Committee on Payment and Settlement Systems New developments in clearing and settlement arrangements for OTC derivatives March 2007 Copies of publications are available from: Bank for International Settlements Press & Communications CH-4002 Basel, Switzerland E-mail: [email protected] Fax: +41 61 280 9100 and +41 61 280 8100 This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 2007. All rights reserved. Brief excerpts may be reproduced or translated provided the source is cited. ISBN 92-9131-738-1 (print) ISBN 92-9197-738-1 (online) Foreword Since the publication by the BIS in 1998 of a report on OTC derivatives: settlement procedures and counterparty risk management, the markets for OTC derivatives have continued to expand and develop rapidly, while risk management practices have evolved and significant changes in market infrastructures have occurred. In early 2006, the CPSS set up a Working Group, comprising representatives of its member central banks and prudential supervisors of major derivatives dealers, to analyse existing arrangements and risk management practices in the broader OTC derivatives market and evaluate the potential for risks to be mitigated by greater use of, and enhancements to, market infrastructure. This project complemented an earlier supervisory initiative that at the time was focused primarily on confirmation backlogs in the credit derivatives markets. The Working Group conducted interviews with some 35 major dealers in OTC derivatives in the G10 countries and Hong Kong SAR. It also met with industry groups and providers of post-trade processing services. Finally, upon completion of the report, it discussed its findings in a roundtable with these entities. The report focuses on six issues, of which three had already been discussed in 1998 and three others have caught the Group’s attention during its discussions with OTC derivatives dealers and service providers: (1) the risks created by delays in documenting and confirming transactions; (2) the implications of the rapidly expanding use of collateral to mitigate counterparty credit risks; (3) the potential for expanding the use of central counterparty (CCP) clearing to reduce counterparty risks; (4) the implications of OTC derivatives prime brokerage; (5) the risks associated with unauthorised novations of contracts; and (6) the potential for significant market disruptions from the closeout of OTC derivatives transactions following the default of a large market participant. The report concludes that, since 1998, the clearing and settlement infrastructure of OTC derivatives markets has been significantly strengthened. But further progress is needed in some areas: • institutions need to extend the successful efforts to reduce confirmation backlogs in credit derivatives to other OTC derivative products, using automated systems whenever possible. To mitigate the risks of remaining backlogs, more systematic use of economic affirmations is appropriate and over time dealers should work toward daily portfolio reconciliations with their most active counterparties; • market participants should identify steps to mitigate the potential market impact of replacing contracts following the closeout of one or more major participants. In addition, as the market infrastructure moves further in the direction of centralised processing of trades and post-trade events, several issues will assume greater importance: • providers of essential post-trade services for OTC derivatives should provide open access to their services and should aim to achieve convenient and efficient connectivity with other systems; • central banks and supervisors will need to consider whether certain existing standards for securities settlement systems, CCPs or systemically important payment systems should be applied to providers of clearing and settlement services for OTC derivatives that are not already subject to those standards. CPSS - New developments in clearing and settlement arrangements for OTC derivatives - March 2007 iii Interested parties are welcome to send comments on the report to the CPSS Secretariat ([email protected]); please mention OTC derivatives in the subject line of your email. Comments will be made available on the website of the BIS. The CPSS is grateful to the members of the Working Group and to its chair, Patrick Parkinson of the Board of Governors of the Federal Reserve System, for their excellent work in writing this report. Timothy F Geithner, Chairman Committee on Payment and Settlement Systems iv CPSS - New developments in clearing and settlement arrangements for OTC derivatives - March 2007 Contents Foreword.................................................................................................................................. iii Executive summary ..................................................................................................................1 Documentation backlogs........................................................................................1 Use of collateral to mitigate counterparty credit risk ..............................................3 CCP clearing ..........................................................................................................3 Prime brokerage.....................................................................................................3 Novations ...............................................................................................................4 Closeout .................................................................................................................5 Overall assessment................................................................................................5 1. Introduction......................................................................................................................7 Background on the 1998 report..............................................................................7 Developments since 1998......................................................................................8 Purpose and organisation of this report ...............................................................11 2. Life cycle of an OTC derivatives trade...........................................................................12 3. Issues analysed in the 1998 report ...............................................................................16 3.1 Delays in documenting and confirming transactions............................................16 Unsigned master agreements ..............................................................................16 Assessment..........................................................................................................17 Outstanding confirmations ...................................................................................17 Tackling the backlogs...........................................................................................19 Assessment..........................................................................................................20 3.2 Use of collateral to mitigate counterparty credit risk ............................................21 Usage of collateral ...............................................................................................21 Implications for risks.............................................................................................23 Assessment..........................................................................................................24 3.3 Development of a central counterparty ................................................................25 Benefits of a CCP.................................................................................................25 Challenges associated with a CCP ......................................................................27 Assessment..........................................................................................................29 4. New issues and concerns .............................................................................................30 4.1 OTC derivatives prime brokerage ........................................................................30 Management of the risks associated with offering prime brokerage ....................31 Assessment..........................................................................................................32 4.2 Novation ...............................................................................................................33 Use of novations and novation practices .............................................................33 CPSS - New developments in clearing and settlement arrangements for OTC derivatives - March 2007 v The novation protocol.......................................................................................... 34 Assessment......................................................................................................... 35 4.3 Closeout .............................................................................................................. 35 Valuation methods............................................................................................... 36 Limiting the potential for market disruptions........................................................ 37 Assessment......................................................................................................... 38 5. Overall evaluation of clearing and settlement arrangements