P2.T7.20.6. Regulation of OTC derivatives market (Hull Ch.17)

Nicole Seaman

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Learning objectives: Summarize the clearing process in OTC derivative markets. Describe changes to the regulation of OTC derivatives which took place after the 2007-2009 financial crisis and explain the impact of these changes.

Questions:

20.6.1. The diagram below plots the exposures of three counterparties (A, B, and C). There are two types of exposures: standard transactions can be cleared centrally and are represented below by the BLUE dashed lines; nonstandard transactions cannot be cleared centrally and are represented by SOLID black lines. For example, between counterparties A and B, the standard transactions (dashed blue line) are worth +40 to A (and -40 to B). while the nonstandard transactions (solid black line) are worth +120 to B (and -120 to A).

We can observe that WITHOUT central clearing, as shown in the diagram, netting implies an average exposure of 50.0%. This is because bilateral netting (without the CCP) allows non-standard transactions to be netted with standard transactions. Consequently, the average exposure equals (0 + 120 + 30) / 3 = 50.0 where counterparty A will net to an exposure of zero, counterparty B will net to a netted exposure of (120.0 - 40.0) + (30.0 + 10.0) = 120.0, and counterparty C will net to an exposure of (80.0 - 50.0) + 0 = 30.0.

What is the average exposure (both including and excluding exposure to the CCP) if we introduce central clearing but only the standard transactions are centrally cleared?

a. Average exposure of 50.0 (including exposure to CCP) and 40.0 (excluding exposure to the CCP)
b. Average exposure of 50.0 (including exposure to CCP) and 95.0 (excluding exposure to the CCP)
c. Average exposure of 100.0 (including exposure to CCP) and 70.0 (excluding exposure to the CCP)
d. Average exposure of 200.0 (including exposure to CCP) and 160.0 (excluding exposure to the CCP)

20.6.2. In regard to changes to the regulation of OTC derivatives that occurred after the 2007-2009 financial crisis, which of the following BEST summarizes the rules for standard (aka, standardized) transactions and uncleared trades (i.e., the derivatives not covered by the rules for standardized transactions)?

a. The new regulations applied NEITHER to standardized transactions NOR uncleared trades
b. Standard transactions had no new requirements; but uncleared trades (between FIs) must clear through a CCP
c. Standard transactions (between FIs) must clear through a CCP; but uncleared trades are exempt from margin requirements
d. Standard transactions (between FIs) must clear through a CCP; and uncleared trades (between FIs) do require both initial and variation margin

20.6.3. Many believe that the unregulated OTC derivatives market was responsible--if not largely than at least partly--for the 2008 credit crisis. In response, today there is more regulation over OTC derivatives. Central counterparties (CCPs) play an important role in the new regulations. Hull argues that the new regulations will encourage a convergence of OTC and exchange-traded derivatives such that eventually the difference may not matter. In regard to these new regulations, each of the following statements is TRUE except which is false?

a. Basel's SIMM applies to the initial margin that must cover stressed market moves over a 10-day period with 99.0% confidence
b. For the purpose of clearing derivatives, the advantage of replacing too-big-to-fail (TBTF) banks with central counterparties (CCPs) is that CCPs are much SIMPLER to regulate than banks
c. Rehypothecation is when collateral posted by A with B is also used by A to meet collateral demands from C, and Hull suggests that the new regulations are likely to inadvertently cause an increase in the use of rehypothecation
d. The ISDA master agreement contains a provision that takes precedence over bankruptcy rules and gives the non-defaulting party the right to terminate all transactions (with the defaulting party) following an event of default

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Nicole Seaman

Director of FRM Operations
Staff member
Subscriber
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