Assessing the macroeconomic impact of
OTC derivatives regulatory reform
Banque de France-Sciences Po and BNP Paribas seminar
Paris, 29-30 October 2013
Stephen G. Cecchetti
Economic Advisor and Head of the Monetary and Economic Department*
*The views expressed here are those of the presenter and do not necessarily reflect those of the BIS
or the Macroeconomic Assessment Group on Derivatives.
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Hedge Fund's Collapse Met With a Shrug
By Steven Mufson
Washington Post Staff Writer
Wednesday, September
20, 2006
Founded in, Amaranth Advisors claimed to employ a “multistrategy approach to investing that allows nimble portfolio
managers to seize opportunities in whatever markets seem to
be most promising at the time.” However, the hedge fund’s
downfall was largely due to huge losses in a single sector:
natural gas. After making $1 billion in 2005 on rising energy
prices and owning up to $9 billion in assets under management,
the company completely collapsed in 2006 after losing more
than $6 billion on natural gas futures.
This is the third biggest trading loss on record. The biggest is $9 billion by Bank of Tokyo
Mitsubishi in October 2008, and the second largest is $7.2 billion by Societe Generale in
January 2008.
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THE MARKETS
Business/Financial Desk; Section A
Seeing a Fund as Too Big to Fail, New York Fed Assists Its Bailout
By GRETCHEN MORGENSON
The speculative investment fund rescued by a consortium of Wall Street banks this
week made complex bets on international financial markets with a total value
drastically higher than previously estimated, financiers who studied its books said
yesterday.
They said that the fund, Long-Term Capital Management, used its $2.2 billion in
capital from investors as collateral to buy $125 billion in securities, and then used
those securities as collateral to enter into exotic financial transactions valued at
$1.25 trillion, with all figures as of the end of August.
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Last updated:September 17, 2008 6:26 pm
US to take control of AIG
By Francesco Guerrera in London, Aline van Duyn in New York and Krishna Guha in Washington
The US Federal Reserve announced that it would lend AIG up to $85bn
in emergency funds in return for a government stake of 79.9 per cent
and effective control of the company – an extraordinary step meant to
stave off a collapse of the giant insurer that plays a crucial role in the
global financial system.
We later learned that AIG had taken on $446 billion in notional credit
risk exposure as a seller of credit risk protection via credit default swaps.
This exposure was largely unhedged and uncollateralised.
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1 short wrt 2
2 is long wrt 1
1
2
3 short wrt 1
1 is long wrt 3
2 short wrt 3
3 is long wrt 2
3
All parties are net zero in bilateral positions!
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1 short wrt 2
2 is long wrt 1
1
2
2 blows up
3 short wrt 1
1 is long wrt 3
2 short wrt 3
3 is long wrt 2
3
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Default!
1
3 short wrt 1
1 is long wrt 3
Default!
3
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1
Can 1 & 2 survive alone?
3 short wrt 1
1 is long wrt 3
3
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Overview
 Motivation
 Approach
 Benefits
 Costs
 Main results
 Caveats
 Conclusions
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Motivation
 Crisis revealed severe shortcomings in OTCD markets
 Counterparty risk
 Lack of transparency
 A range of regulatory reforms in response
 Mandatory central clearing for standardised derivatives
 More stringent capital and margining requirements for
OTC derivatives
 Question: how does all this add up?
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Approach
 Compare long-term costs and benefits of OTCD reform
 Output gains/losses as common metrics
 Benefits: foregone output loss as crises become less
frequent
 Costs: reduced economic activity resulting from higher
prices of risk transfer
 Suite of models used to estimate costs and benefits
 Robustness of results
 Data limitations
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Benefits
Pre-crisis
Derivatives
dealers
Shock
• Valuation
losses
• Margin calls
Post regulatory reforms
Central clearing
• Netting
• Collateralisation
OTC
• Extra capital
• Extra margin
requirements
• Stronger capital
buffers
• Better risk
management
due to greater
transparency
• Reduced
counterparty
credit risk
• Less frequent
and less
procylical
margin calls
Financial
system
• Rising leverage
• Funding stress
• Heightened risk
aversion
• Less increase in
leverage
• Reduced risk of
funding stress
• Less
procyclicality
• Greater
confidence
• Defaults
• Runs
Real
economy
• Credit crunch • Output losses
• Negative wealth • Unemployment
effects
• Loss of
confidence
• Much less
• Foregone
frequent crises
output loss
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Benefits (contd.)
 Foregone output loss
 Annual probability of crisis of 0.26%
 Median cost of banking crisis of 60% of GDP
 Equals annual GDP gain of 0.16%
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Costs
Central clearing
• Netting
• Collateralisation
OTC
• Extra capital
• Extra margin
requirements
Derivatives
dealer
• Cost of extra
capital
• Cost of extra
collateral
• Operating fees
Financial
system
• Less trading and
market making
• Additional
collateral
demand
• Higher cost of
capital
Real
economy
• Increase in bank • Output loss
credit spreads
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Costs (contd.)
 Output loss
 Compute sum of costs of increased margin and capital
requirements and operating costs
 Translate these in changes in bank lending spreads
 Use macro models to estimate change in long-run GDP
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Main results
Macroeconomic benefits and costs of OTC derivatives regulatory reforms
Change in expected annual GDP after full implementation and effects of reforms; in per cent
Low-costs scenario
(high netting)
Central scenario
High-costs scenario
(low netting)
Benefits1
+0.16
+0.16
+0.16
Costs2
–0.03
–0.04
–0.07
Net benefits
+0.13
+0.12
+0.09
Reduction in output losses from financial crises, computed as the estimated decline in the probability of financial crises propagated by OTC
derivatives exposures multiplied by the average cost of past financial crises. 2 Effect on GDP of higher prices of financial services, as evaluated
by a range of macroeconomic models. The table reports the GDP-weighted median effect calculated by these models.
1
Table 1
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Caveats
 Non-quantified effects
 Transparency
 Risk-taking and risk management
 Criticisms
 Multilateral netting and creditor subordination
 Collateralisation and credit risk
 Concerns
 Collateral availability
 Cyclicality of margins
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Conclusion
 MAGD important step to fully understanding the macro
implications of OTCD reforms
 Remaining uncertainties:
 Lack of access to firm-level OTCD exposures data
 Lack of modelling techniques that allow for joint analysis of
costs and benefits
 Still, unambiguous conclusion that economic benefits of OTCD
reforms are likely to exceed their costs
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Thank you!
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