1. The definition of derivatives

The key purpose of a derivative is the management and especially the mitigation of risk.

When a derivative contract is entered, one party to the deal typically wants to free itself of a specific risk, linked to its commercial activities, such as currency or interest rate risk, over a given time period. It is ‘hedging’; and the more exact that hedge, the better for the hedging party.

The other party to the deal assumes the risk, though it may then ‘lay it off’ elsewhere, in a process akin to reinsurance. Thus risk passes to those most willing to take it on (including investors, who are usd to taking similar risks through other financial instruments).

The value of a derivative contract is determined by the change in value of an ‘underlying’ asset. This characteristic is what allows a precisely targeted over-the-counter (OTC) derivative to cancel out the economic effect of existing exposures. The practical applications are limitless.

2. Legal / process standardisation overview

 Legal documentation – ‘Master Agreement’ framework first established for netting out counterparty exposures in 1985 and steadily extended since then to accommodate new products and jurisdictions. Collateralisation documents added in early 1990s, allowing the securing of residual counterparty exposure.  Standard procedures for transferring contracts to third parties (subject to the agreement of all relevant parties; known as ‘novations’).  A common computer language (called ‘FpML’) to support the automation of post-trade process, initiated 10 years ago and now widely used.  Automatation of trade detail (‘confirmation’) matching at nearly 100%. (Only 1/900,000 trades in Lehman Brothers portfolio was disputed; also, backlogs effectively eliminated.  Portfolio reconciliation – centralised services for ensuring consistency between pairs of firms as to the data about mutual derivative transactions on their books.  Dispute resolution – procedures for decisively resolving disagreements between parties as to the value of derivatives (particularly when the correct amount of collateral is to be calculated) ; currently being updated.  Trade repositories – central databases for transactions in derivatives, supporting supervisory oversight of net risk positions.  Trade ‘compression’ – reducing counterparty exposures and operational burden by removing economically redundant transactions from firms’ books; (NB compression is applicable to a wider range of products than clearing and has reduced notional amounts in the credit and interest-rate market by $10s of trillions).  Standardised settlement procedures, particularly for credit derivatives, where a ‘Determinations Committee’ agrees on whether ‘trigger’ events have in fact occurred, leading to a market-wide process to determine the settlement value (praised by the ‘Senior Supervisors Group).  Central clearing (where feasible) – aggressive targets were met last Autumn (for ‘G15’ banks: 70% of eligible interest rate swaps; 80% of eligible credit derivatives).  Some forms of economic standardisation, where relevant (eg, standard ‘coupons’ apply to many credit derivatives, making their prices more easily comparable)

3. Multilateral netting

Netting is the process of calculating how much ‘counterparty’ credit exposures (ie, exposures between parties to contracts) cancel each other out. Thus, in the case of bilateral netting, if I owe a party 10 on one contract, while they owe me 8 on another, the net amount payable is 2. In multilateral netting, to work out what is payable, I consider what I owe to and am owed by more than one party at a time.

(The ‘exposures’ that are netted arise as a result of derivative contracts acquiring value, ie, upon any changes in value of the ‘underlying’ asset to which the derivative refers. On any contracts which have positive value for me, I rely on the ability of my counterparty to perform at the point of settlement. Often, parties to contracts will cover the risk of default by the counterparty on a positive net exposure, by requiring ‘collateral’ *ie, cash or government bonds such as Gilts].)

Netting routinely applies ‘bilaterally’ between pairs of parties to OTC derivatives (under the terms of a ‘Master Agreement’ between them). Multilateral netting extends the calculation to more than one relationship at once, usually intermediated by a financially strong central counterparty (CCP) that ‘steps in’ between the original parties to a contract. Consider the following illustrative example. Assume that:

 ‘A’ and ‘B’ enter a contract, then the CCP steps in, such that ‘A’ has a contract with the CCP, while the CCP has an equal but opposite contract with ‘B’; (parties such as ‘A’ and ‘B’ that deal directly with a CCP are known as ‘clearing members’;)  The value of these contracts today is such that A ‘owes’ the CCP, ie, the CCP is relying on A to perform for it; simultaneously, B is relying on the CCP to perform (for exactly the same amount).  From a separate contract, initially between B and C but also intermediated by the CCP, B ‘owes’ an amount to the CCP (ie, the CCP is in this case relying on B to perform); the CCP in turn ‘owes’ an identical amount to C.  Assume also, for the sake of the illustration, that the amounts owed as a result of the ‘B-CCP-C’ contracts are the same as those owed from the ‘A-CCP-B’ contract.

Schematically, this situation can be represented as in the diagram below (with amounts payable upon settlement in the direction arrow-head). Note that in the case of Bank ‘B’, it ‘owes’ money to the CCP but also is ‘owed’ money by the CCP, as a result of the dealings initially carried out with A and C.

In this scenario, B has two offsetting counterparty exposure positions (both of them with the CCP); while A owes money to the CCP and C is owed money by the CCP. In the B-CCP relationship, there is zero current counterparty credit exposure. Vis-a-vis A and C, there is net exposure for the CCP to A and for C to the CCP.

The CCP will require amounts of collateral from A, B and C accordingly, reflecting these net positions. B will still post some amount of collateral (for the general strength of the CCP). So will C. A (which is the party on whom performance effectively depends) will post much more than either B or C.

(In the event of B’s default, C’s exposure would be to the CCP – not to B – while the CCP would still have a surviving counterparty in A. In practice, the CCP would then look to other clearing-member parties to take on the contracts which B had on its books, to ensure its own book reverted to the same mix of contracts as before the default of B. It is at this point that the collateral taken by the CCP becomes important, cushioning it against any losses on those positions while it seeks to replicate them.)

4. Collateral retrieval

As outlined above, one party (‘A’) posts collateral to another (‘B’) when a contract (or, on a net basis, a set of contracts) between them has positive value for the second. If B then defaults, one of two things can happen, with an equal economic effect. Either:

1. A pays B the current (net) value of the derivative(s) and B returns the collateral; or 2. A does not pay what it owes on the contract(s) and B keeps the collateral, to make up for that.

As the economic effect of either outcome will be the same, the parties will be indifferent as to which applies. Either way, the collateral amount offsets the amount payable on the derivative(s). B may even have posted that collateral on with another party (‘rehypothecating’1 it to ‘C’, to secure a separate exposure towards C). In this situation, A is no worse off, since it can simply point to the original transfer of collateral to B and withhold payment on the derivative. Nor is B disadvantaged by that withholding, since it has had use of the collateral to reduce the amount that it must pay to C. In these scenarios, therefore, whether or not collateral is retrieved is moot.

This is entirely different from the situation where entity ‘X’, as the owner of some securities, lodges them with a broker acting in a custodial capacity (as some investors’ did with Lehman Brothers). In that instance, the usage of those securities by the broker (say, to seccure exposures it represents to third parties) should be subject to a clear agreement on the part of X, giving it the legal right to recover those securities in the event of the broker’s default.

There is one final consideration, regarding the use of collateral to secure OTC derivative exposures. If, for some reason in the A-B example above, B has required collateral from A in excess of the amount that A owes it on the contract(s), then A faces a different situation. At that point, it is not indifferent to B retaining the collateral upon B’s default, since the collateral’s value is greater than what A owes B on the derivative(s). At this point, A will become an unsecured creditor for any amount in excess of what it owed B on the derivative(s), and will be very much concerned about how to retrieve it. Note however, that it is only concerned about that excess amount – not about the whole amount of collateral posted.

1 We attach a note from counsel on the legal aspects of rehypothecation.