INTRODUCTION

This chapter explores Title VII of the Dodd-Frank Act, which heavily regulates over-the-counter (OTC) derivatives markets. We will develop an understanding of the level of counterparty exposure through looking at historical data of the notional outstanding, gross market value, gross credit exposure, and collateral associated with OTC derivatives markets. We will then explore how Title VII of the Dodd-Frank Act works to reduce the counterparty exposure faced by participants in the OTC derivatives market through setting mandatory clearing and other requirements.

After you read this chapter you will be able to:

• Distinguish between notional outstanding, gross market value, gross credit exposure, and collateral.
• Show the degree to which OTC derivatives markets are characterized by counterparty exposure.
• Explain the evolution of the U.S. regulatory approach toward OTC derivatives.
• Describe key provisions of Title VII of the Dodd-Frank Act.
• Discuss criticism of Title VII.

MEASURING COUNTERPARTY EXPOSURE IN THE OTC DERIVATIVES MARKET

In this chapter we explore how Title VII of the Dodd-Frank Act works to reduce the counterparty exposure faced by participants in the OTC derivatives market. Before doing so, it will be useful to understand the various ways that counterparty exposure can be measured and to look at historical data to explore the degree to which the OTC derivatives market is characterized by counterparty exposure. We explore the following four measures, which were introduced in the previous chapter.

Notional outstanding: Each swap agreement specifies a dollar amount of notional principal, which is used to translate the rates associated with swaps into cashflows. Typically, notional principal is not exchanged either at initiation or at termination. Notional outstanding is the aggregate of the notional principal of all OTC derivatives securities.

Notional outstanding provides a crude metric of counterparty exposure insofar as it provides observers a sense of market size. However, notional outstanding is not a true metric of counterparty exposure. After all, typically notional principal is not exchanged. Hence any write-down that occurs upon the failure of a counterparty is not based on the notional principal. Indeed, the actual cashflows associated with an OTC derivative security are often a small proportion of the notional principal.

Gross market value: Counterparties record the value of a given derivative security as either an asset or a liability. Gross market value refers to the aggregate of the gross assets of all OTC derivative securities. Hence, gross market value does not take into account the ability of the counterparties to engage in closeout netting should there be a termination event. Because derivative securities are zero-sum games, the gross market value is exactly equal to the aggregate of gross liabilities associated with all OTC derivatives.

Gross market value provides a more realistic metric of counterparty exposure insofar as it reflects the assets that entities have built up against counterparties. Gross market value can ostensibly be used as an indication of the write-downs that will occur should these counterparties experience financial distress. However, gross market value is also not a true metric of counterparty exposure, as it fails to take into account closeout netting, which mitigates the actual exposure.

Gross credit exposure: Closeout netting occurs when one of the counterparties to an agreement experiences a termination event, at which time the gross assets and gross liabilities across all of the agreements are netted out. The smaller net positions means that the counterparty has less counterparty credit risk exposure than the gross asset position might suggest. Gross credit exposure refers to the aggregate of the net asset positions held by all participants in OTC derivative securities. Gross credit exposure is a superior metric of counterparty exposure, as it reflects the actual write-downs that will occur should a given entity's counterparties experience financial distress. However, one limitation of gross credit exposure is that it does not take into account the collateral that market participants hold, which they receive if their counterparties do not satisfy their obligations per the agreement.

Collateral: Collateral refers to property that the counterparties to an agreement pledge to each other, which they agree to forfeit if they do not satisfy their obligations per the agreement. Collateral, when compared to gross credit exposure, can provide a strong sense of the OTC derivatives markets' actual counterparty exposure.

OVERVIEW OF HISTORICAL DATA

To explore the counterparty exposure faced by participants in the OTC derivatives market, let's look at the historical data for notional outstanding, gross market value, gross credit exposure, and collateral. The sources of the data we will explore are the semiannual OTC derivative statistics provided by the BIS and the annual ISDA margin survey.

Figure 12.1 presents the notional outstanding for OTC derivatives from June 1998 through June 2016. The notional outstanding over this time period increased tremendously. The change in notional outstanding can be best understood through looking at two separate time periods: June 1998–June 2008 and June 2008–June 2016. From June 1998 through June 2008, the notional outstanding increased tenfold, from approximately 72 USD trillion to 672 USD trillion. During June 2008–June 2016 the notional outstanding did not increase dramatically, and in fact dropped from approximately 672 USD trillion to 544 USD trillion, with increases and decreases in the notional outstanding across various semiannual periods.

An individual measuring counterparty exposure using notional outstanding would be very alarmed: 600–700 USD trillion is a tremendous amount of exposure. However, an individual measuring counterparty exposure on this basis would be engaging in a superficial exercise: as noted, notional outstanding is not a true metric of counterparty exposure as any write-down that occurs upon the failure of a counterparty is not based on the notional principal, which is, after all, typically not exchanged between the counterparties.

Figure 12.2 presents the gross market value and the gross credit exposure for OTC derivatives from June 1998 through June 2016. For every semiannual period, gross market value is only a small fraction of the notional outstanding. For example, in December 2008, when gross market value reached its highest level of approximately 35 USD trillion, it was only 6% of the approximately 598 USD trillion notional outstanding at that time. Further, as noted, gross market value is also not a true metric of counterparty exposure as it fails to take into account closeout netting, which mitigates the actual exposure. The gross credit exposure, also presented in Figure 12.2, is a small fraction of the gross market value. For example, in December 2008, the gross credit exposure was approximately 5 USD trillion, approximately 14% of the gross market value and less than 1% of the notional outstanding.

We see that from the perspective of gross credit exposure, counterparty exposure is much smaller than one would perceive when looking at notional outstanding or gross market value. Further, as noted, gross credit exposure does not take into account the collateral that market participants hold. Figure 12.3 presents the gross credit exposure and the estimated collateral for each year from 1999 through 2014. We see from this figure that the estimated collateral is a large proportion of the gross credit exposure, particularly following the 2007–2008 crisis. For example, in December 2008, the estimated collateral is approximately 4 USD trillion, which is 80% of the 5 USD trillion in gross credit exposure. Further, Figure 12.3 demonstrates that the estimated collateral closely tracks the level of gross credit exposure. Indeed, the correlation across the two is approximately 96%.

THE EVOLUTION OF THE U.S. REGULATORY APPROACH TOWARD OTC DERIVATIVES

The previous section illustrates that OTC derivatives' counterparty exposure during the runup to the Credit Crisis of 2007–2009 was offset by both closeout netting and the use of collateral. Regardless, the financial crisis led to intense scrutiny of the willingness and ability of financial institutions to manage the counterparty exposure of participants in OTC derivatives markets. As noted in the previous chapter, factors driving this perception included the private bilateral nature of most OTC derivatives agreements pre-Crisis; limited understanding on the part of regulators of the nature of exposures; the low recovery values associated with insolvent financial institutions; poorly understood and difficult-to-evaluate products and strategies; and the off-balance-sheet nature of exposures.

As a result of the perceived flaws in the ability of financial institutions to manage the counterparty exposure associated with OTC derivatives, the Dodd-Frank Act extensively transformed the nature of the OTC derivatives market. So as to reduce counterparty exposure, Title VII of the Dodd-Frank Act, formally titled “Wall Street Transparency and Accountability Act of 2010,” mandated changes to the OTC derivatives markets that effectively forced them to be similar to derivatives exchanges, a change known as the “futurization of OTC derivatives.”

We will explore key aspects of Title VII in the next section. Before doing so, note that Title VII represents the most recent evolution of the approach of regulators and politicians toward the regulation of OTC derivatives. Previously, the Commodities Exchange Act of 1936 prohibited “off-exchange futures.” This prohibition was loosened through notable rule changes such as the Swap Exemption of 1993 that exempted OTC swaps from the Commodities Exchange Act. It was eventually overturned by the Commodities Futures Modernization Act of 2000, which provided legal certainty to OTC derivatives trading. Title VII's key objective is to reverse course through forcing OTC derivatives to trade in a way that is similar to how exchange-traded derivatives trade.

KEY PROVISIONS OF TITLE VII OF THE DODD-FRANK ACT

This section will explore key provisions of Title VII of the Dodd-Frank Act. Throughout, we will make reference to OTC derivatives that trade through networks of dealers that are employed by financial institutions, and not through an exchange. Title VII refers to OTC derivatives as either “swaps,” “security-based swaps,” or “mixed swaps.” While the definition of each is detailed, the expression “swaps” refers to OTC derivatives based on broad-based indexes, interest rates, and currencies, among other underlying assets. A security-based swap refers to OTC derivatives based on a single security or a narrowly defined index, while a mixed swap refers to an OTC derivative with characteristics of both swaps and security-based swaps. While the key provisions that we explore in this section broadly apply to all OTC derivatives, the distinction between swaps, security-based swaps, and mixed swaps is noteworthy insofar as swaps are regulated by the Commodities Futures Trading Commission (CFTC), security-based swaps are regulated by the Securities and Exchange Commission (SEC), and mixed swaps are jointly regulated by the CFTC and the SEC.

The key provisions that we will explore are the following:

• Mandatory clearing
• Execution platforms and data repositories
• Registration requirements
• The push-out rule
• The end user exemption

CRITICISM OF TITLE VII OF THE DODD-FRANK ACT

Among the objectives of the Dodd-Frank Act is the promotion of financial stability, the ending of “too big to fail,” and the ending of bailouts. Proponents of Title VII will argue that its mandatory clearing requirement and the transparency associated with its execution platform and reporting requirements work to reduce the perceived counterparty exposure and opaqueness that characterized the OTC derivatives markets during the period of time preceding the Credit Crisis of 2007–2009.

Yet others criticize Title VII. They argue that the complexity of Title VII and the costs associated with complying with its provisions will make it more difficult to transact OTC derivatives. This can have the effect of making OTC derivatives markets less liquid and OTC derivatives more difficult to use for hedging and risk-mitigating purposes. They also argue that Title VII has not ended “too big to fail” but instead has created a new type of too-big-to-fail entity—namely the CCPs, which facilitate multilateral clearing in OTC derivatives markets. The concentration of counterparty exposure against CCPs means that their failures would require extensive write-downs on the part of their many counterparties. These counterparties include systemically important financial institutions; hence, the failures of CCPs would represent a threat to financial stability.

As explored in Chapter 9, the Dodd-Frank Act requires that the Financial Stability Oversight Council identify Systemically Important Financial Market Utilities (SIFMUs), such as CCPs, and subject them to standards of risk management and conduct, enhanced supervision, and liquidity requirements. Broadly, however, given the concentration of exposure associated with CCPs there is concern whether they are sufficiently protected. Indeed, as recently as Summer 2016, the Financial Stability Board was seeking comment on resolution planning for CCPs.⁴

KEY POINTS

• Notional outstanding provides a crude metric of counterparty exposure insofar as it provides observers a sense of market size. However, notional outstanding is not a true metric of counterparty exposure as the actual cashflows associated with an OTC derivative security are often a small proportion of the notional principal.
• Gross market value provides a more realistic metric of counterparty exposure insofar as it reflects the assets that entities have built up against counterparties. However, it fails to take into account closeout netting, which mitigates the actual exposure.
• Gross credit exposure refers to the aggregate of the net asset positions held by all participants in OTC derivative securities. Gross credit exposure is a superior metric of counterparty exposure, as it reflects the actual write-downs that will occur should a given entity's counterparties experience financial distress. However, it does not take into account the collateral that market participants hold.
• Historically, notional outstanding has been hundreds of trillions in USD terms. Gross market value has been in the tens of trillions and gross credit exposure is less than five trillion. Estimated collateral is equal to a significant proportion of gross credit exposure.
• Title VII of the Dodd-Frank Act mandated changes to the OTC derivatives markets that effectively forced them to be similar to derivatives exchanges. Previous approaches include the Commodities Exchange Act of 1936's prohibition of “off-exchange futures,” the Swap Exemption of 1993, and the Commodities Futures Modernization Act of 2000, which provided legal certainty to OTC derivatives trading.
• Key provisions of Title VII of the Dodd-Frank Act include mandatory clearing of OTC derivatives through a CCP; mandatory trading through formal platforms; requirements to report to a registered data repositories; and registration requirements.
• The push-out rule of Title VII prohibits the U.S. federal government from bailing out, or providing any other financial assistance to, financial institutions that participate in an OTC derivatives market, effectively forcing financial institutions that wish to participate in OTC derivatives market to push out their OTC derivatives activities to an affiliate. There is also an end-user exemption to the mandatory clearing requirement for nonfinancial entities that are using the OTC derivative for risk-mitigating or hedging purposes.
• Criticism of Title VII includes its complexity and the costs associated with complying with its provisions, as well as the concentration of counterparty exposure against CCPs, effectively creating a new type of too-big-to-fail entity.