The Evolving Landscape of the OTC Market
The over the counter (OTC) market has existed for many years, allowing direct bilateral trades between two parties outside of formal exchanges. While this gives participants more flexibility and the ability to tailor contracts to their specific needs, it also brings a high degree of counterparty risk. This is the risk that the party on the other side of the trade will default and not fulfil their obligation.
The importance of counterparty risk in OTC markets became particularly apparent during the global financial crisis of 2008. Lehman Brothers’ default highlighted the potential systemic risk in the OTC market, where a single entity’s failure could create a chain reaction impacting many other entities. OTC derivatives, such as credit default swaps, were central to the issues that arose in the 08’ crisis.
Regulatory Interventions Post-2008 Crisis
As a result, post-crisis, regulators worldwide turned their attention to reducing counterparty risk in OTC markets to improve the stability of the financial system. Several measures such as central clearing, margin requirements, reporting and transparency requirements, standardization of contracts and collateral management were introduced to mitigate this risk.
In this paper we will focus on the trends toward central clearing measure as it appears to have moved to the forefront as key mechanism to mitigate counterparty risk. Indeed, Central counterparties (CCPs) stand in the middle of every trade, acting as the buyer to each seller and the seller to each buyer, therefore reducing counterparty credit risk that the financial participants face when entering transactions.
What are the main reasons for the shift away from bilateral OTC trading?
First, it is interesting to clearly define the two practices on the OTC trade market.
According to the International Monetary Fund, bilateral trading happens when two parties agree to enter a trade directly with each other. In this type of trading, each party bears the counterparty risk, which is the risk that the other party may fail to fulfil their obligations under the contract. This form of trading is common in the over the counter (OTC) market, where trades are customized and do not occur on an exchange (for example: New York Stock Exchange).
While cleared trading involves an additional party, a clearinghouse (for example LCH). When two parties agree to a trade, the clearinghouse steps in and becomes the counterparty to both the buyer and the seller. This arrangement reduces the counterparty risk because even if one party defaults, the clearinghouse guarantees the completion of the trade. Contrariwise of the bilateral, the original parties are no longer directly exposed to each other’s credit risk. Cleared trades often occur with more standardized contracts on exchanges but are also increasingly used in the OTC market especially for interest rate swaps (IRS) and certain types of credit default swaps (CDS) derivatives.
What are the benefits for central clearing?
Cleared trades offer numerous advantages in response of the OTC bilateral weaknesses to reduce systemic risk in the financial system. Indeed, the main benefit of cleared trades is that the CCP significantly mitigates counterparty risk. If one party defaults, the CCP guarantees the completion of the trade.
As already mentioned here above, cleared trades involves standardized contracts which reduces complexity in the trading process.
Moreover, the OTC cleared market offers increased market transparency. CCPs collect and often publicly report trade data, increasing transparency regarding pricing, volumes and exposures of the contracts.
Finally, central clearing enhances the liquidity and the access of the market as it allows more participants to get into contract and trade with each other through CCP.
What are the challenges of bilateral trading?
The OTC bilateral market offers various advantages such as customization, flexibility, less formal, although often well-organized, networks of trading relationships focused around one or more dealers. However, they do have key disadvantages specifically on the risk perspective and the lack of transparency.
Counterparties in OTC transactions faces are exposed to each other’s default risk, especially in larger transactions or market volatility conditions which is significant.
Operational risk is to be noted, as bilateral trades use complex processes which requires effective risk management to avoid potential errors that can lead to losses through the lifecycle of a trade (execution to settlement)
There also can be liquidity risk due to the specificity in the contracts, which cannot be easily bought or sold. Therefore, causing liquidity issues.
Finally, the systemic risk is also a factor as the failure of a large participant could potentially lead to a snowball effect on the entire financial system (notable factor in financial crisis of 2008)
There is a lack of transparency in the OTC market. Indeed, information about pricing, volumes, and participants is often less accessible, making it more challenging for participants to assess market risk.
Promoting cleared trades rather than OTC bilateral trades largely depends on the specific needs and circumstances of the trading entities involved.
There are good reasons to assume that CCPs can protect against a market against crisis. As matter of fact cleared trades offer significant advantages including reduced counterparty risk, standardization and increased market transparency and efficiency. These can be particularly beneficial in financial markets where trades occur frequently and involve large amounts of capital.
However, these advantages come at the expense of customization, concentration risk, and potentially higher capital requirements. Furthermore, the right implementation of the procedure by the management is crucial as the concentration of risk in a central counterparty is considerably greater than that in a decentralized market, therefore the repercussions of mismanagement would be proportionally larger.
Additionally for less standardized contracts or more specific risk management needs that require more flexibility and customization, OTC bilateral trades may be more suitable. Plus, some entities may not have the resources to meet regulatory and capital requirements associated with CCPs.
Even though by definition the cleared trades are « better » than bilateral in terms of risk management and other points mentioned in here this article, the best choice will always depend on key factors such as the nature of trade, the profile of the trading party, regulatory requirements and the market conditions.