Streetwise Professor

October 28, 2013

Moral Hazard, Defaulter Pays, and the Relative Costs of Cleared and Uncleared Derivatives Trades

I’ve been beavering away at the clearing section of my next book, which will be titled Market Macrostructure.  It’s been something of a struggle, because there are so many aspects to this issue that it is challenging to organize the material in a logical fashion.  I analogize it to trying to write a history of a complicated battle, where many things are happening simultaneously over space, and these things interact.  Inevitably, the narrative must jump around in either space or time or both, and the writer must summarize some material about one action at one time to relate it to the narrative of what is going on at another place at another time.

So it is with writing an analysis of clearing.  There are many moving parts that interrelate and interact, so there is always the challenge of relating detailed analyses of important pieces to one another, and to clearing as a whole, and to the trading process (execution and clearing) as a whole.

One virtue of this struggle, however, is that it can lead  the writer to new insights.  Conceptualization at a fairly highly level facilitates organization, and the process of conceptualization can lead to new ways of understanding.  So it is, I hope anyways, with the clearing analysis.

This post is my first attempt to crystalize those thoughts; indeed, one of the original purposes of the the blog was to provide a place where I could think out loud and commit to pixels some early thoughts to be refined going forward in more formal writing.

The issue that I have been grappling with is why are some trades cleared, and others not?  Why do we see exchanges that trade cleared contracts operate side by side with bilateral markets trading similar contracts (and sometimes nearly identical ones) that aren’t cleared?  What determines the division of trade between these alternatives?

This is an issue that I’ve been looking at since the ’90s, and I identified some factors, but I was never completely satisfied.  But putting together some pieces that I have written about before, I think I’ve come up with a more complete explanation that captures some of the salient aspects of the economics of clearing and counterparty risk generally.

The first piece is that in theory-and indeed, in most theoretical treatments of clearing by academics (including yours truly)-clearing can operate as a classical risk pooling/insurance mechanism, in which market participants pool counterparty risk.  To the extent that this risk is idiosyncratic, such pooling allocates risk more efficiently and makes risk-averse participants better off.

But as I pointed out in my earliest work, and emphasized more in some later papers, like any risk sharing arrangement, mutualization of counterparty risk creates the potential for adverse selection and moral hazard problems.  Moral hazard problems are likely to be particularly acute.  Clearing participants can affect the distribution of the default losses they impose on the mutualization pool by adjusting the riskiness of their trading positions in the cleared derivatives.  They can also do so by adjusting the risks of their balance sheets, through, for instance, adjusting their trades in non-cleared derivatives (or in derivatives cleared at another CCP), changing their leverage, or adjusting the risk of other assets on their balance sheets

The prospect for moral hazard will inevitably lead to limits on the amount of insurance provided through the clearing mechanism.  That is, not all default risk will be mutualized.

Clearinghouses use margins to limit the amount of risk that is mutualized.  Only losses on defaulted positions in excess of margin posted by the defaulter are mutualized.  The higher the margin cover, the lower the level of risk sharing.

In practice, CCPs utilize a “defaulter pays” model in which margin covers losses on defaulted positions with extremely high probability, e.g., 99.7 percent of the time.  In a defaulter pays model, the amount of risk mutualization is very low.  CCPs are not, therefore, primarily an insurance mechanism.  They insure only tail risks (which has important implications for systemic risk and wrong way risk).

Note LCH.Clearnet’s boast that it had collected far more margin than necessary to cover the realized losses on the Lehman’s derivatives positions that it cleared.   The CME also had more than enough Lehman margin to cover losses on its positions (although there were shortfalls on some product segments that were covered by excessive margins on others).

At the Paris conference I attended in September, the head of Eurex Clearing, Thomas Book, was adamant that the goal of his CCP, and of CCPs generally, was to avoid mutualizing risk if at all possible.  His answer surprised Bruno Biais, whose model of clearing in the paper he presented focuses on the role of the CCP as a default risk insurer.

I confess that I have been inadequately appreciative of this point as well.  Understanding its implications has important consequences, as I hope to show in a bit.

To summarize.  CCPs generally operate on a defaulter pays basis: this is also sometimes referred to as a “no credit” system.  That term will help illuminate the differences between cleared and uncleared markets.  The defaulter pays system means that the amount of risk shared through a CCP is extremely limited.  This limitation on risk sharing is best explained as the consequence of moral hazard.

In contrast to a cleared market operating on the no credit model, dealers in bilateral OTC markets historically extended credit to derivatives counterparties.  Put differently, OTC deals often bundled a derivatives trade with credit provision.  That is, dealers often willingly took on exposure to a default loss when entering into a derivatives deal with a customer.  (This is not true for all types of customers.  For instance, hedge funds typically had to post margin.)  Taking credit exposure is equivalent to extending credit to the counterparty.

Now consider whether a firm will prefer to trade a cleared derivative, requiring the posting of a high margin and which thus embeds no credit, or prefers instead to trade an otherwise identical OTC product that does embed credit.  To fix ideas originally, let’s consider a firm that is cash constrained.  Therefore, if it wants to trade the cleared product, it must borrow to fund the initial margin.  The cleared derivative is a no credit transaction, but that doesn’t mean that moving to clearing necessarily reduces the amount of credit the firm obtains: it can borrow the money needed to post margin, and indeed, may have to borrow it.

One source of credit is dealer banks.  So the firm could either enter into an uncleared bilateral trade with a dealer, or borrow money from the dealer bank to fund the IM.  (The argument doesn’t really depend on dealing with the same bank on the derivatives deal and the borrowing: this just facilitates the exposition.)

Here’s were the loser pays aspect of margin comes in.  Let’s say that the firm is selling a derivatives contract with payoff P. If the firm defaults, the OTC counterparty’s exposure is max[P,0].  But in a loser pays model, the margin M is almost always greater than max[P,0].  Thus, the borrowing from bank to fund margin almost always exceeds the default loss that the bank would incur if it entered into a bilateral deal with the firm.

I can show formally that if the firm already has debt outstanding, under standard pro rata/pari passu default loss allocation mechanisms, holding everything equal,  the bank’s default losses if it extends credit to the firm to fund margin almost always exceed, and never are smaller than*, the default losses that it would incur if it had entered an uncleared bilateral trade with the firm.  This, in turn, will make the cleared transaction more expensive for the cash-constrained firm, and it will prefer to trade the OTC product.

There are at least a couple of reasons why the cleared transaction can be more expensive.  One is what is effectively a debt overhang problem.  In order to induce the bank to lend the margin for posting at the CCP, the firm must promise it higher payments in non-default states than it has to promise the bank in these states when it trades OTC instead.  Since the firm’s managers, acting in the interest of equity, only care about payoffs in non-default states, this means that returns to shareholders are lower when it borrows to fund margin than when it deals OTC.  This can be seen another way.  I can also show formally that the payoffs to the firm’s other creditors are almost always higher, and never lower, if it borrows to fund margin than if it trades OTC.  Thus, the value of the the firm’s non-margin-related debt is higher if it trades a cleared product and funds the margin by borrowing, than if the firm uses the OTC product.  Since the value of the firm’s assets doesn’t differ in the cleared vs. uncleared cases, and since value is conserved, this means that equity is less valuable when the firm trades cleared products than bilateral ones.   Some of the benefit of borrowing to fund margin flows to other creditors; this is where the analogy to debt overhang comes in.

This is most easily seen in the following scenario.  The firm can become insolvent when max[P,0]=0, i.e., the bilateral contract is out of the money to the bank, and the bank suffers no loss due to default, and all the losses of insolvency would fall on other creditors.  However, if the bank had lent the firm money to fund margin, it would suffer a loss on the margin loan in this circumstance.  This loss would reduce the loss suffered by the other creditors.

OTC is cheaper than cleared products in other models of capital structure.  For instance, moral hazard (or adverse selection) mean that the firm will be credit constrained: the amount it can borrow is limited by its collateral, and/or the amount of cash flows that it can credibly pledge to lenders.  The same formal analysis implies that more cash flows in non-default states must go to supporting a margin loan in a defaulter pays clearing model than in a bilateral transaction.  This leaves less cash flows to support other borrowing, so by borrowing to fund margin loans the firm must borrow less to support other investments (which, in this sort of model, it has insufficient equity to fund itself).  Thus, borrowing to fund margins on cleared transactions crowds out borrowing to fund positive NPV investments.

This analysis implies that this cash constrained firm will choose to trade OTC rather than cleared products with defaulter pays margins funded with loans.  The bank is indifferent, because it will price the product or the loan to cover its costs, but the firm is always better off  with the bilateral trade because it has to pay the bank less if it trades OTC than if it borrows to fund margin.

Moreover, the analysis implies that if the firm is forced to clear, it will either scale back its derivatives trading (because the cleared transaction is more expensive), and/or reduce its investments in positive NPV projects. Cutting back derivatives trading is costly if this trading reduces the deadweight costs of debt, for instance.  Indeed, I can show that the cost of margin is especially high when the derivatives trade is a “right way” risk, as would occur when the firm is hedging.

Clearing mandates are therefore expensive for such firms, and there is a legitimate reason to exempt such firms from clearing requirements.  (Note that even if these firms are exempted, other rules affecting dealer banks, e.g., punitive capital charges on OTC derivatives trades, can induce an inefficient use of cleared transactions.)

This analysis explains the preference of many firms, especially corporate end users, for uncleared OTC trades that embed credit, as opposed to cleared transactions that must be funded by increased borrowing.  This, in turn, can explain the growth of OTC markets relative to exchange traded markets from the 1980s onwards.

It is useful to step back a bit here, and understand what is really going on.  In essence, in this model clearing is expensive because it causes one agency problem to exacerbate another.  CCPs adopt defaulter pays because of an agency problem: the moral hazard associated with risk sharing.  Debt is expensive or constrained for firms because of agency problems (e.g., debt overhang problems, or constraints on borrowing due to moral hazard).  Effectively, the firm must obtain more credit to support a cleared position than an uncleared one, and  the cost of debt arising from agency problems makes this higher level of credit more expensive.

This analysis raises the question of why firms would ever choose to clear.  There are a couple of answers to that.

First, there may be other (private) benefits.  For instance, netting economies may be greater with clearing.  Of course, the efficiency effects of netting are equivocal (because netting primarily has the effect of redistributing losses among creditors), but as a positive matter is is pretty evident that netting offers private benefits, and thus the mulitilateral netting that can occur in clearing, but not to the same degree in bilateral trades, could induce some traders to prefer clearing.

Second, the analysis started from the assumption that the firm at issue is cash constrained and hence has to borrow to fund margin on the cleared trade.  Some firms are not.  One example would be an ETF like USO or USNG, which collect the entire notional value of derivatives in cash from their investors.  These firms do not require any credit to meet margins.  Large real money funds, like a Pimco, that collect cash from investors and use derivatives to gain exposure to price risks would be another.

Even many hedgers may not suffer from cash constraints that limit their ability to trade cleared contracts.  Consider commodity trading firms.  They typically use derivatives to hedge inventories of commodities.  Banks, in turn, are willing to lend against these inventories as collateral.  Thus, the commodity trader can fund margin using borrowings secured by commodity inventories, and the lender does not share in default losses pro rata with other creditors.  This type of borrowing is fundamentally different than the borrowing considered above, in which the firm borrows against its balance sheet and default losses are shared with other creditors.

Thus, the simple models would predict that whereas cleared derivatives used to hedge liquid inventories are as cheap or cheaper than uncleared derivatives, it is much more expensive to use cleared derivatives to hedge cash flows on illiquid assets, or to hedge broad balance sheet risks.  This is largely consistent with my understanding of the pattern of usage of cleared and uncleared derivatives.

This model, which combines a model of the cost of risk sharing at a CCP with a model of the capital structure of firms, has both positive and policy implications.  In particular, it can explain the adoption of defaulter pays by CCPs.  It can also explain the disparities between OTC and cleared markets when CCPs utilize defaulter pays.  Moreover, it demonstrates that clearing mandates can be inefficient if they are applied too broadly.  One source of this inefficiency is that the mandate leads to a perverse interaction between agency problems.

Of course, a rationale for clearing mandates is that clearing reduces systemic risk.  Anyone who has read my work will know that I am dubious of that rationale on many grounds, but it is worthwhile to consider the implications of the foregoing analysis for systemic risk.

The model is too sparse to make very strong conclusions, but one consideration does stand out.   If firms borrow from OTC dealer banks to fund margins, holding the rest of the firm’s liabilities and assets constant, these banks suffer larger losses when the firm goes bankrupt if they lend to them to fund margins on  derivatives trades than if they enter into identical uncleared OTC derivatives trades.  As noted before, there is a distributive effect: other creditors suffer smaller losses.  The systemic implications of this redistribution depend on the relative systemic importance of the banks and the other creditors.  Dealer banks are definitely systemically important, but other creditors may be too.  Therefore, it is not evident how this cuts, but if one believes that large financial institutions that serve as OTC dealers are especially crucial for systemic stability, moving to cleared trades would tend to increase systemic risk because clearing actually increases their credit exposures to customers.

But again, caution is warranted here.  The redistribution result holds capital structure and derivatives trades constant, but of course these will be different if firms have to clear than if they don’t.  These changes are difficult to predict, and the systemic riskiness of different configurations is even more difficult to compare given how little we really know about the sources of systemic risk.   But the fact that clearing can lead to adverse interactions between agency problems should raise concerns about the systemic implications of forcing clearing.

*To be more precise.  When P>M, the CCP and the lender suffer default losses, and the sum of these default losses is the same as the bilateral counterparty would incur on an uncleared trade.  Relatedly, other creditors of the bankrupt firm suffer the same default losses in the cleared and uncleared cases when this condition holds.  They suffer smaller losses whenever this condition does not hold and the firm goes bankrupt.

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  1. Hi Craig,

    I agree that quite a few buy side firms are not collateral constrained given their un-leveraged eligible securities inventory (at least not yet). Yet others hedge bank risk with CDS and clearing enables them to take off some of that protection. So carefully managed there would be some elective take up for a well regulated client clearing environment. Buy side incentives will be added to when bilateral margin rules kick in.

    Whilst clearing is expensive for some participants when mandated, my view (as referred to in my recent post on is that the worst effect of the clearing mandate is the lack of flexibility the mandate imparts in reducing legacy risk and the associated reg capital costs. The legacy portfolios risk (given 99+% of cleared risk is covered by defaulter pays IM) is practically the totality of systemic cpty risk at the moment clearing mandate begins. Yet the mandate entrenches it by forcing mutually risk reducing trades in clearing mandated product to clear thus thwarting their bilateral risk reduction purpose and causing the trade not to get done. Thus even though incentivized by Basel III risk-based capital (alone) to be reduced, legacy risk will have a slow and costly erosion through portfolio rollover and margining of the new trades under the new margin rules. Dealers (and post bilateral margin mandate buy side firms) want to respond to regulatory incentives but a risk compression trade which would mutually reduce bilateral bank risk-based capital and buy-side IM now has to find a way to avoid the clearing mandate and the bilateral IM mandate if it is to achieve its purpose.

    Realistically there is little hope that we can turn back the clock and proceed on an incentive only approach instead (i.e. with an earlier implementation of bilateral IM and elimination of the clearing mandate). However, a feasible approach is to create a clearing and bilateral IM mandate exemption for trades otherwise cleared or bilateral IMd which demonstrably reduce legacy risk. Of course there would be some challenges in proving this was the case and policing it (e.g. a practical way to unequivocally demonstrate the risk is reduced on both portfolios). Regulators ought to want this if they are serious about reducing systemic connectedness risk (as opposed to moving it around the system). A central source of cpty pair portfolio sensitivities and margin would be a start…

    There is another relevant question: what is the logical extent of product clearability (beyond today’s CCP capabilities) on an elective or mandatory basis. Legislators and regulators have occasionally been quoted as assuming that everything goes to CCPs in a clearing nirvana state. The reality is that there may be strong systemic risk arguments against piling up more and more esoteric / non-linear risks in CCPs comingled with more linear risk e.g. these may make it much harder to unwind or auction a portfolio given lack of option volatilities which happens from time to time.

    I’d be interested in your view on both these points.


    Comment by Jon Skinner — October 28, 2013 @ 8:51 pm

  2. Great ideas – I really enjoyed the line of thinking. However, when you state “since the value of the firm’s assets doesn’t differ in the cleared vs. uncleared cases” – is this necessarily true? I think it depends who is the calculation agent for the mark-to-market of an OTC contract. If a dealer bank takes into account the CDS curve of a bilateral counterparty to calculate the mark-to-market, then the value of this OTC contract will be different if cleared or non-cleared (cleared trades all settle to a single curve). Whilst the difference should, in theory, be equal to the funding of the IM over the life of the trade, the IM is not dynamic in the same way an FVA mark-to-market is. Would be interested to hear your thoughts on this…..

    Comment by Chris Barnes — October 29, 2013 @ 4:11 am

  3. @Jon-Thanks for the thoughtful comment. Will respond in detail later. Quick response to your second relevant question. I agree there are reasons not to pile up more esoteric and non-linear risks. Even some linear risks can be dangerous, in the linear products are insufficiently liquid. There is a fundamental tension here. My guess is that it will work out (perversely) as follows. Many CCPs will eschew taking on certain products. Regulators and legislators will be frustrated that their everything-on-CCPs nirvana is not coming to pass. In response, they become more prescriptive in mandating what must be cleared, leading to the accumulation of risks that are not appropriate for clearing inside CCPs.

    @Chris-Thanks. Yes, cleared and uncleared prices may be somewhat different, though on default (which is the relevant case in the analysis) it’s not evident this will be a big effect. Under the ISDA protocol, the deal will be valued not using the defaulted counterparty’s curve, but a solvent counterparty. And in the analysis, from the bank’s perspective, the loss is the bank’s replacement cost. The cleared and uncleared prices will be different at the initiation of the deals, but that’s taken into account in the analysis. The uncleared price, which determines payoffs to the bank in non-bankruptcy states, will adjust to reflect the distribution of losses in bankruptcy states. I will make sure to bring out these points when I write up the model more formally, but I believe that they are implicit in what I present here, and don’t overturn the result.

    The ProfessorComment by The Professor — October 29, 2013 @ 11:43 am

  4. uncleared trades needed this page, streetwise Prof.
    The fallacy of exempting some users (and then a few more who are also exempted as they are “end-users”) has resulted in CCPs. if everyone posted their fair share of IM and VM there is no need for CCPs. Given that some privileged few are exempted, this asymmetry will now unfold itself in the CCP recovery/resolution– that skirts taxpayer bailout. In this new line of CCP thinking, CCPs cannot fail; so users–including buy side guys like hedge funds or pension funds– will keep them afloat by using +VM of all users. Think of CCPs being the sifiest of SIFIs. So if Brevan Howard does a ton of rate swaps it may have a large + VM and large – VM due to the hedges. On the other hand, a pension fund or energy firm could be one directional..former can have a +VM and no -VM and vice versa for the latter. In the new line of CCP resolution, only +VM can be haircut. So hedgers like Brevan will pay disproportionally (as their -VM will be ignored) relative to the occasional users, or those that are not hedgers (in fact those with -VM and no +VM do not pay at all here)

    Comment by bunty — October 29, 2013 @ 3:31 pm

  5. […] is it? But you might be forgiven for thinking that there’s something here if you read a post by the Streetwise professor on clearing. To save you time, here’s the short […]

    Pingback by Deus Ex Macchiato » Increasing credit risk, um, increases credit risk (clearing edition) — October 30, 2013 @ 2:15 am

  6. Caution should be exercised when discussing the benefits of netting as between cleared and uncleared positions. Central clearing can actually diminish the benefits of netting which a firm enjoys through bilateral contracts, increasing the total exposure of a firm to market counterparties. Let’s say I have 50 long JPY/USD and 50 long EUR/USD with the same counterparty. The JPY/USD positions go through a clearing house while the EUR/USD positions net and margin bilaterally. If I am in the money on one position and out of the money on the other, the exposures net to a single pay/receive of margin between the two of us. However, if one position goes through a clearing house and the other remains bilateral, I will have to post margin to the clearing house and hold original margin with the clearing house regardless of the exposure on the uncleared position. The firm can end up having to post margin on both positions well in excess of the margin that would have been required on a single net position.

    Comment by London Banker — October 30, 2013 @ 4:39 am

  7. One other point Craig. If the trades letter on Basel III CCP capitalization is taken on face value then client clearing is already a low return business without another one added to it given current / foreseeable future of low rates and unsecured lending RWA is something like CRW x loan principal…

    Comment by Jon Skinner — October 30, 2013 @ 5:25 pm

  8. @London Banker. Very aware of the issue of breaking netting sets. I wrote about it in my ISDA study on clearing, and in several working papers.

    That said, the effects of netting are equivocal from an efficiency perspective. The main effects of netting are to redistribute from one set of creditors to another.

    The ProfessorComment by The Professor — October 30, 2013 @ 7:26 pm

  9. The derivative world is far more complicated than described here. Anonymity and liquidity drive trading to a matching platform (cleared or OTC) far more often than cost of collateral or credit concerns with respect to clearing. And firms often have different benefits/costs than the traders themselves. I trade cleared and equivalent OTC contracts with little concern for the difference. Where is the best price and trade execution? those are the key issues.

    If clearing is really superior… then let it win on its own merits. OTC derivative is nothing more than a privately negotiated contract. If the enlightened intellectuals think they can or should prohibit me from privately trading with my colleagues, then capitalism and free markets are at risk.

    What is wrong with the simple notion of letting the clearing houses capture the trading business in an economic manner??? instead they demand new regulations, forced collateral reserves and prohibitions. why is clearing even an academic question for policy makers? Clearing began as a an econmic incentive (not through government action) and I would much prefer to have clearing stay on the same economic (not political) path.

    Comment by Scott — November 2, 2013 @ 4:28 pm

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