Markets Embrace Use of Collateral

Terry Flanagan

Among large dealers, 84% of transactions have collateral agreements, according to ISDA.

With reduction of counterparty risk a central tenet of OTC derivatives reform, risk reduction techniques such as collateralization, clearing, and netting and portfolio compression are being incorporated within trading firms’ business practices.

Market participants continue to expand their use of collateral to mitigate OTC derivatives credit exposures.
Among large dealers, 84% of all transactions are now executed with the support of a collateral agreement, up from 80% in 2011, with 96% of all trades executed in the credit derivatives markets subject to collateral arrangements, according to the 2012 Margin Survey by the International Swaps and Derivatives Association.

In an evolving regulatory environment that seeks to reduce the counterparty risk associated with derivatives, the continued use of bilateral collateralization has, in the same way as clearing, an important role to play in risk mitigation, according to ISDA.

As the OTC derivatives industry moves forward towards implementing the clearing mandate, there is a need to maintain consistency between the bilaterally transacted OTC derivative world and the newly emerging cleared world, ISDA said.

“Failure to maintain consistency could prove problematic for all involved, including hedgers, market makers and CCPs,” said Robert Pickel, CEO of ISDA.

“Inconsistency in practices between the bilateral world and the cleared world is likely to give rise to market fragmentation, lack of fungibility between cleared and uncleared products as well misguided incentives as to where to do business,” Pickel said.

In the bilateral world, counterparty risk is all aggregated in the ISDA Master Agreements between parties. Considerable effort has been spent to ensure legal enforceability of this agreement around the world through the netting and collateral opinions.

In the cleared world, this is substituted with a set of agreements involving CCPs and in some cases other parties (FCMs).

“These agreements, apart from being inconsistent among CCPs, typically only cover a single product,” Pickel said. “In the cleared world, as many as four additional counterparties are potentially being inserted between the two transacting parties (a SEF, an FCM, a CCP and another FCM).”

The role of CCPs in clearing trades and in managing collateral is of growing importance. The survey asked 14 large dealers to indicate their level of collateralization with CCPs. The dealers delivered approximately $50 billion of collateral as margin in CCPs.

The survey also shows that active collateral agreements number almost 138,000, of which 85% are ISDA agreements.

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