Report on OTC Derivatives: Settlement procedures and counterparty risk management

September 1998

Foreword

In recent years, both the Committee on Payment and Settlement Systems and the Euro-currency Standing Committee have published reports on the implications of the very rapid growth of over-the-counter (OTC) derivatives markets in terms of risks to banks and other counterparties to those transactions and risks to the financial system as a whole. However, none of these reports has provided a comprehensive survey and analysis of the practices and procedures that participants in these markets actually use to manage their counterparty risks. The two Committees jointly organised a study group to fill this gap. This report presents the study group's work.

The study group, chaired by Mr. Patrick Parkinson of the Board of Governors of the Federal Reserve System, was given two specific objectives. First, it was to coordinate a survey of OTC derivatives dealers designed to develop a clear and comprehensive understanding of existing policies and procedures for documenting, processing and settling OTC transactions and for managing the associated counterparty risks. Secondly, it was to identify any weaknesses in practices that appear to exacerbate counterparty risks significantly or even possibly pose risks to the financial system generally, and to consider changes in practices, including new services, that could mitigate those risks.

The study group coordinated interviews with 30 leading dealers in OTC derivatives, including two or more from each of the G-10 countries. Overall, the results of the interviews indicate that practices for processing trades and managing counterparty risks are broadly similar in all the G-10 countries. Standard legal agreements and confirmation templates are used to document most transactions. Transaction processing, from data capture through to confirmation and settlement, is increasingly automated, although the more structured transactions still usually require manual intervention. Netting and, to a growing extent, collateral agreements are used to mitigate counterparty credit risks. Finally, the vast majority of OTC transactions are settled bilaterally between the counterparties, rather than through clearing houses.

A potential weakness in practices that was identified in the interviews was the existence of significant backlogs of unsigned master agreements and outstanding confirmations. The degree to which risks are exacerbated by these practices cannot be reliably assessed on the basis of the interview results. Given the size of some of the reported backlogs, this clearly deserves further attention. The study group recommends that both derivatives counterparties and prudential supervisors review the backlogs, assess the risks entailed and take appropriate steps to ensure that the risks are adequately controlled.

A development that the study group believes could significantly mitigate risks in OTC derivatives transactions is the rapidly expanding use of collateral. However, to ensure that the benefits concerned are realised, counterparties must effectively manage the liquidity, legal, custody and operational risks of using collateral. The study group recommends that counterparties carefully assess these risks and that prudential supervisors consider developing supervisory guidance in this area.

The expansion of clearing houses for OTC derivatives may also reduce counterparty risks. The study group recommends that counterparties assess the benefits of clearing, taking into account the effectiveness of the clearing house's risk management procedures and the effects of clearing on credit risks on uncleared contracts. National authorities should ensure that there are no unnecessary legal or regulatory impediments to clearing and that clearing houses adopt effective risk management safeguards.

The Committees are indebted to Mr. Parkinson for his excellent leadership in chairing the study group. Able assistance in editing and publishing the report was provided by the BIS.

Wendelin Hartmann, Chairman Yutaka Yamaguchi, Chairman
Committee on Payment and Settlement Systems Euro-currency Standing Committee
Member of the Directorate of the Deutsche Bundesbank Deputy Governor of the Bank of Japan