The cost of trading bilateral derivatives could be less than its central cleared equivalent despite new and stringent margin requirements, new research has found.
Regulators are looking to discourage bilateral OTC derivatives trading with large capital and collateral requirements. The incentivised alternative is to clear through a central counterpartY (CCP), therefore increasing stability in the financial system.
However, a study by the Office of Financial Research (OFE) has found that there may not be cost incentives to using the new system which counteracts global regulatory initiatives for the reduction of systemic risk.
The revelation could come as a blow to global regulators who have spent years writing and implementing central clearing regulations to reduce systemic risk.
The paper ‘Does OTC Derivatives Reform Incentivise Central Clearing?’ concludes that these cost comparisons are significant factor in banks’ decisions whether to use central clearing or not.
Despite the hike in cost of bilateral, the paper still says that bilateral trading may carry lower capital and collateral costs.
The authors, Samim Ghamami and Paul Glasserman, compared the total capital and collateral costs when banks transact only bilaterally to the capital and collateral costs when they clear only through CCPs, with evidence suggesting that central clearing is sometimes more expensive.
Part of this is down to contributions to a default funds creating capital and collateral costs for member banks. The authors also explored the relative benefits of netting through bilateral and central clearing; the margin period of risk used to set initial margin and capital requirements.
Margin offsets are often touted as a major advantage in central clearing, however the paper identifies that central clearing may not enhance netting if diﬀerent products are cleared through diﬀerent CCPs or multiple CCPs clear the same product.
The paper concludes that cost comparison of netting benefits would overwhelmingly favour bilateral trading without an exclusion on cross-asset netting in bilateral margin levels.
It should be noted that the analysis does points to a lack of available data to the public and regulators in understanding the impact of OTC derivative reform.