Central Clearing of Derivatives May Not Always Have Cost Advantage Over Bilateral Trading

Central Clearing of Derivatives May Not Always Have Cost Advantage Over Bilateral Trading

The financial crisis showed that over-the-counter (OTC) derivatives can create risks for the financial system. G-20 reforms have sought to reduce those risks by requiring central clearing of standardized contracts. They also set higher capital and collateral requirements for derivatives that are not centrally cleared. Part of the motivation for those requirements is to create an incentive for banks to clear through central counterparties (CCPs).

But a new OFR working paper shows that the cost incentive does not necessarily favor central clearing. The paper is, “Does OTC Derivatives Reform Incentivize Central Clearing?”

The authors, Samim Ghamami and Paul Glasserman, compare the total capital and collateral costs when banks transact only bilaterally to the capital and collateral costs when they clear only through CCPs. The evidence suggests that central clearing is sometimes more expensive.

The cost comparison is key. In the absence of a cost advantage, market participants may customize contracts to trade them bilaterally. Without a cost advantage, banks also may be less inclined to move legacy trades to CCPs.

To analyze the cost incentives, the authors developed a model of OTC clearing. They calibrated it using data the Federal Reserve collected from five large bank holding companies.

The authors identify the main factors driving the relative costs of bilateral trading and CCPs. Those include the relative benefits of netting through bilateral and central clearing; the margin period of risk used to set initial margin and capital requirements; and the level of CCP guarantee fund requirements. The margin period of risk is the period between a counterparty’s default and the time the position is closed out. The guarantee fund consists of assets that banks provide to protect the CCP in the event that a member of the CCP defaults.

CCP regulation leaves substantial ambiguity about the appropriate size of guarantee funds. The authors conclude that the costs these funds impose on banks are a significant factor in banks’ decisions whether to use central clearing. A main finding is that cost incentives that favor central clearing are at odds with efforts to maintain sufficiently high levels of guarantee funds.

Stacey Schreft is Deputy Director for Research and Analysis at the Office of Financial Research