  using  the 
following  fixed  coupons:  25,  100,  500  and  1000bp  for  new  trades  and  300  and  750bp  for 
recouponing existing trades.  

The reason for coupon harmonisation is that, in absence of any convention, CDS traded at par, 
i.e.  the  coupons  was  determined  at  the  time  of  the  trade,  therefore  multiple  strikes  were 
available on the market and trades could not easily offset. 

While fixed coupons have the benefit to bring liquidity to one or the other coupon, it has the 
negative effect that an upfront payment is due at time of trade. This upfront payment will be 
smaller or larger, depending on how far from the par spread the fixed coupon is. Furthermore, 
under the floating coupons system, CDSs have "short first coupons", meaning that if there are 
less  than  three  months  to  the  first  coupon,  the  first  payment  is  smaller.  Under  the  fixed 
coupons  convention,  the  first  coupon  is  a  full  coupon  and  the  protection  seller  need  to 
incorporate accrued interests in the price of the CDS.  

Converting between upfront and spread is model dependent. For this reason a quoted spread 
will  be  introduce.  This  quoted  spread  assume  a  flat  credit  spread  curve,  but  since  spreads 
curves are not flat, the par spread and the quoted spread will differ. This means that there will 
be three ways to express the price of a CDS: upfront, quoted spread, par spread. It is clear that 
the closest the par spread is to the fixed coupon the less sensitive to valuation assumptions the 
price of the CDS will be. In this sense it is argued that multiple coupons are more transparent. 
However, in practice the above three prices will be available to market participants. 

In order to convert existing trades in the new standards each trade will be split into new trades 
with  fixed  coupons.  However,  with  only  two  fixed  coupons,  recouping  existing  trade  with 
restructuring  does  not  always  preserve  the  risk  profile  of  the  existing  trade.  In  particular, 
when the spread of the original trade lies outside of the range of the available coupons (less 
then 100bp or more than 500bp), one of the resulting trade will be in the opposite direction 
and as mentioned above, under restructuring buyer and seller have not the same obligations. 
For  example,  assuming  an  original  trade  of  €10m  notional  and  660bp  spread  and  a  buy 

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position,  under  the  100/500  convention  it  will  be  converted  in  a  sell  of  €4m  with  100bp 
coupon and a buy of €14m with 500bp coupon. This im plies that the presence of restructuring 
require  the  necessity  of  more  coupons  for  recouponing  existing  trades.  In  fact,  under  the 
agreed EU convention, existing trades would always be converted into two contracts having 
the  same  direction.  Since  also  North  American  legacy  contracts  have  restructuring,  the 
presence of more coupons, at least for recouponing, will be necessary in the US as well. 

The  standardisation  of  coupons  will  facilitate  CCP  clearing  of  single  names  contracts,  by 
concentrating  liquidity  on  certain  coupons.  However,  it  is  not  strictly  necessary  as  CCPs 
would be able to clear also floating coupons contracts.  

3.1.5.  Market infrastructure 

In terms of market infrastructure, CDS has invested heavily in recent years. 

•  Trade execution: Inter-dealer transactions takes place on electronic platforms provided by 
inter-dealers brokers. Dealer–to-client transactions may occur by phone or through dealer-
to-client platforms.. 

•  Trade confirmation: substantial improvements have been made to reduce the operational 
risk  related  to  the  execution  of  CDS.  They  are  special  even  in  this  respect,  with  97%  of 
electronic  volume  as  a  percentage  of  total  volume,  92%  of  electronic  confirmations  and 
97% eligibility for electronic confirmations. All these numbers are well above all the other 
OTC derivatives products. The most widely used affirmation and confirmation system for 
CDS  is  called  Deriv/SERV  and  is  offered  by  a  subsidiary  of  the  DTCC.  According  to 
DTCC data, 90% of CDS transactions are confirmed within T+1. 

•  Data repository: All the trades that are electronically confirmed through Deriv/SERV are 
recorded  in  the  Trade  Information  Warehouse  (TIW),  a  central  database  run  by 
Deriv/SERV.  

•  Price  transparency:  Price  information  on  CDS  is  provided,  among  others,  by  Markit 
which  collect  the  information  from  different  market  makers  and  makes  it  available  to  its 
customers.  This  company  also  runs  a  reference  entities  database  (Markit  RED),  which 
provides  unique  alphanumeric  RED  codes  that  enable  financial  institutions  to  efficiently 
confirm  trades  and  manage  their  positions.  CDS  indices  (iTraxx  and  CDX)  are  also 
managed by Markit. In order to improve market transparency in the CDS market, Markit 
makes publicly available free of charge a daily report where it publishes the last quote any 
active dealer in the CDS market makes available to its institutional clients before 4:00pm 
on the most liquid contracts, representing roughly 450 entities. 

The Trade Information Warehouse 

The  registration  in  the  TIW  does  not  change  the  legal  nature  of  a  contract  between  the  two  original 
counterparties.  The  TIW  facilitates  the  post-trading  operation  of  the  registered  trades  and  it  is  particularly 
relevant for CDS due to the number of corporate events that may influence the contracts.  

Services 

The TIW currently performs the following functions: (i) payment calculation for one-time fees and coupons, (ii) 
multi-currency payment netting and central settlement, provided in partnership with CLS Bank International, (iii) 
centralized  processing  of  credit  events  such  as  bankruptcies  and  defaults,  and  (iv)  novation  consent  that 
automates the approval process when one party to a transaction assigns its position to another. 

Contribution to transparency 

Since  most  of  the  transactions  on  the  CDSs  are  recorded  in  the  TIW,  it  represents  an  essential  source  of 
information  both  for  the  public  and  from  a  regulatory  perspective.  Basically  the  TIW  can  detect  the  positions 

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(exposures) of all its participants, all the static information concerning the registered contracts and information 
on the new and terminated transactions registered with the TIW.  

In an effort to improve transparency in the CDS market, the TIW since October 2008 makes publicly available 
on  a  weekly  basis  the  following  aggregate  information:  (i)  gross  notional  outstanding  per  customer  type 
(Dealer/Non Dealer) and product type (single names, indices and tranches), (ii) single names reference entities 
types (by sector) by buyer and seller of protection, (iii) on the run/off the run indices and tranches by buyer and 
seller of protection, (iv) top 1000 reference entities (gross and net notional), (v) all indices and tranches (gross 
and  net  notional),  (vi)  aggregate  single  name  contracts  by  year  of  termination  date,  (vii)  change  in  weekly 
activity for all the above, and (viii) weekly transaction activity (new trades, terminations, assignments).  

Since  market  players  have  already  invested  highly  in  the  warehouse  and  in  other  facilities  that  improve  the 
operational  efficiency  of  the  market,  they  want  to  leverage  to  the  maximum  extent  possible  the  existing 
infrastructure in moving to CCP clearing. In this sense, the TIW becomes an essential infrastructure for all CCPs 
that want to offer clearing services in CDSs and receive the information on confirmed trades from the TIW.  

Comparison with CCPs 

The level of information held by a CCP once a CDS is cleared is not inferior to the information held by the TIW. 
However, not all the CDSs registered in the TIW will be CCP eligible, therefore even after CCP clearing will be 
implemented, the TIW will represent an essential source of information. For this reason and for the central role 
played by the TIW in the CDS market, it will be probably become a regulated entity subject to the supervision of 
the Federal Reserve Bank of New York and New York State Banking Department. 

CESR is conducting a feasibility study for the eventual establishment of a trade warehouse in the EU to support 
EU CCPs. 

3.1.6.  Risk management – the gradual advent of CCP clearing 

CDS is a young market and clearing has so far been done on a bilateral basis. However, as a 
result of the financial crisis, regulators around the world have pushed industry to adopt CCP 
clearing.  

In the US, ICE Trust is live since the beginning of the year and it has so far (as of end of May 
2009) cleared volumes amounting to USD 600 billion. 

In  Europe,  there  are  currently  four  providers  running  clearing  systems  notified  under 
Directive 98/26/EC Settlement Finality Directive (SFD) that provide or aim to provide CCP 
clearing services for CDSs (in order of announcement of their service): 

•  BClear, operated by NYSE Liffe and LCH.Clearnet Ltd (operational since December 2008, 
but that has recently announced its intention not to make any  further investment into the 
project at this point); 

•  Eurex Clearing; 

•  ICE Clear Europe; 

•  LCH.Clearnet SA. 

Apart  from  the  four  providers  above  who  either  have  developed,  or  are  in  the  process  of 
developing, their solutions, there is also a potential fifth entrant in the European market, i.e. 
the Chicago Mercantile Exchange (CME), which has initiated the process for the authorisation 
as a Recognised Clearing House (RCH) in the United Kingdom. 

All offers differ in many aspects, e.g. membership requirements, indirect access availability, 
default  fund  contribution,  default  management  procedures,  operational  flows  and  time  to 
market. 

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3.2. 

Interest rate derivatives 

Interest rate derivatives are by far the most popular derivative instruments traded OTC. This 
section outlines the characteristics of this mature market. 

3.2.1.  Nature of contracts 

Interest  rate  derivatives  exist  to  facilitate  the  management  of  specific  and  structural  interest 
rate risks faced by clients. There are many types of interest rate derivatives, the major ones 
being  interest  rate  swaps,  interest  rate  options  and  forward  rate  contracts.  An  interest  rate 
swap is an agreement to exchange one set of cash flows (perceived as risky, as linked to e.g. a 
floating interest rate) against another set of cash flows (perceived as stable, as linked to, say a 
fixed interest rate).  

3.2.2.  Market structure 

Interest  rate  derivatives  are  the  largest  asset  class  of  OTC  derivatives.  As  of  end-2008,  the 
overall size of the market for interest rate derivatives was $418.6 trillion.31 Of these, interest 
rate swaps account for the overwhelming market share. The popularity of IRS is explained by 
a  number  of  factors,  including  that  (i)  they  are  ‘self-funded’  in  the  sense  that  there  is  no 
principal  payment  at  the  outset,  (ii)  they  are  relatively  easy  to  price,  as  well-defined  swap 
curves  exist  even  for  long  maturities,  and  (iii)  the  liquid  Euribor  market  makes  it  easy  for 
market making dealers to hedge the risk they take on. 

Table 3: Interest rate contracts, on- and off-exchange 

Notional amounts outstanding, USDbn, December 2008 

Interest rate swaps 

Interest rate options 

Forward rate contracts 

OTC 

328.114 

51.301 

39.268 

On exchange 

19.3 

35.2 

n.a. 

Source: BIS (2009). 

The listed interest rate futures market developed in the 1970s, in order to satisfy issuers that 
wanted to be able to issue the kind of debt requested by investors (fixed rate, long term). To 
do so, the issuer needed to hedge, hence need for a future market. The off-exchange interest 
rate market developed in the 1980s, as issuers' needs became more diverse. Today, the OTC 
market  dwarfs  the  listed  market  in  terms  of  notional  outstanding32.  While  the  OTC  interest 
rate  swap  market  is  the  biggest  market  in  terms  of  notional,  the  amount  of  transactions  is 
fewer compared to e.g. CDS.  

The  OTC  interest  rate  market  is  deep.  It  has  a  wide  variety  of  customers  (e.g.  issuers,  fund 
managers, banks, hedge funds, corporates, sovereigns and insurance companies). In terms of 
dealers,  while  the  leading  dealers  dominate,  there  is  nevertheless  a  long  tail  of  second  tier 
institutions.  Accordingly,  the  counterparty  make  up  is  different  compared  to  e.g.  CDS 
(thousands of counterparties for IRS as compared to hundreds for CDS).  

31 
32 

BIS (2009a). 
It should, however, be recognised that standardised on-exchange contracts perfectly off-set each other, 
whereas  OTC  derivatives  are  not  perfectly  fungible  and  in  order  to  reduce  the  notional  amount 
outstanding portfolio compression sessions need to be run. 

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3.2.3.  Market infrastructure 

The OTC rate market is also mature in terms of market infrastructure:  

•  Trade  execution:  there  are  three  types  of  trading  methods.  First,  the  so-called  direct 
market,  where  banks  negotiate  directly  (voice-based).  Second,  the  inter-dealer  market 
(voice and electronic) and, third, the dealer to client market (voice or electronic execution 
platforms). Overall, voice continues to dominate given the bespoke nature of the market.  

•  Trade  confirmation:  The  majority  of  trades  are  since  2002  electronically  confirmed  via 
Markit  Wire  (formerly  Swaps  Wire).  This  has  an  impact  on  process  flow:  execution, 
affirmation and confirmation take place at T+0. While electronic volumes for long trailed 
non-electronic  volumes,  the  relationship  has  been  reversed  since  the  default  of  Lehman. 
The  share  of  electronically  eligible  volume  among  the  major  dealers  is  above  90%  and 
within that universe, nearly 80% are actually electronically confirmed. To expand the reach 
of electronic trade confirmation further requires broadening the scope of products covered 
by Markit Wire and expanding its use by second tier banks and customers. 

3.2.4.  Risk characteristics 

The  risks  encountered  in  interest  rate  contracts  are  different  from,  say,  CDS.  Most 
importantly,  the  pay-out  structure  associated  with  the  rights  and  obligations  with  a  contract 
are  continuous  in  nature,  as  these  rights  and  obligations  evolve  as  the  underlying  market 
moves. Unlike CDS, where the protection seller faces a binary pay-off (small fee received in 
normal  times,  but  need  to  provision  for  materialisation  of  tail  risk  with  enormous 
consequences),  an  interest  rate  swap  seller's  rights  and  obligations  are  more  continuous  in 
nature; as interest rates evolve, so does the related cash flow arising from the net rights and 
obligations. Also the underlying data (interest rates) are transparent and widely available.. For 
these reasons, interest rates swaps were mostly used for hedging and could hardly be misused. 
Even  though  interest  rate  shocks  may  occur,  this  does  not  dramatically  alter  the  balance  of 
rights and obligations as it is the case in CDS (e.g. jump-to-default).  

3.2.5.  Risk management 

Similar  to  other  OTC  derivatives,  risk  management  occurs  at  different  levels.  First,  sales 
personnel operate on the basis of dealer's assessment of appetite for entering into a deal with a 
particular counterparty (based on assessment of risk associated with particular counterparty). 
Second,  dealers  hedge  the  exposure  they  take  in  that  transaction.  Third,  provision  of 
collateral.  

The  interest  rate  OTC  market  has,  as  outlined  above,  a  CCP  in  place.  Risk  management 
therefore differs depending on whether rate contracts are cleared or not.  

3.2.5.1.  CCP clearing - SwapClear 

SwapClear is currently the dominant provider of CCP clearing services for interest rate swaps. 
Operated  by  LCH.Clearnet  Ltd,  it  is  in  place  since  1999.  Legal  contracts  were  already 
sufficiently standardised under the ISDA master agreement and the terms of the contracts did 
not need to further standardisation to allow CCP clearing. SwapClear has thrived even though 
contracts  remain  largely  tailored  to  bespoke  needs.  The  necessary  prerequisites  for  CCP 
clearing in the rate space were: (i) confirmed matched trade, (ii) a risk engine, and (iii) default 
management  process.  In  addition,  a  more  concentrated  liquidity  has  also  contributed  to 
enabling  CCP  clearing  in  comparison  with  CDS,  where  liquidity  is  much  more  fragmented, 

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with  thousands  of  reference  entities,  than  for  IRS,  where  key  currencies  are  limited  to  a 
dozen.  

Governance  of  SwapClear  is  shared  between  LCH.Clearnet  and  the  major  13  dealers 
organised  within  OTC  DerivNet.  SwapClear  currently  has  24  General  Clearing  Members 
(GCMs).  The  governance  of  SwapClear  and  its  GCMs  play  a  crucial  role  in  managing  a 
potential default of another GCM. Since its inception, both LCH.Clearnet and the GCMs have 
focused on ensuring a safe and sound CCP. This has been done by a close interaction between 
dealers and the CCP, stringent membership criteria, strong margin requirements and a detailed 
and  ex-ante  worked  out  process  for  dealers  and  the  CCP  to  work  together  in  managing 
defaults. Furthermore, LCH.Clearnet has recently announced the extension of its services to 
buy-side  institutions  that  would  be  allowed  to  access  the  CCP  via  a  clearing  member.  This 
and other measures to expand the coverage of SwapClear are further outlined in chapter 4. 

It is estimated that currently SwapClear clears around 20% of the OTC interest rate market. 
For  intra-dealer  flow,  the  share  is  significantly  higher,  with  cleared  volumes  amounting  to 
around 50% of overall dealer-to-dealer notional outstanding. For CCP eligible trades, the vast 
majority of new interest rate trades are cleared by SwapClear (83-93% of eligible trades).  

The default management process of SwapClear 

When  a  GCM  defaults,  the Default  Management  Group –  comprising a  subset  of  the  GCMs  –  second  trading 
personnel to LCH.Clearnet. 

The DMG acting on behalf of LCH.Clearnet quantifies and hedges the risk from the default. 

LCH.Clearnet conducts auctions to sell the defaulter’s portfolio. 

All  SwapClear  members  are  required  to  bid  in  these  auctions.  Accordingly,  prospective  GCMs  need  to 
demonstrate the ability to effectively carry out this obligation. 

If  there  are  losses,  they  are  allocated  as  follows:  (i)  the  defaulting  GCM’s  initial  margin,  (ii)  the  defaulting 
GCM’s  default  fund  contribution,  (iii)  part  of  LCH.Clearnet’s  profits,  (iv)  other  GCMs’  default  fund 
contributions, (v) further fixed cash contributions from the other GCMs’, and (vi) LCH.Clearnet’s share capital.  

This process proved  its  worth  following  the  default  of  Lehman  Brothers.  Lehman’s  EUR7  trillion portfolio of 
66,000  trades across  five  currencies was  replaced and  less  than 50%  of  Lehman  Brother’s  initial  margins (the 
first bulwark of defence) was required to hedge the risk, manage and auction the position.  

While  SwapClear  is  so  far  the  only  CCP  for  interest  rate  contracts,  there  are  signs  of  other 
CCPs entering the rate market. The International Derivatives Clearing Group (IDCG), a US 
based  CCP  that  is  majority-owned  by  NASDAQ  OMX  has  recently  started  to  clear  interest 
rate contracts, albeit from a very small base.  

3.2.5.2.  Bilateral clearing 

For trades that are not eligible for CCP clearing, the normal approach to collateralisations of 
bilateral  credit  exposure  applies,  as  outlined  above.  According  to  ISDA,  63%  of  credit 
exposure  as  share  of  trade  volume  is  collateralised  for  fixed  income  (71%  as  share  of 
exposure). 

Moreover, portfolio compression and reconciliation services are increasingly used in the rate 
space.  Currently,  market  participants  use  triResolve  to  reconciliate  cash  flows  between 
themselves and triReduce to tear up economically redundant trades.  

Portfolio compression cycle has also been tested within SwapClear. Portfolio compression has 
benefits also for a CCP: while multilateral netting provided by CCP offers a single net credit 
risk  of  each  counterparty,  that  risk  is  calculated  by  assessing  all  trades  in  system.  Trade 
compression  reduces  the  number  of  trades  (tear  up  many  old  trades,  replace  with  one  trade 
mimicking  original  portfolio's  economic  risk  profile).  This  is  beneficial,  as  (i)  reduces 

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information space and (ii) reduces complexity (Lehman: need to assess all outstanding trades, 
hence value in reducing number of trades per se).  

3.3. 

Equity Derivatives 

Equity  derivatives  are  one  of  the  smallest  OTC  derivative  segments,  with  a  sizeable  listed 
element. Equity derivatives are much smaller than the underlying market. Equity derivatives 
are  also  a  relatively  young  instrument,  which  is  illustrated  by  the  limited  lack  of 
standardisation and relatively novel infrastructure arrangements. 

3.3.1.  Nature of contract 

There are three types of equity derivatives OTC contracts: options, equity swaps and variance 
swaps. As regards equity options, there are two types of equity options, calls and puts. A call 
option  gives  its  holder  the  right  to  buy  an  underlying  security,  while  a  put  option  gives  the 
right to sell an underlying security. In an equity swap, counterparties make payments to each 
other  with  at  least  one  set  of  payments  being  set  by  a  share  or  an  index  return.  The  other 
payments  can  be  fixed  or  floating  rates,  or  the  return  of  another  share  or  index.  A  variance 
swap allows investors to trade future realised (or historical) volatility against current implied 
volatility.  

3.3.2.  Market structure 

The equity derivatives market is not global, but fragmented. Fragmentation follows that of the 
underlying  equity  markets.  Regionalisation  is  segmented  by  the  fact  that  trading  the  equity 
derivative in a different region exposes the dealer to a legal basis risk (especially as regards 
corporate action rules). BIS estimates suggest that Europe is the biggest regional market. 

Table 4: Regional distribution of OTC equity derivatives markets 

Notional amounts outstanding, USDbn, December 2008 

Region  

European Equities 

US Equities 

Japanese Equities 

Other Asian Equities 

Latin American Equities 

Other Equities 

$bn 

4,036 

1,505 

403 

185 

99 

266 

Source: BIS (2009) 

The  OTC  equity  derivatives  market  is  smaller  than  the  CDS  and  interest  rate  markets, 
amounting to $6.5 trillion in notional amounts outstanding by the end of 2008.33 The equity 
derivatives market shrank from $10 trillion to $6.5 trillion from June to December 2008. The 
exchange  traded  market  amounted  to  $5.1  trillion  by  the  end  of  2008.34  The  market  of  the 
underlying  cash  equities  pool  remains  significantly  bigger  than  the  derivatives  pool,  with 
global cash equity market capitalisation standing at $32.5 trillion by the end of 2008.35 

Table 5: Equity derivative contracts traded on and off-exchange 

Notional amounts outstanding, USDbn, December 2008 

33 
34 
35 

BIS (2009a). 
BIS (2009b) 
World Federation of Exchanges (2009). 

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OTC 

Forwards and swaps 

Options 

On exchange 

Equity index futures 

Equity index options 

$bn 

1,632 

4,862 

0.7 

4.4 

Source: BIS (2009). 

The balance between listed vs. OTC differs between regions. For example, the US market is 
characterised by more trading on rather than off-exchange. The main reasons for that are: (i) a 
highly efficient listed options market with six competing exchanges served by a single CCP 
(The  OCC)  and  fungible  contracts,  (ii)  pre-trade  transparency  (obligation  to  display  OTC 
quotes  on  exchange  floor),  and  (iii)  retail  dominated  order  flow.  By  contrast,  the  European 
equity  derivatives  market  is  more  OTC,  as  clearing  is  fragmented,  the  market  is  largely 
dominated by professional investors and currently the MiFID transparency requirements only 
apply to financial instruments admitted to trading on a regulated market.  

Compared to e.g. CDS, dealer-to-dealer business is less dominant in OTC equity derivatives. 
The  largest  global  dealers  face  competition  from  second  tier  regional/local  dealers  in  all 
markets.  

3.3.3.  Market standardisation 

The equity derivatives market is not very standardised. While contracts are often concluded 
under the umbrella of either ISDA, regional, country or dealer bespoke Master Confirmation 
Agreements,  they  are  more  customised  in  terms  of  e.g.  dividends,  valuation  mechanism,  or 
corporate events.  

Equity  derivative  contracts  are  accordingly  not  contractually  fungible.  Moreover,  the 
processes  for  managing  corporate  events  are  less  formalised  compared  to  the  CDS  market 
(especially after the Big Bang protocol). Accordingly, while it is easier to value the economic 
consequences of an event for an equity derivative contract compared to a CDS, the number of 
events is much higher.  

3.3.4.  Market infrastructure 

The  equity  derivative  market  is  relatively  young  and  infrastructure  appears  less  well 
developed  compared  to  some  other  more  mature  OTC  derivatives  asset  classes,  notably 
interest rate derivatives. More specifically: 

•  Trade execution: trade execution occurs either on inter-dealer networks (e.g. ICAP, TFS 

and Tullet) or internally within the broker if it is a client trade. 

•  Trade  confirmation:  Markit  Wire  and  DTCC’s  DerivNet  remain  the  reference  networks 
for  electronic  trade  affirmation  and  confirmation.  However,  compared  to  other  OTC 
derivatives asset classes, only a small share (around 20%) of total trade volume of equity 
derivatives  are  eligible  for  electronic  affirmation/confirmation.  Moreover,  this  share  has 
decreased recently, which may be due to the fact that there is currently more demand for 
more  bespoke,  and  accordingly  less  standardised  and  electronically  eligible,  equity 
derivative contracts. However, within the electronically eligible category it is evident that 
the  major  dealers  have  made  an  effort  to  ensure  that  such  trades  are  indeed  confirmed 
electronically,  as  manifested  by  a  trend  increase  in  recently  with  electronic  confirmation 
rates as share of electronically eligible reaching around 85%. This share is close to 100% 

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for the largest global dealers (G16).36 However, the wide diversity of plain vanilla equity 
derivatives appear to come with a cost in terms of the time it takes to affirm and confirm 
contracts.  While  backlogs  have  been  reduced,  it  has  proved  difficult  to  eliminate 
outstanding confirmations aged over 30 days. This significant time is due to the diversity 
in MCAs and the limited rate of electronic confirmations. The time it takes to confirm in 
general  depends  on  whether  (i)  MCA  is  in  place  (trade  easily  confirmed  within  a  week), 
and  (ii)  electronically  eligible  (easily  confirmed  within  hours).  The  limited  uptake  of 
electronic confirmation is primarily due to second tier of market (local institutions that see 
less value of investing and upgrading of internal procedures).  

•  Trade  repository:  Industry  is  currently  debating  merits  of  developing  centralised  post-
trade  solution  (e.g.  corporate  action  processing)  à  la  DTCC's  Trade  Information 
Warehouse. 

3.3.5.  Risk characteristics 

Compared  to  e.g.  CDS,  equity  derivatives  have  a  less  dramatic  pay-out  structure.  It  is  not 
binary,  but  continuous.  Accordingly,  the  consequences  of  an  event  in  the  equity  derivatives 
space are less dramatic (often contract alterations, not necessarily pay-out).  

Another  factor  that  moderates  the  risk  of  this  class  of  derivatives  is  that  they  are  easier  to 
value compared to e.g. CDS, as an objective, observable and tradable market prices exist in 
most  circumstances  thanks  to  the  price  discovery  provided  by  the  trading  venue  where  the 
underlying cash equity is listed and other venues where it is traded.  

In  equity  OTC  derivatives  markets  MCAs  are  generally  concluded  between  the  parties  and 
these govern the general trading relation between a dealer and a client for a given portfolio. 
When  a  trade  is  actually  concluded,  the  exact  details  of  that  transaction  often  follow  a 
negative  affirmation  procedure.  Under  negative  affirmation,  equity  swaps  are  confirmed 
through a unilateral communication from the dealer to the client that is not countersigned by 
the client. Confirmations are typically brief statements of the remaining trade variables: e.g. 
ticker, price, quantity and currency. If client does not come back within 5 days, the transaction 
is considered confirmed. The risk associated with this market practice is client repudiation, as 
the dealer does not have a countersigned agreement evidencing the trade.  

3.3.6.  Risk management 

As with other OTC derivatives, managing the counterparty credit risk associated with equity 
derivatives involve either the use of a CCP or the reliance on bilateral collateral management.  

As  regards  bilateral  clearing,  the  share  of  credit  exposure  that  is  covered  by  collateral  is 
relatively limited, amounting (according to ISDA) to 52% by the end of 2008. While portfolio 
reconciliation  services  lend  themselves  equally  well  to  equity  derivatives,  portfolio 
compression  services  do  so  less,  as  the  high  level  of  customisation  of  even  plain  vanilla 
contracts (e.g. strike price, treatment of market events etc) makes it difficult to find suitable 
matching trades to tear up. 

As  regards  CCP  clearing,  almost  all  derivatives  exchanges  allow  clearing  uptake  of  OTC-
traded transactions where the derivative contract is listed on the exchange. There are attempts 
to  offer  CCP  clearing  services  for  non-listed,  OTC-traded  equity  derivative  contracts  (e.g. 
Liffe’s BClear solution).  

36 

Markit (2009) 

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Overall though, CCP clearing for OTC trades appears to be hampered by various issues, e.g. 
different treatment of corporate action events by CCPs. It is therefore desirable that the major 
CCPs and exchanges continue efforts of harmonising their treatment in this respect.  

3.4. 

Commodity derivatives 

Commodity derivatives exist since a long time. This market is incredibly diverse. The market 
structure  differs  depending  on  segment,  with  some  being  more  standardised  and  subject  to 
CCP clearing, with others being pure OTC. 

3.4.1.  Nature of contracts 

The same types of contracts exist in commodities, i.e. futures, options, forwards and swaps. 
Their relative weights are summarised in the table below. Unfortunately, the numbers are not 
comparable, as OTC is quoted in notional amounts outstanding and on-exchange in number of 
contracts. 

Table 6: Commodity derivative contracts traded on and off-exchange 
December 2008 

OTC, notional amount outstanding  

Forwards and swaps 

Options 

On exchange, turnover (number of contracts) 

Futures 

Options 

bn 

$2,624 

$1,797 

1.6 

0.2 

Source: BIS (2009). 

3.4.2.  Market structure 

The  commodity  derivatives  market  is  very  diverse  and  comprises  several  market  segments, 
including  e.g.  gas  trading,  base  metals  trading,  power  trading,  crude  oil  trading,  agriculture 
trading and emissions trading just to mention a few.  

These segments trade both on exchange and OTC and can be both financially and physically 
settled.  

Commodity  derivatives  involve  a  broad  range  of  market  participants,  e.g.  financial  firms 
(banks,  investment  firms),  international  energy  firms,  specialised  energy  traders,  power 
producers,  energy  distribution  and  supply  companies  (be  they  public  or  private)  and  other 
corporate and government actors as well as consumers.  

3.4.3.  Market standardisation 

Commodity  derivatives  are  relatively  non-standardised.  Vanilla  trades  are  often  tailored  to 
client needs (e.g. in terms of payout and valuation mechanism). Moreover, there are several 
Master  Confirmation  Agreements  (MCAs),  including  both  the  ISDA  global  one  as  well  as 
those of other governing bodies (e.g. EFET, NBP). The multitude of market conventions and 
rules  is  driven  by  product  specificities  related  to  physical  delivery  of  the  underlying 
commodity.  

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3.4.4.  OTC trade execution 

In  view  of  bespoke  and  non-standardised  nature,  most  OTC  commodity  trades  are  voice-
brokered. However, execution networks such as EBS, LME Select, Trayport and Bloomberg 
Chat are increasingly used. 

3.4.5.  OTC trade confirmation 

The  lack  of  standardisation  and  the  wide  diversity  of  players  active  in  the  market  present 
particular  challenges  as  regard  the  broad  uptake  of  automated  trade  confirmation  services. 
Accordingly,  electronic  trade  confirmation  averages  are  historically  lower  for  OTC 
commodity derivatives.  

Among the major financial firms, electronically eligible volume as share of total trade volume 
has increased and now amounts to 90%. Electronic volume as share of total trade volume has 
also increased, amounting to 48% in March 2009.  

The confirmation service provider differs depending on market segment. 

Table 7: Confirmation service providers for OTC commodity derivatives 

Market 

Energy 

Power and gas (Europe) 

Oil, softs, coal and freight 

Precious metals 

Service provider 

ICE e-confirm 

EFET 

Markit Wire (as of April 2009) 

SWIFT 

3.4.6.  Risk characteristics 

Compared to e.g. CDS, settlement is not triggered by a single event on the reference entity but 
rather depends on a multitude of factors (e.g. multiple strike prices, on different dates). The 
contracts therefore evolve in a more continuous nature.  

Settlement  is  moreover  often  done  by  delivery  of  an  underlying  commodity  or  by  cash 
payment calculated by a formula using objective market prices.  

3.4.7.  Risk mitigation 

In  terms  of  CCP  clearing,  as  a  significant  share  of  commodity  derivatives  are  traded  on-
exchange,  there  are  a  significant  number  of  CCPs  in  the  commodity  derivatives  space.  The 
take-up of CCP clearing has been particularly prevalent in energy commodities and was to a 
large  extent  driven  by  the  default  of  Enron  and  the  increased  importance  attached  to 
counterparty credit risk by other market participants.  

However,  most  of  these  only  cater  for  listed  commodity  derivatives.  Normally,  where  OTC 
derivatives  on  commodities  make  reference  to  exchange  traded  contracts  on  the  same 
underlying,  they  clear  by  the  same  CCP.  It  is  estimated  that  22%  of  OTC  derivatives 
commodities on the same underlying of the exchange traded contracts are CCP cleared. The 
contracts that are eligible for clearing are typically the ones with more liquid underlying (e.g. 
WTI  and  Brent).  For  pure  OTC  derivatives,  no  CCP  as  of  yet  provides  a  CCP  take  up 
solution.  

As  regards  trades  that  are  not  eligible  for  CCP  clearing,  as  elsewhere  counterparty  credit 
exposure is managed by collateral provisioning. According to ISDA estimates, 30% of such 

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credit  exposures  in  metals  and  energy  (share  of  trade  volume)  are  currently  collateralised.37 
The  relatively  low  level  of  collateralisation  is  primarily  explained  by  the  fact  that  many 
counterparties in commodity derivatives are non-financial firms and as such less accustomed 
to  collateral  or  exempt  from  collateral  provisioning.  Moreover,  collateral  provisioning  is 
complemented for physical trades that are not marked-to-market by other sorts of assurances, 
such as parent company guarantees, pledge of assets, prepayments or letters of credit.  

Table 8: Commodity derivatives CCPs 

Market 

Gas 

CCP 

ECC, ICE Clear Europe, CME Clearport, APX 

Precious metals 

LCH.Clearnet, CME Clearport 

Power 

Plastic products 

ECC, APX 

LCH.Clearnet 

Oil products 

Crude oil 

Coal 

Freight 

Agriculture 

Emissions 

ICE Clear Europe, CME Clearport 

ICE Clear Europe, CME Clearport 

CME Clearport 

NOS Clearing, LCH.Clearnet 

CME Clearing, ICE Clear US, BClear 

ICE Clear Europe, NOS clearing, ECC 

The  diversity  of  market  participants  also  affect  the  take  up  of  portfolio  reconciliation  and 
compression services. For non-financial firms, the user of multilateral service providers in this 
area is considered less interesting.  

3.5. 

Foreign exchange derivatives 

Foreign  exchange  (FX)  derivatives  are  closely  intertwined  with  the  underlying  foreign 
exchange 'spot' market, i.e. the market where currencies change hand instantaneously. The FX 
market  is  large  and  mature.  Overall,  the  further  one  moves  from  the  spot  to  the  exotic 
derivative  part  of  the  market,  the  less  standardised  and  subject  to  central  infrastructure  the 
market becomes. Past focus in terms of risk management has been settlement risk; credit risk 
is increasingly becoming an additional focus. 

3.5.1.  Nature of contracts 

The FX derivative market traditionally is closely interlinked with the underlying cash market. 
The FX market can be divided into a cash side and a derivative side. On the cash side is the 
outright  spot  market  (exchange  of  currencies  up  to  within  two  days)  as  well  as  the  forward 
and swaps with very short maturity (e.g. two weeks). On the derivative side there are options, 
exotics and non-deliverable forwards and options.  

An FX swap is an agreement to exchange one currency for another at a moment close in time 
and then reverse at a later point in time. A vanilla option gives the buyer the right to buy one 
currency  for  another  at  an  agreed  rate.  There  are  many  exotic  FX  options,  including  e.g. 
options that disappear if currencies trade at a certain level, options with binary payouts etc.  

What unites them all is that they are used to facilitate currency risk management, payment and 
accounting needs of e.g. corporate, asset managers, sovereigns and speculators.  

37 

ISDA (2009b). 

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Table 9: FX derivative contracts traded on and off-exchange 
Notional amounts outstanding, USDbn, December 2008 

OTC  

Forwards and forex swaps 

Currency swaps 

Options 

On exchange 

Currency futures 

Currency options 

$bn 

24,562 

14,725 

10,466 

102 

126 

Source: BIS (2009). 

3.5.2.  Market structure 

The  FX  market  is  concentrated  in  terms  of  products.  For  example,  the  top  three  currencies 
account for close to 80% of market. However, the market is diverse in terms of participation. 
While  naturally  the  global  market  making  dealers  are  important,  there  are  thousands  of 
participants in the FX market.  

Europe is the location of choice for the global FX market, accounting for 57% of the global 
market turnover.38 The majority is traded out of the City of London.  

Traditionally,  the  FX  derivative  market  has  been  characterised  by  large  sized  trades  (large 
notional  /  small  amount  of  transactions).  However,  volumes  have  picked  up  in  recent  years 
and  have  been  further  amplified  during  crisis.  They  are  likely  to  increase  further,  as  retail 
investors become more active and algorithmic trading – enabled by electronic trading – takes 
off. Even so, that development is likely to be more pronounced for the more standardised cash 
side of the FX market as well as the vanilla side of the derivatives than for the more exotic 
part of the market.  

The FX market is nearly solely conducted OTC, which stands for 95% of notional and 90% of 
tickets. The exchange part is predominantly traded on the CME in the US.  

3.5.3.  Market infrastructure 

The infrastructure differs depending on the segment of the market.  

•  Trade  execution:  In  terms  of  trading,  the  FX  market  trades  in  three  segments,  some  of 
which are very exchange-like: (i) the voice market, where counterparties negotiate directly, 
(ii) the electronic inter-dealer market (e.g. EBS/ICAP and Reuters for spots, TFS-ICAP for 
FX options), and (iii) the electronic dealer to client market, where trades are conducted on 
Electronic  Communication  Networks  (ECNs,  e.g.  Currenex).  The  switch  to  electronic 
trading  has  occurred  during  the  last  five  years  and  is  particularly  prevalent  for  the  spot 
market,  as  the  electronic  trade  channels  cater  significantly  less  well  for  contracts  with 
bespoke  maturities.  For  the  derivatives  part,  the  trade  channel  of  choice  remains  voice 
brokerage. 

•  Trade  confirmation:  electronic  confirmation  is  done  via  SWIFT  since  1977.  SWIFT 

offers both confirmation and payment messaging.  

38 

BIS (2007)  

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Overall,  there  is  a  strong  incentive  to  automate  as  much  as  possible,  as  margins  are  limited 
and  the  business  is  based  on  volume.  As  the  derivative  side  of  the  market  becomes 
increasingly  commoditised,  it  becomes  more  amenable  to  electronic  execution,  affirmation 
and confirmation.  

3.5.4.  Market standardisation 

FX  products  are  easy  to  define.  There  is  industry  agreement  on  market  definition  of  all 
products’  characteristics,  including  half  of  the  more  exotic  products.  The  market  is 
accordingly  standardised  in  terms  of  contract  specifications.  Moreover,  the  big  institutions 
typically trade out of one jurisdiction (predominantly London) thereby centralising their OTC 
FX business on one type of contract (ISDA MCA, English law).  

As  regards  market  technology  standards,  as  outlined  above  electronic  confirmation  is  the 
norm for the cash side of the market. For vanilla derivatives, there is an incentive to automate 
in order to reduce ticket costs, but further efforts from the industry are necessary in that area.  

3.5.5.  Counterparty risks characteristics 

The  predominant  risk  in  FX  markets  is  cross-currency  settlement  risk,  i.e.  the  risk  that  a 
settlement does not take place as expected. This may happen because one party defaults on its 
clearing obligations. This risk is particularly prevalent in FX, which is a global market where 
participants operate in different time zones and where it takes time to  settle obligations and 
where the working hours of inter-bank payment and settlement systems may not overlap. In 
such situations, the failure of one counterparty to settle its side of a deal may trigger a chain 
reaction of cross-defaults.  

These  risks  are  often  called  Herstatt  risk  after  a  small  German  bank  (Bankhaus  Herstatt), 
which  defaulted  in  1974  during  the  period  it  was  supposed  to  settle  a  contract  after  having 
received  the  payment  from  the  counterparty.  Herstatt’s  default  caused  a  cascade  of  rapid 
defaults,  totalling  a  loss  of  $620  million.  Since  then,  similar  defaults  have  involved  Drexel 
Burnham Lambert in 1990, Bank of Credit and Commerce International in 1991 and Barings 
in 1995.  

However,  while  settlement  risk  may  be  the  most  high-profile  risk,  it  is  only  one  part  of  the 
risk  exposure  of  FX  counterparties.  Settlement  is  actually  only  one,  albeit  important  (as  the 
entire notional amount is at stake), part of a derivative contract, where positions are open for 
some time and the residual  value  of  the contract  evolves during which time,  which exposes 
counterparties to more traditional credit risk. Depending on the maturity of the FX derivative 
contract,  counterparties  face  more  or  less  counterparty  credit  risk  exposure.  However,  two 
factors mitigate this risk in certain FX derivative transactions. First, the average maturity of 
FX  derivative  contracts  are  short  (less  than  three  months),  hence  limiting  the  counterparty 
credit  risk.  Second,  the  market  is  deep  and  liquid,  which  a  priori  facilitates  replacing  a 
particular contract should the counterparty default.  

3.5.6.  Risk management 

To  deal  with  cross-currency  settlement  risk,  market  participants  are  using  the  Continuous 
Linked  Settlement  System  (CLS).  Founded  in  1997  and  operational  since  2002,  CLS  is 
special purpose bank that provides continuous linked settlement services that simultaneously 
settles both payments under a FX transaction. It is operated by CLS Bank International, based 
in New York and owned by the major banks in the FX market. It is supervised by the Federal 
Reserve Bank of New York. It is designated by the Bank of England for the purposes of the 
UK  legislation  that  implements  the  Settlement  Finality  Directive  (SFD)  and  it  is  notified  to 

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the Commission under Article 10(1) of the SFD. CLS Bank's rules are governed by English 
law. 

CLS  consolidates  positions  across  the  FX  market  and  multilaterally  nets  payments  of  gross 
value instructions based on value date. CLS settles matched trades on a payment vs. payment 
basis  across  17  currencies.  Netting  rates  for  payments  amount  to  98%.  CLS  also  facilitates 
premium payments arising during the maturity of a contract. 

There are limits to CLS in terms of scope: 

•  In  terms  of  material  scope,  for  a  currency  to  be  eligible  for  CLS  settlement  requires 
approval by the Central Bank of the currency in question as well as this currency to have a 
Real-Time Gross Settlement system (RTGS).  

•  In terms of personal scope, the counterparty to the FX transaction has to be able to connect 
to  CLS.  As  regards  the  latter,  there  are  three  categories  of  CLS  users:  shareholders  and 
Member Banks (60) and third party users (roughly 4,600). This last category has expanded 
rapidly in recent years. Third party users are indirect participants to CLS, effectively using 
one  of  the  Settlement  Member  Banks  as  their  way  into  CLS.  These  third  party  users  are 
known to CLS.  

In  view  of  the  above  limits,  CLS  is  currently used  for  55%  of  FX  transactions  (90%  of  the 
interbank market) with the remaining 45% remaining bilaterally settled. To improve the rate 
of usage requires expanding (i) the scope of services (e.g. expanding the settlement cycle in 
terms of time), (ii) the scope of currencies, and (iii) the scope of membership.  

For  non-CLS  transactions,  the  process  remains  manual  (confirm  trade,  confirm  standard 
payment instructions, agree amount, net against other instructions if applicable).  

The benefits of CLS were illustrated during autumn 2008. All transactions related to Lehman 
were in CLS and hence were protected (even though Lehman was not a direct bank member 
of  CLS,  but  was  using  Citi).  When  the  problems  emerged  with  the  Icelandic  banks,  some 
transaction fell outside CLS, which accordingly generated losses. 

As  regards  credit  risk,  it  can  either  be  addressed  by  bilateral  collateral  management  or 
introducing a CCP. As regards the former, ISDA estimates that 36% of exposures as share of 
trade volume  are  currently collateralised.39 The low rate is explained by corporate and fund 
managers that typically do not provide collateral. While the major dealers mark-to-market and 
collateralise on a T+2 basis, other market participants may collateralise less frequently.  

A  CCP  would  be  response  to  the  credit  risk.  However,  CLS  perform  some  functions 
traditionally performed by CCPs (e.g. multilateral netting). Moreover, as CCPs novate trades, 
they tend to work with aggregate positions as regards settlement instructions. This may not be 
compatible with CLS’ current business model. In view of these and other issues, there has so 
far not been any appetite, on the side of market making dealers, for introducing a CCP in the 
FX market. One such project saw the day some years ago (a joint venture between CME and 
Reuters, which connected to CLS) but failed to take off. However, in view of the increase in 
trade volumes, the increasing use of ECNs and the increasing focus on remaining credit risk, 
views on the relative merits of a CCP may evolve. 

39 

ISDA (2009b). 

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4. 

EFFECTIVENESS OF CURRENT RISK MITIGATION MEASURES 

This chapter looks at the effectiveness of current risk mitigation measures, namely CCP use, 
in  addressing  the  general  risks  associated  with  OTC  derivatives  and  the  specific  risks 
associated with each market segment, detailed in previous chapters.  

4.1. 

Credit default swaps 

Credit default swaps have been the focus of particular attention for a number of years in view 
of  the  explosive  growth  of  the  market.  This  focus  has  strengthened  with  the  role  played  by 
CDS in the events of September 2008.  

As  outlined  above,  CDS  have  particular  risks  (e.g.  discontinuous  pay-out  structure, 
concentrated  market  structure,  derivative  market  much  larger  than  the  underlying  market, 
problems  of  valuing  the  underlying  risk  in  stressed  market  circumstances)  all  of  which  are 
difficult  to  mitigate.  Among  these,  another  important  characteristic  is  the  lack  of 
standardisation in the contracts and procedures following a credit event.  

For  all  these  reasons,  CCP  clearing  is  desirable.  To  allow  CCP  clearing,  important 
developments outlined above have taken place following the industry commitment to move to 
CCP clearing.  

The  letter  of  commitment  states  that  the  signatories  will  start  clearing  eligible  CDS  on 
European reference entities and indices on these entities through one or more European CCPs 
by 31July 2009. The Commission services consider that the industry is putting in considerable 
efforts  in  trying  to  meet  the  deadline  stated  in  its  commitment.  Indeed,  industry  initiatives 
have so far proved to be effective on both sides of the Atlantic as far as the standardisation of 
CDS is concerned. However, the most critical issue for the clearing of European CDS, i.e. the 
restructuring credit event, has not been solved yet. 

The  European  CCPs  currently  proposing  services  for  CDS  clearing  differ  in  the  time  to 
market:  

•  Bclear is already operational for CDS indices (iTraxx Europe), but until now no trade has 
been cleared. No definitive date has been provided for the extension to single names CDS, 
which would require a separate regulatory approval process and a separate segment of the 
default  fund.  It  has  also  recently  announced  its  intention  not  to  make  any  further 
investment into the project at this stage. 

•  Eurex Clearing has announced that it will be ready (pending regulatory approval) to clear 
both CDS indices (iTraxx Europe) and single names (components of most liquid indices) 
before the end of July 2009.  

•  ICE  Clear  Europe,  subject  to  regulatory  approval,  its  initial  offering  expected  before  the 
end of July 2009 should cover indices and may also cover a selected list of single names. 
Once  single  names  will  be  added  to  the  offering,  the  one  originated  from  a  restructuring 
credit event on an index component, will be included in the list of the cleared single name 
contracts. 

•  LCH.Clearnet  SA  is  expected  to  be  ready  to  offer  its  services  starting  from  December 

2009. 

Overall,  as  of  today,  it  is  too  early  to  judge  whether  the  dealers’  efforts  will  be  enough  to 
respect the commitment to clear eligible European CDS by 31July 2009. Given the threat to 
financial stability, if it was not respected, other ways to reach the same objective would have 
to be found.  

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4.2. 

Interest rate swaps 

The interest rate derivatives market is the biggest in terms of size. It is also the most mature in 
terms of market infrastructure, notably by the presence of a well-established CCP; SwapClear. 
This  infrastructure  successfully  mitigates  the  risks  encountered  in  interest  rate  derivative 
markets.  This  is  particularly  the  case,  as  these  risks  are  less  dramatic  and  more  easily 
mitigated than the risks associated with CDS.  

The solidity of that infrastructure was demonstrated when SwapClear's Default Management 
Group  successfully  unwound  the  risk  related  to  open  trades  subsequent  to  the  default  of 
Lehman Brothers. Overall the vast majority of IRS contracts are eligible to clear on a CCP. 
The  exception  would  be  the  more  exotic  contracts,  which  currently  amount  to  around  one 
third of the market. It is, therefore, worth considering expanding the scope of CCP clearing 
scope further in three respects, provided that regulatory and supervisory objectives continue to 
be met: 

•  Extending  the  scope  of  products:  in  terms  of  e.g.  cross-currency  trades,  basis  trades, 

currencies included and maturity.  

•  Extending direct participation in SwapClear: Another limitation to the level of clearing 
is the number of counterparties that are General Clearing Members (GCMs) of SwapClear. 
If  the  number  of  GCMs  was  extended,  a  higher  share  of  the  market  would  become  CCP 
cleared40. However, there are limits and trade-offs related to extending participation. Not 
all  dealers  can  become  GCMs,  as  it  comes  with  strict  obligations  in  terms  of  ability  to 
shoulder  a  part  of  the  default  management  burden.  That  requires  ability  to  process  and 
value significant portfolios in a short time span. 

•  Offering CCP clearing to GCM clients: SwapClear has recently announced its intention 
to offer clearing services to clients of GCMs enabling them to benefit from CCP clearing.41 
This could bring a significant additional share of the market onto SwapClear.  

4.3. 

Equity derivatives 

The equity derivative market is significantly smaller than most of its OTC derivatives peers. 
Moreover, some of its inherent characteristics – e.g. continuous pay-out structure, presence of 
an  objective  market  price  for  risk  valuation  purposes  even  under  stressed  market 
circumstances – limit the amount of systemic risk potentially triggered by this segment.  

Even  so,  the  equity  derivative  markets  are  associated  with  other  characteristics  that  may 
contribute to risk. First, there is a lack of standardisation. For example, standard contractual 
documentation differs depending on region and sometimes countries. Moreover, the uptake of 
electronic trade confirmation remains limited. While part of this lack of standardisation is due 
to  the  inherent  divergences  in  the  underlying  cash  equity  markets,  it  would  nevertheless  be 
desirable  to  address  the  major  differences  in  the  contractual  underpinnings  of  equity 
derivatives as well as achieving a higher degree of electronic take up.  

Moreover,  while  CCP  services  exist  for  OTC  equity  derivatives,  the  take  up  is  so  far  very 
limited. Accordingly, it is necessary to assess ways of further promoting the take-up of CCP 
services.  Moreover,  it  is  necessary  to  further  assess  the  ability  of  existing  infrastructures  to 
connect to and channelling trade flows to a CCP. The bilateral clearing model could also be 

40 

41 

On 18 May 2009 three new banks (ING Bank NV, Natixis SA and Rabobank NV) became Swapclear 
members. 
LCH.Clearnet (2009).  

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further strengthened, as the level of credit exposures covered by collateral remain well below 
the average for OTC derivatives as a whole.  

4.4. 

Commodity derivatives  

Commodity  derivatives  are  extremely  varied  and  diverse.  The  market  structure  differs 
depending on segment, with some being more standardised and subject to CCP clearing, with 
others being pure OTC. The diversity of the various market segments and the broad range of 
actors involved reduce the amount of systemic risk but make it difficult to gather centralised 
market information and equally present challenges in terms of standardisation.  

As  regards  clearing,  many  CCP  clearing  houses  are  in  place,  but  predominantly  cater  for 
listed  commodity  derivatives.  There  are  inherent  limitations  to  CCP  uptake  in  markets  as 
diverse  as  commodities  and  bilateral  clearing  can  accordingly  be  expected  to  continue  and 
even extend as regards coverage.  

However,  achieving  more  stability  and  transparency  in  commodity  derivatives  requires 
developments outside the post-trade area as well. A significant number of participants in these 
markets  are  not  financial  firms,  but  commercial  producers  hedging  their  price  risks. 
Therefore, legislation designed for the financial sector may not be adequately tailored to their 
activity and risk profile. Indeed, this is reflected in a number of exemptions from EU financial 
legislation, such as MiFID and CRD. Ensuring access of such firms to commodity derivative 
markets  is  important  as  it  supports  building  competition  within  the  recently  liberalised  EU 
commodity markets (e.g. electricity and gas). It also contributes to market liquidity.  

While  regulation  aimed  at  financial  players  may  not  be  appropriate  for  commercial  firms, 
various provisions in recently adopted EU energy and emissions market legislation signals the 
need  to  converge  key  aspects  of  the  regulation  of  some  physical  commodity  markets  and 
financial commodity derivative markets.42 There is a  growing consensus that the efficiency, 
and better oversight, of various commodity markets could be improved with the formulation 
of dedicated EU-wide, sector-specific rules on, for example, market abuse and transparency of 
trading activity. The Committee of European Securities Regulators (CESR) and the European 
Regulators'  Group  for  Electricity  and  Gas  (ERGEG)  have  recently  delivered  advice  to  this 
effect to the Commission.43  

4.5. 

Foreign exchange derivatives 

The  FX  derivative  market  –  closely  intertwined  with  the  underlying  spot  market  –  is  large 
mature  and  systemically  important.  Since  2002,  the  FX  derivative  market  is  using  CLS,  a 
payment  system  notified  by  the  United  Kingdom  under  the  Settlement  Finality  Directive 
(SFD),  which  has  significantly  reduced  the  systemic  risk  associated  with  FX.  Other 
characteristics  of  the  FX  derivative  market  also  attenuate  the  systemic  risk,  e.g.  extremely 
liquid market, a relatively high degree of standardisation, dispersed market structure. 

However,  so  far  only  55%  of  the  FX  derivative  market  is  covered  by  CLS  (90%  of  the 
interbank  market).  It  would  therefore  be  desirable  that  CLS  uptake  broadens  further  by  (i) 

42 

43 

See  Article  12  of  the  revised  Emissions  Trading  Scheme  directive,  and  Articles  22f/24f  and  Recitals 
20/22,  as  amended,  of  the  Third  Legislative  Package  for  Gas  and  Electricity  Markets  amending 
Directives 
2003/55/EC 
and 
(http://register.consilium.europa.eu/pdf/en/08/st03/st03737.en08.pdf, 
http://ec.europa.eu/energy/gas_electricity/third_legislative_package_en.htm). 
See CESR and ERGEG (2009a and b). 

2003/54/EC 

EN 

   EN 

 
 
                                                 
expanding  the  set  of  currencies  covered,  (ii)  broadening  the  range  of  participants  that  can 
connect to it, and (iii) expanding the settlement cycle.  

In  addition,  while  settlement  risk  may  be  the  most  important  risk  in  FX  derivative  market, 
credit risk remains. So far, no CCP provides services in this area due to market participants’ 
views that credit risk is not as important in this segment as in others. Even so, one needs to 
consider what the rapid expansion of electronic trading in general and algorithmic trading in 
particular,  plus  the  new  type  of  counterparties  coming  to  the  market  imply  for  the  level  of 
risk. There are,  therefore,  good  reasons for market participants to actively  consider  ways of 
addressing credit risk as well as settlement risk. 

EN 

   EN 

 
 
BIBLIOGRAPHY 

Bliss,  R.  and  C.  Papathanassiou  (2006),  Derivatives  clearing,  central  counterparties  and 
novation: The economic implications. 

(2009a),  Semi-annual  OTC  derivatives 

BIS 
http://www.bis.org/statistics/derstats.htm 

BIS (2009b), BIS Quarterly Review, March 2009. 

statistics  at  end-December  2008, 

BIS  (2007),  Triennial  Central  Bank  Survey  of  Foreign  Exchange  and  Derivatives  Market 
Activity,  

Buffet, Warren (2009), Letter to shareholders, Berkshire Hathaway (February 2009). 

CESR  and  ERGEG  (2009),  Final  advice  -  CESR  and  ERGEG  advice  to  the  European 
Commission 
Package, 
of 
http://www.cesr.eu/index.php?docid=5086, http://www.cesr.eu/index.php?docid=5478.  

context 

Energy 

Third 

the 

the 

in 

CESR  and  ERGEG 
http://www.cesr.eu/index.php?docid=5270. 

(2009b),  Response 

to  Question  F.20  –  Market  Abuse, 

CPSS (1998), OTC derivatives: settlement procedures and counterparty risk management. 

CPSS  (2007),  New  developments  in  clearing  and  settlement  arrangements  for  OTC 
derivatives. 

de  Larosière  Group  (2009),  Report  from  the  High-level  Group  on  Financial  Supervision 
chaired by Jacques de Larosière.  

Duffie, D. and H. Zhu (2009), Does a Central Clearing Counterparty Reduce Counterparty 
Risk? 

ECB (2008). Decisions taken by the Governing Council of the ECB (in addition to decisions 
setting 
2008, 
http://www.ecb.int/press/govcdec/otherdec/2008/html/gc081219.en.html. 

December 

interest 

rates), 

18 

Economic  and  Financial  Affairs  Council,  2911th  Council  meeting  -  ECONOMIC  and 
FINANCIAL 
2008 
http://www.consilium.europa.eu/uedocs/NewsWord/en/ecofin/104530.doc 

AFFAIRS, 

December 

Brussels, 

2 

European  Commission  (2009a).  Driving  European  Recovery,  Communication  from  the 
European Commission, 4 March 2009 – COM(2009) 114.  

European  Commission  (2009b).  Ensuring  efficient,  safe  and  sound  derivatives  markets, 
Communication from the European Commission – COM(2009) XXX.  

European  Commission  (2009c).  Consultation  document:  possible  initiatives  to  enhance  the 
resilience of derivatives markets, Commission Staff Working Paper, SEC(2009) XXX. 

Financial  Times  (2009).  "AIG  saga  shows  how  dangerous  credit  default  swaps  can  be",  7 
March 2009. http://www.ft.com/cms/s/0/52bb328a-0ab9-11de-95ed-0000779fd2ac.html 

FSA (2009), The Turner Review: A regulatory response to the global banking crisis.  

G20  (2009).  Declaration  on  strengthening  the  financial  system  –  London  summit,  2  april 
2009, http://www.londonsummit.gov.uk/resources/en/PDF/annex-strengthening-fin-sysm 

Gerken,  A.  and  H.  Karseras  (2004).  "The  real  risks  of  credit  derivatives",  The  McKinsey 
Quarterly, No. 4 2004. 

EN 

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Hrovatin,  S.,  M.  Levin,  M.  Nava  and  F.  Planta  (2009),  Financial  regulation  and  financial 
cirsis: Lessons learned and the way forward. Swiss Derivatives Review – Issue 39. 

ISDA (2009a), Market Survey 2008, www.isda.org 

ISDA (2009b). Margin Survey 2009, http://www.isda.org/c_and_a/pdf/ISDA-Margin-Survey-
2009.pdf  

LCH.Clearnet (2009). "LCH.Clearnet to launch client clearing for OTC interest rate swaps", 
Press  Release  27  May,  http://www.lchclearnet.com/media_centre/press_releases/2009-05-
27.asp. 

McCreevy,  C.  (2008).  Time  for  regulators  to  get  a  better  view  of  derivatives,  17  October 
2008, SPEECH/08/538. 

(2009). 

Markit 
http://www.markit.com/assets/en/docs/products/research-and-
reports/Quarterly%20Metrics%20Report%20-%20March%202009%20Month%20End.pdf 

Quarterly 

Report 

March 

Trend 

2009, 

World  Federation  of  Exchanges 
exchanges.org/statistics.  

(2009),  Annual  Statistics,  http://www.world-

EN 

   EN 

 
 
GLOSSARY

44 

Affirmation (of a trade confirmation)  A  procedure  in  a  confirmation  process,  whereby  a 
single  record  of  the  trade  is  created  by  one  party 
evidencing  the  full  terms  of  the  trade  and  the 
counterparty  verifies  and  agrees  to  that  record. 
Affirmation  of  trade  confirmations  is  different  from 
(also  known  as  economic 
trade  verification 
affirmation),  which  is  limited  to  principal  economic 
terms 

Arbitrage 

Basis point 

Bid-ask spread 

Central counterparty (CCP) 

Clearing 

Collateral 

Confirmation 

Confirmation process 

The  exploitation  of  price  differences  in  connected 
markets. 

0,01 of a percent. 100 basis points equal 1 percent. 

The difference in price between the highest price that 
a buyer is willing to pay for an asset and the lowest 
price for which a seller is willing to sell it. 

that 

interposes 

An  entity 
the 
counterparties to the contracts traded in one or more 
financial markets, becoming the buyer to every seller 
and the seller to every buyer. 

itself  between 

The  process  of  establishing  settlement  positions, 
including  the  calculation  of  net  positions,  and  the 
process  of  checking  that  securities,  cash  or  both  are 
available.  In  other  words  it  is  the  process  used  for 
managing the risk of (cid:214) open positions.  

An  asset  or  third-party  commitment  that  is  used  by 
the  collateral  provider  to  secure  an  obligation  to  the 
collateral  taker.  Collateral  arrangements  may  take 
different  legal  forms;  collateral  may  be  obtained 
using the method of title transfer or pledge. See also 
margin. 

A document identifying the details of a trade and any 
governing  legal  documentation,  as  agreed  upon  by 
both parties. This document serves as the final record 
of the transaction 

The process by which trade details are verified with a 
counterparty, with a view to obtaining a final record 
of the trade. This is generally done by exchanging a 
confirmation  proposal  via  fax,  mail  or  an  electronic 

44 

This  glossary  draws  partly  on  glossaries  contained  in  various  reports  published  by  Committee  on 
Payment and Settlement Systems of the Bank for International Settlements. 

EN 

   EN 

 
 
                                                 
Counterparty credit risk 

Coupon 

Credit event 

Default fund 

Exposure 

Hedge 

Leverage 

Margin 

Marking to market 

Master Agreement 

confirmation service. Either one party provides trade 
details and the other then verifies the information, or 
both  parties  submit  records  of  the  trade  and  verify 
each other’s records. 

The  risk  that  a  counterparty  will  not  settle  an 
obligation  for  full  value,  either  when  due  or  at  any 
time  thereafter.  Credit  risk  includes  pre-settlement 
risk  (replacement  cost  risk)  and  settlement  risk 
(principal risk). 

The regular payment on a contract, often also referred 
to as premium or (cid:214) spread. The coupon can be fixed 
or floating. 

An  event  that  may  trigger  the  exercise  of  a  CDS 
contract.  Credit  events  include,  for  example,  failure 
to pay (interest or principal when due), bankruptcy or 
(cid:214) restructuring. 

A  fund  composed  of  assets  contributed  by  a  CCP’s 
participants  that  may  be  used  by  the  (cid:214)  CCP  in 
certain  circumstances  to  cover  losses  and  liquidity 
pressures  resulting  from  defaults  by  the  CCP’s 
participants. Also known as clearing fund. 

The amount of funds at risk, i.e. the amount that one 
may lose in an investment. 

A (cid:214) position established in one market in an attempt 
to  offset  (cid:214)  exposure  to  the  risk  of  an  equal  but 
opposite obligation or position in another market. 

A financial ratio that compares some form of owner's 
equity (or capital) to borrowed funds. The higher are 
the  borrowed  funds  with  respect  to  own  capital,  the 
higher is the leverage. 

An asset (or third-party commitment) that is accepted 
by a counterparty to ensure performance on potential 
obligations  to  it  or  cover  market  movements  on 
unsettled transactions. 

The  practice  of  revaluating  open  positions 
in 
financial instruments at current market prices and the 
calculation of any gains or losses that have occurred 
since the last valuation. 

An  agreement  that  sets  forth  the  standard  terms  and 
conditions  applicable  to  all  or  a  defined  subset  of 
transactions that the parties may enter into from time 

EN 

   EN 

 
 
Multi-lateral netting 

Multi-lateral trading facility (MTF) 

to  time,  including  the  terms  and  conditions  for 
closeout netting. 

Netting  on  a  multilateral  basis  by  summing  each 
participant’s  bilateral  net  positions  with  the  other 
participants  to  arrive  at  a  multilateral  net  position. 
Such  netting  is  often  conducted  through  a  central 
counterparty  (but  it  can  also  be  done  by  other 
entities).  In  such  cases  the  multilateral  net  position 
represents  the  bilateral  net  position  between  each 
participant and the central counterparty. 

A  multilateral  system,  operated  by  an  investment 
firm  or  a  market  operator,  which  brings  together 
multiple  third-party  buying  and  selling  interests  in 
in 
financial 
accordance  with  non-discretionary  rules  -  in  a  way 
that results in a contract. 

the  system  and 

instruments  - 

in 

Netting 

Notional amount 

Novation 

Open interest 

The  offsetting  of  positions  or  obligations  by 
counterparties. 

The reference amount on which a derivative contract 
is written. 

The  replacement  of  a  contract  between  two  initial 
counterparties to a contract (the transferor, who steps 
out of the deal, and the remaining party) with a new 
contract  between  the  remaining  party  and  a  third 
party (the transferee). 

The  total  number  of  open  derivative  contracts  on  a 
specific underlying. 

Par value 

The stated, nominal or face value of a security. 

Plain vanilla transactions 

Portfolio reconciliation 

Generally  used  to  refer  to  a  type  of  derivatives 
transaction  with  simple,  common  terms  that  can  be 
that  have 
processed  electronically.  Transactions 
unusual or less common features are often referred to 
as exotic, structured or bespoke. 

The  process  of  verifying 
the  existence  of  all 
outstanding trades with a particular counterparty and 
comparison of their principal economic terms. 

Portfolio compression  

(cid:214) Multi-lateral netting. 

Position 

EN 

The stance an investor takes vis-à-vis the market. An 
investor's position is said to be long (short) when she 
buys (sells) a financial instrument. 

   EN 

 
 
Reference entity 

Restructuring 

Settlement 

Speculation 

Spread (of a CDS) 

Trade matching 

A  corporate,  a  sovereign  or  any  other  form  of  legal 
entity  which  has  incurred  debt,  on  which  a  CDS  is 
written. 

One  of  the  (cid:214)  credit  events  that  may  trigger  the 
exercise  of  a  CDS  contract.  The  term  denotes  a 
change in the legal terms of an issuer's ((cid:214) reference 
entity)  obligation,  such  as  the  reduction  in  the 
obligation principal, the reduction in the contractually 
agreed  interest  payments  and  the  deferral  of  interest 
or principal payments. 

The  completion  of  a  transaction,  wherein  the  seller 
transfers  securities  or  financial  instruments  to  the 
buyer and the buyer transfers money to the seller. 

The  act  of  making  an  investment,  i.e.  taking  a  (cid:214) 
position in the market, without certainty of being able 
to  recover  the  initial  investment  or  earning  a  return 
on the investment. 

The  (cid:214)  coupon  of  a  CDS  contract  expressed  as  a 
percentage  of  the  notional  amount.  For  example,  a 
spread  of  400  (cid:214)  basis  points  for  a  five-year  CDS 
with  a  notional  amount  of €  10m  implies a payment 
of  €400.000  per  year,  or  €100.000  per  quarter,  as 
payments are made quarterly. The spreads reflects the 
probability of default of a reference entity: the higher 
the spread, the higher the probability of default. 

The  process  by  which  both  counterparties  to  a  trade 
create  a  written  or  electronic  record  evidencing  the 
full  terms  of  the  trade.  These  two  records  are  then 
they  are 
compared  and  considered  matched 
identical. 

if 

EN 

   EN