Report on OTC Derivatives: Settlement procedures and counterparty risk management
17 September 1998
The Committee on Payment and Settlement Systems (CPSS) and the Euro-currency Standing Committee (ECSC) of the central banks of the Group of Ten countries are today releasing a report entitled OTC Derivatives: Settlement Procedures and Counterparty Risk Management. In recent years, the various committees of the G-10 central banks have published numerous studies about the very rapid growth of derivatives activities, and the implications for the risks to banks and other counterparties to those transactions and for the risks to the financial system as a whole. However, none of these reports provided a comprehensive survey and analysis of the practices and procedures that participants in the over-the-counter (OTC) derivatives markets use to manage their counterparty risks. The CPSS and the ECSC have jointly published this report in order to fill this gap.
Settlement procedures and counterparty risk management in OTC derivatives transactions
The report identifies the risks associated with OTC derivatives and describes the practices commonly used by dealers to settle their transactions and manage these risks. Practices for processing trades and managing counterparty risks were found to be broadly similar in all the G-10 countries. Standard master agreements and confirmation templates are used to document most transactions. Transaction processing, from data capture through 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 derivatives are settled bilaterally between the counterparties.
Key issues and concerns
The report then draws attention to three sets of issues for further analysis. These issues concern the implications for counterparty risks and systemic risk of: (1) delays in completing master agreements and confirming transactions; (2) the rapidly expanding use of collateral; and (3) the potential expansion of clearing houses for OTC derivatives. With regard to the first set of issues, it was found that there are significant backlogs of unsigned master agreements and outstanding confirmations. The degree to which risks are exacerbated by these practices cannot be reliably assessed, but the practice of executing transactions before signing a master agreement and the occasional failure to confirm transactions promptly may jeopardise a dealer's ability to perform close-out netting. With regard to the second set of issues, the use of collateral can significantly reduce counterparty credit risks, but introduces additional liquidity, legal, custody and operational risks that counterparties must effectively manage. Finally, the use of clearing houses has the potential to mitigate credit, liquidity, legal and operational risks. The benefits of clearing would depend in particular upon the effectiveness of the clearing house’s risk management procedures and the effects of clearing on the credit risks of uncleared OTC derivatives transactions.
For each of the three issues analysed, the report puts forward recommendations for actions by market participants and national authorities that would mitigate risks to OTC derivatives counterparties and enhance the stability of global financial markets.
With respect to delays in documenting and confirming transactions, derivatives counterparties should review the backlogs of unsigned master agreements and outstanding confirmations, assess the risks entailed, and take appropriate steps to manage the risks effectively. They should also assess the potential for reducing backlogs and associated risks through the use of existing or new systems for the electronic exchange or matching of confirmations. Prudential supervisors should review the backlogs and associated risks at institutions they supervise (especially derivatives dealers), assess the effectiveness of the institutions’ policies and procedures for limiting the associated risks, and encourage improvements in practices where appropriate.
With respect to the expanding use of collateral, derivatives counterparties should assess the legal risks (including those arising in cross-border arrangements), operational risks, liquidity risks and custody risks associated with their use of collateral and ensure that these risks are managed effectively. Prudential supervisors should consider developing supervisory guidance on the use of collateral as a means of reducing credit risk, including guidance on operational risks and on legal due diligence. In addition, derivatives counterparties, prudential supervisors and central banks should encourage governments to take action where necessary to reduce legal uncertainty about the enforceability of collateral agreements.
With respect to the use of clearing houses, derivatives counterparties should assess the potential for clearing houses for OTC derivatives to reduce credit risks and other counterparty risks, taking into account the effectiveness of the clearing house’s risk management procedures and the effects of clearing on their bilateral credit risks on contracts that are not cleared. Central banks and prudential supervisors should ensure that there are no unnecessary legal or regulatory barriers to the establishment of clearing houses for OTC derivatives. They should also ensure that clearing houses adopt effective risk management safeguards, including arrangements for covering losses from the failure of any participant.
Notes to editors:
- The CPSS, based at the Bank for International Settlements (BIS), serves as a forum for the central banks of the G-10 countries to monitor and analyse developments in payment and settlement arrangements and to consider related policy issues. The Chairman of the CPSS is Mr. Wendelin Hartmann, Member of the Directorate of the Deutsche Bundesbank. This report is a continuation of the CPSS’s earlier work on the payment and settlement infrastructures that underpin financial markets, including clearing arrangements for exchange-traded derivatives (on which a report was published in March 1997).
- The ECSC, based at the BIS, serves as a forum for the central banks of the G-10 countries to monitor and analyse developments in financial markets and to consider related policy issues. The Chairman of the ECSC is Mr. Yutaka Yamaguchi, Deputy Governor of the Bank of Japan. Previous ECSC studies on derivatives markets include "Macroeconomic and monetary policy issues raised by the growth of derivatives markets" (November 1994), "Issues of measurement related to market size and macroprudential risks in derivatives markets" (February 1995), "Proposals for improving global derivatives market statistics" (July 1996) and "The measurement of aggregate market risk" (November 1997).
- The Chairman of the Study Group that prepared this report was Mr. Patrick Parkinson, Associate Director, Division of Research and Statistics, Board of Governors of the Federal Reserve System. A list of the members of the Study Group is contained in the report.
- The report is available on the BIS World Wide Web site (http://www.bis.org). Copies can be obtained from the individual G-10 central banks and the BIS.