BNY Mellon experts and the University of Cambridge Judge Business School did a deep dive on OTC reforms and their impact on SWFs. Concluding our series, we lay out a cost-benefit analysis of SWFs’ options for OTC derivative clearing, touching on broader strategic counterparty implications.
As we discussed in Part 2, 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:
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 (Figure 1a).
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 (Figure 1b).
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 (Figure 1c).
The remainder of this section will analyze the direct and indirect costs to the SWF in using the three models described above. Costs to SWFs include:
For each model, we look at a transaction between a SWF and a dealer as well as the dealer’s transaction with another counterparty to offset the exposure to the SWF. The worked examples assume the current regulatory framework and the common industry practice, where initial and variation margin requirement for bilateral clearing has not been implemented but variation margin is already exchanged in practice in inter-dealer derivative transactions.
Additional topics covered in this section include:
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