OTC Derivatives Reforms: Considerations and Challenges

1. OTC Derivatives Reforms: Considerations and Challenges ESRC Conference on Diversity in Macroeconomics Mark Manning, Reserve Bank of Australia

2. Overview • Policy motivation • An initial contribution • Methodology • Exposures and collateral demands • Financial stability under different clearing structures • Policy messages and future work

3. Policy Motivation • Fundamental changes to core financial markets • G20 financial reform agenda • Strengthen risk management; reduce interconnectedness • Collateralisation and central clearing • Trade-off between counterparty risk and liquidity risk • Encumbrance; funding and liquidity • Assess implications for stability, market functioning and real economic outcomes

4. Initial Contribution • OTC Derivatives: Netting and Networks • Joint work with Alex Heath and Gerard Kelly • Simulation approach • Static: Exposures and collateral demands • Dynamic: Financial stability • Flexible, but stylised • Can examine a variety of clearing structures • Stylised ‘world’: network structure; balance sheets

5. Links to Literature • Duffie and Zhu (2011) • Model dealer exposures in alternative clearing settings; consider fragmentation and un-netting • Macroeconomic Assessment Group on Derivatives (2013) • Examine costs/benefits of G20 reforms: net long-run impact on GDP • Duffie (2014) • Model collateral demand in alternative clearing settings using bilateral CDS exposure data

6. Basic set-up • Two agent types: banks (b) and investors (i) • Core/Periphery network structure • Draw derivative positions from a transaction matrix

7. Static Analysis: Exposure and Collateral • Bilateral clearing: • Central clearing, single CCP: • Central clearing, separate CCPs: • Mixed clearing: • Split clearing: and

8. Total Exposures

11. Dynamic Analysis: Networks (1) • Previous model extended by giving agents balance sheets • Banks and investors hold a composite ‘illiquid asset’ • Can be sold/transformed into a ‘liquid asset’ to meet collateral needs • Liabilities comprise debt and equity for banks and equity only for investors • Both banks and investors can default due to illiquidity; banks can also default due to insolvency

12. Dynamic Analysis: Networks (2) • Models the dynamic interaction between derivative exposure and other balance sheet items under alternative clearing arrangements • Focus is on how price shocks are transmitted to balance sheets and how they may trigger liquidity shortages or defaults • Examines also the dynamics of collateral transformation

13. Simulation and Timeline • Monte Carlo simulation with 70 000 iterations. Seven steps: • Populate transaction matrix • Draw illiquid asset price change • Draw derivative price change • Calculate variation margin payment obligations • Sell/transform illiquid assets to obtain liquidity for variation margin payments; could trigger default • Default could impose losses on others • Update balance sheets

15. Policy Messages • The appropriate scope of central clearing and collateralisation will depend on product and agent characteristics • There is likely to be an ‘optimal’ level of collateralisation, which will vary with the structure of clearing arrangements

16. Future Work • Economic significance of the results • Take the model to ‘real’ data • Add richness to banks’ and investors’ balance sheets • Endogenise pricing and agents’ trading choices