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OTC Derivatives Reform: Part 2

Putting asset owners and sovereign wealth funds in the driver’s seat | November 2016

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The challenges and opportunities presented by OTC derivatives reform prompted BNY Mellon to engage the University of Cambridge Judge Business School to analyze the impact on asset owners and sovereign wealth funds. This report provides recommendations for an evolving environment. Part 2 of 3

OTC Derivatives Clearing: A cost-benefit analysis

Changes to clearing are one of biggest structural changes to the OTC derivatives markets imposed by post-crisis reforms, albeit with exemptions for certain institutions including SWFs, which can choose from three different methods of clearing OTC derivatives to maximize their benefits. This section further investigates the advantages and disadvantages for the following three models:

1. Bilateral trading with unilateral collateral posting (one-way CSA model)
Under this model, whilst the dealer has to post collateral to the SWF when the SWF has a positive exposure, the SWF does not have to post collateral when it has a negative exposure. For SWFs, this model neither requires much liquidity nor sophisticated operational systems related to managing or monitoring collateral posting. However, since the dealer usually has mutual collateral exchange (two-way CSA) in an offsetting transaction, the funding cost due to the asymmetric margining incurred by the dealer can be passed on to the SWF, depending on the terms of individual transactions.

2. Bilateral trading with mutual collateral posting (two-way CSA model)
Two-way CSA means the mutual exchange of collateral between the SWF and the dealer. As it allows for symmetric margining in both the transaction with the SWF and the offsetting transaction, there is virtually no funding cost transferred from the dealer to the SWF. However, the SWF needs to prepare sufficient liquidity to post collateral, as well as to set up or outsource an operational system to manage the collateral exchange.

3. Central clearing for eligible OTC derivatives (CCP model)
This model allows the dealer to benefit from multilateral netting of exposures, and such benefit may be passed through to the SWF in the form of product price reduction. In contrast, the dealer has to incur the considerable costs to clear through CCP as discussed in Section 3, which can also be passed on to a SWF. In addition, the initial and variation margin requirements in this model call for additional liquidity by SWFs and may cause operational burdens.


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OTC Derivatives and the Post-Crisis Reform Agenda

A review of key reforms to the OTC derivatives market that are having significant impact on SWFs and their counterparts.

Additional topics covered in this section include:

  • Mandatory Central Clearing
  • Margining Requirements for Non-centrally Cleared Derivatives
  • Capital Requirements for Counterparty Credit Risk
  • Exemptions from Derivatives Clearing and Margin Requirements
  • Capital and Liquidity
  • Recovery and Resolution
  • Collateral Management, Securities Lending and Repo


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