Lot of Hedge funds and Investment banks have started publishing the margin FAQ’s after the Credit crisis. As part of Dodd-Frank, by the end of 2012, all standardised over-the-counter derivatives will have to be cleared through central counterparties.
That’s the biggest challenge for the market as OTC derivatives account for almost 95% of the derivatives markets. In June 2011, the notional value of outstanding OTC derivatives was around $707 trillion or €540 trillion. The OTC derivatives market comprises a wide variety of product types across several asset classes (interest rates, credit, equity, foreign exchange (FX) and commodities) with widely differing characteristics and levels of standardisation. OTC derivatives are used in a variety of ways, including for purposes of hedging, investing, and speculating. Contrary to derivatives traded on exchanges, OTC derivatives are not automatically cleared through Central Clearing Parties.
let’s try to define what Central Clearing Parties (CCP) are,a CCP is an entity that interposes itself between the two counterparties to a transaction, becoming the buyer to every seller and the seller to every buyer. A CCP’s main purpose is to manage the risk that could arise if one counterparty is not able to make the required payments when they are due –i.e. defaults on the deal.
I have tried to put of the definitions for the most important factor:-
Imagine the market for $707 trillion and that has to be cleared through CCP. When a CCP comes in between margins are required to put up. Just to quote an example when Silver was fluctuating too much commodity exchange (CME)hiked silver margins 5 times in a row) silver market is tiny by comparison to OTC it is easy to be pushed around, and thus exchanges can easily represent the illusion that they are in control of counterparty risk
Nothing could be further from the truth: where exchanges are truly at risk is when it comes to mitigating the threat of counterparty default for participants in a market that is millions of times bigger than the silver market: the interest rate and credit default swap markets.
So the 14 Dealers that dominate derivatives trading includes major banks will soon need to post billions in initial margin, and as a brand new BIS report indicates, will likely need significant extra cash to be in compliance with regulatory requirements.
The Topic is vast will continue in my next post.