When dealing with market risk, it is not important whether a contract is formed in an OTC market or in an exchange market; however, when dealing with credit risk, it is of vital importance.
By way of introduction, it can be said that OTC contracts are tailored, as both sides can negotiate all the terms, while contracts administered in organised markets are standard contracts where everything but the price is fixed. Like everything tailored, OTC contracts bear a higher credit risk, as only the other party responds and there is no stock exchange to fall back on to solve possible conflicts that may arise. In addition, these OTC contracts usually have liquidity problems.
12.2.1 OTC Markets
By definition, an over-the-counter contract is a bilateral contract in which two parties agree on the terms for the liquidation of the instrument. This is exactly what differentiates them from contracts traded in organised markets, where contracting does not occur between the two parties but
each party contracts directly with the stock market. These OTC contracts are normally made between an investment bank and the customer directly and more often than not are implemented by telephone or electronically.
The main advantage of this type of contract is that they are not standard, that is, the parties may negotiate any and all of the clauses in order to obtain a contract that best suits their needs. Another important advantage is that, unlike in organised markets, commission payments are not required nor is it essential to provide guarantees, all of which implies higher credit and liquidity risks.
As noted in the above example, credit risk appears for one of the parties when it makes profits in its position, since this is when the other party cannot meet their obligations. Also note that, unlike in organised markets, in these markets credit risk cannot be eliminated unless the other party accepts the total cancellation of the contract, because although one of the parties takes an opposite position to the one that it already has in a new contract and in doing so eliminates market risk, credit risk remains.
Liquidity risk occurs due to the fact that, by definition, these contracts are not standardised and each is defined in a different way, which means that if one party wants to get out of it, or a market agent is looking for a counterparty for an OTC contract that perfectly suits their needs, the necessary counterpart may not be found. It is also important to note that the fact that these products present credit risk also reduces their liquidity.
However, not all OTC markets are equal and present these risks to the same extent, for example, since the foreign exchange market is an OTC market which is mainly carried out between governments and large corporations, it hardly presents any credit risk problems and is the most liquid market in the world. Similarly, markets like the NYMEX have created compensation mechanisms for some commonly traded energetic OTC derivatives, a mechanism that allows counterparties of many bilat- eral OTC transactions to agree to mutually transfer the negotiation to a clearing house, eliminating credit risk. Equally, in the United States the OTC negotiation of shares is carried out through mediators and is monitored by the National Association of Securities Dealers (NASD).
Contrary to how they may be perceived, OTC markets are large and have grown exponentially over the past two decades, especially the very active international entities whose profits are closely linked to activity in
these markets. The expansion has occurred mainly in derivative markets on interest rates, currency and Credit Default Swaps (CDSs), to be discussed in the next chapter, and, according to the International Swaps and Derivatives Association (ISDA), the volume of these OTC markets was around 600 trillion dollars at the end of 2010.
Also, many OTC contracts are held on framework agreements. A framework agreement is an agreement between two parties which specifies the standard rules that will apply to all transactions between the two parties, and in this way, with each new transaction the framework agree- ment standards do not need to be renegotiated and are automatically applied. The OTC derivatives traded betweenfinancial institutions usu- ally adopt clauses of the ISDA as a framework.
12.2.1.1 International Swaps and Derivatives Association:
Framework
The International Swaps and Derivatives Association is a trade organisa- tion of participants in OTC markets which has created a standardised contract, the ISDA Master Agreement, for derivatives transactions. It is part of a framework of documents which consists of a “Master Agree- ment”, a “Schedule”, “Confirmations”, “Definition Booklets” and a
“Credit Support Annex”.
The ISDA Master Agreement is the most commonly used master service agreement for OTC derivatives transactions internationally and it is a document agreed between two parties that sets out standard terms that apply to all the transactions entered into between those parties. Each time a transaction is entered into, the terms of the master agreement do not need to be renegotiated but rather apply automatically.
Probably the most important aspect of the ISDA Master Agreement is that the Master Agreement and all the Confirmations form a single agreement. It has crucial importance as it allows the parties to an ISDA Master Agreement to aggregate the amounts owed by each of them and replace them with a single net amount payable by one party to the other.
12.2.2 Organised Markets
An organised market or stock market is a private organisation that pro- vides the necessary facilities for its members to conduct negotiations for the sale and purchase of securities, such as shares in companies, public and private bonds, certificates, equities and a variety of investment instruments.
The word“stock”has its origins in a building that belonged to a noble family with the surname Van Der Buởrse from the European city of Bruges in the Flanders region, where meetings of a commercial nature were held. The family’s coat of arms featured three leather bags, com- monly used as purses at the time. Due to the volume of transactions and negotiations that were held there, it was given the name by which it is now known, the Stock Exchange, because of the surname Buởrse. However, it is believed that the world'sfirst stock exchange was established in Antwerp (Belgium) in 1460 and the second in Amsterdam (Netherlands) in the early seventeenth century, when the city became the most important centre of world trade. Much later, this leading role was conquered by the so-called London Stock Exchange which was founded in 1801.
Currently these markets are located in many countries. Based on the volume of trading, the most important stock exchange in the world today is the New York Stock Exchange.
These organised markets have the following characteristics in common:
• Their regulation establishes the standardisation of the elements of the contract, such as their underlying assets, number of titles, dates of birth and strike price.
• There is also a clearing house in which the settlement of contracts is carried out without the need for direct contact between their buyers and sellers.
• Similarly, in these markets many measures are taken to minimise credit risk to ensure that the losses suffered in the clearing house are as low as possible. The daily settlement of gains and losses and the provision of guarantees may be included in these measures.
• Finally, there is the commission charged, providing a profit to com- pensate for the risk assumed by the house.
As a result of these characteristics, in these markets the risk of default is very small as it can only occur if the clearing house collapses. In addition, market liquidity is guaranteed because the intermediary company assumes the risk of potential defaults and contracts are standardised. Similarly, these markets provide transparent information regarding the supply and demand of both their contracts and their price, which favours liquidity. It should also be noted that these markets are regulated, supervised and controlled by nation states, although most of them were founded prior to the creation of official supervisory agencies.
However, these markets are not without drawbacks, such as commis- sion payments and the fact that contracts are standardised and therefore cannot be adapted to the specific needs of their participants.
12.2.2.1 The Clearing House
The clearing house is an agency that acts as a counterparty of the contracting parties within an organised market, where it is the buyer to the seller and the seller to the buyer. Due to the existence of the clearing house, the negotiating parties of a contract have no obligation to each other, only to the house, which virtually eliminates counterparty risk and allows those involved in the contracting process to remain anonymous.
As indicated, this house assumes counterparty risk and, therefore, charges commission, that is, when an agent wants to buy or sell, they enter an order into the system specifying whether they want to buy or sell and at what quoted price. If another participant wants to execute the opposite order for the same price, that is, if there is a sale order and they want to purchase or there is a purchase order and they want to sell, the transaction exchange occurs. However, neither assumes counterparty risk, as both parties contract with the clearing house and no one else. Thus, a blind market is formed where trading is anonymous, as no participant knows the counterparty directly. As a result, it is possible to leave the position at any time, which is not feasible with an OTC contract.
Formally, the functions of this house are to:
• Act as a counterparty for the contracting parties, as a buyer for the seller and a seller for the buyer.
• Determine security deposits for open positions daily.
• Liquidate gains and losses daily.
• Liquidate contracts at maturity.
As the house eliminates counterparty risk for those who trade in the market, a mechanism must be established to prevent losses when faced with the possible insolvency of a market member. In order to do this, firstly, each participant is required to provide a daily settlement of profits and losses, as well as a security deposit.
The daily settlement of profits and losses involves proceeding to settle- ment every day once the market has closed, regardless of when the contract matures. In order to better explain this concept, the following example is presented: imagine a futures contract on an underlying asset trading today at€20 (S0ẳ€20) with a maturity of one year and a strike price also equal to€20 (Kẳ€20). If the price of the underlying asset rises to€21 over the next day, the party with the long position will have made
€1, while the party with the short position will have lost€1. If the contract was an OTC contract, the loss or profit would be unknown until matu- rity. In order to avoid a situation whereby the loss at maturity has reached such an extent that the losing party cannot meet its obligations, in a futures contract traded in an organised market the participants are required to materialise the losses daily. Thus, at the end of the following day the party with the long position will receive€1 from the house, while the seller will have to pay this amount and, for all practical purposes, the contract remains a futures contract with the same maturity but with a strike price equal to €21. In this sense, it must not be forgotten that a futures contract which is traded in an OTC market is called a forward, while when it is traded in an organised market it is called a future (Fig.12.1).
Thus, if at the end of the day a party cannot meet their obligations—in this example, the party with the short position cannot pay the house€1—
the house assumes their position and the loss that has occurred on that day
and the other party is unaware of this since they receive their profits from the house. Consequently, it is the house that assumes the counterparty risk but the loss they suffer is much lower than that suffered in an OTC market, as at most it assumes the loss suffered in a day, which will usually be much lower than that which occurs over a longer period of time, a year in this example. Note that when the market opens the following day, the house disposes of its position, thus avoiding having to manage its market risk.
Since the house assumes the loss caused by counterparty risk, in an organised market each participant is required to settle a security deposit determined by the number and type of contracts bought or sold. Using market research, the house estimates the maximum loss that could occur if an agent could not carry out the daily settlement of their profits and losses, and based on this estimate each participant is required to settle a security deposit. When a participant cannot satisfy the daily settlement of profits and losses, this security deposit will be executed in order to minimise the house’s loss as a result of this risk. For this guarantee to remain
Profit or Loss throughout the Life of the Contract
Profit or Loss in a day
Fig. 12.1 Profit and loss over time (Author’s own composition)
unchanged, the clearing house adjusts it daily using deposit updates. In addition, each type of futures contract specifies the amount of money to be deposited as collateral margin concept.
Finally, it should be noted that in organised markets commission is charged precisely to offset any losses that may result from this type of event. Thus, if the house manages this type of event well, profits are made from the commission charged, while if it manages it badly, losses are suffered.
Part IV
Other Risks
13
Operational Risk