Why Are Highly Customized Otc Derivatives Unsuitable for Central Clearing unlike Standardized Equity Products? ▴ Question

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Concept

The distinction between centrally cleared, standardized equity products and their over-the-counter (OTC) counterparts represents a fundamental architectural division in modern financial markets. This division is a direct consequence of the intrinsic properties of the instruments themselves. Standardized equity options and futures, by their very design, are fungible and interchangeable. Their homogeneity allows for efficient, anonymous, and large-scale trading on exchanges, with risk centrally managed by a clearinghouse.

The system functions because each contract is a perfect substitute for another of the same series. This interchangeability is the bedrock of their liquidity and the reason they are suitable for the centralized risk management model of a central counterparty (CCP).

Highly customized OTC derivatives, conversely, are created to address unique, specific risk exposures that standardized products cannot. Each OTC contract is a bespoke agreement, negotiated privately between two counterparties. The value of these instruments lies in their non-standardization. They can be tailored to an exact notional amount, a specific maturity date, a unique underlying asset, or a complex set of payout conditions.

This customization, however, is precisely what renders them unsuitable for central clearing. A CCP operates on the principle of novation, where it becomes the buyer to every seller and the seller to every buyer. To manage the immense risk this entails, the CCP must be able to value and net positions across a large number of participants in real-time. This is only possible when the products are standardized.

The unique nature of each OTC contract makes it impossible to net positions in the same way, and creates insurmountable challenges for valuation and risk modeling on a portfolio basis. The very features that make OTC derivatives valuable to end-users are the same features that make them incompatible with the operational model of a CCP.

The fundamental incompatibility arises because central clearing relies on product standardization for risk management, while the value of customized derivatives is derived from their unique, non-standard features.

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The Nature of a Bespoke Contract

A bespoke derivative contract is more than just a financial instrument; it is a tailored solution to a specific problem. Consider a corporation that wants to hedge its exposure to the price of a specific commodity that is not listed on any exchange. It can enter into a commodity swap with a financial institution, with the terms of the swap precisely matching the corporation’s risk profile. The maturity of the swap, the payment schedule, and the exact specification of the commodity are all negotiated to meet the corporation’s unique needs.

This level of customization is impossible to achieve with a standardized futures contract. The value of the OTC derivative is in its precision.

This precision, however, comes at the cost of liquidity and transferability. The commodity swap is a bilateral agreement between the corporation and the financial institution. It cannot be easily sold to another party. Its value is dependent on the creditworthiness of the two counterparties.

This is in stark contrast to a standardized futures contract, which can be bought and sold on an exchange at any time. The liquidity of the futures contract is a direct result of its standardization.

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The Role of the Central Counterparty

A central counterparty is a critical piece of financial market infrastructure. Its primary function is to mitigate counterparty credit risk, which is the risk that one party to a financial contract will default on its obligations. The CCP achieves this by standing between the buyer and the seller of a standardized financial instrument. In doing so, the CCP becomes the counterparty to both sides of the trade.

This process, known as novation, transforms the bilateral credit risk between the two original counterparties into a credit risk to the CCP. Since the CCP is a highly regulated and well-capitalized entity, this significantly reduces the overall level of risk in the financial system.

The CCP’s ability to manage this risk is predicated on its ability to net positions across all market participants. Netting is the process of offsetting all of a participant’s buy and sell positions in a particular security to arrive at a single net position. This reduces the total amount of collateral that needs to be posted and simplifies the settlement process. Netting is only possible when the instruments being traded are standardized.

The unique nature of OTC derivatives makes it impossible to net positions in this way. Each OTC contract is a unique instrument, with its own specific terms and conditions. As a result, it is impossible to offset one OTC contract with another.

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Strategy

The strategic decision to clear a derivative product is a function of its lifecycle and its utility to the market. Standardized products are designed for mass consumption. They are the workhorses of the financial markets, used by a wide range of participants for a variety of purposes, including speculation, hedging, and arbitrage. Their standardization is a key feature, as it allows for deep and liquid markets to develop.

The liquidity of these markets, in turn, makes them attractive to a wide range of participants. This creates a virtuous cycle, where liquidity begets more liquidity.

Customized OTC derivatives, on the other hand, are designed for a more niche audience. They are used by sophisticated market participants to manage complex and unique risks. The value of these instruments lies in their ability to be tailored to the specific needs of the end-user. This customization, however, comes at the cost of liquidity.

OTC derivatives are typically traded in thin, illiquid markets. This makes them unsuitable for central clearing, which requires deep and liquid markets to function effectively. The strategic rationale for keeping these products outside of central clearing is to preserve their core function as customized risk management tools.

Forcing customized derivatives into a central clearing model would effectively destroy their primary value proposition, which is the ability to create a perfect hedge for a unique risk exposure.

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The Standardization Spectrum

It is useful to think of derivatives as existing on a spectrum of standardization. At one end of the spectrum are highly standardized products, such as exchange-traded futures and options. These products have standardized terms and conditions, and are traded on public exchanges. At the other end of the spectrum are highly customized OTC derivatives, which are privately negotiated between two counterparties.

In between these two extremes are a range of products with varying degrees of standardization. For example, some OTC derivatives may be “cleared-eligible,” meaning that they have some standardized features that make them suitable for central clearing.

The decision of where a particular product falls on this spectrum is a function of a number of factors, including the needs of the market, the complexity of the product, and the state of technology. As markets evolve and technology improves, it is possible for products to move along the spectrum. For example, some OTC derivatives that were once highly customized may become more standardized over time as the market for them grows and matures.

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Table of Derivative Standardization

Feature	Exchange-Traded Derivatives (e.g. Equity Futures)	Centrally Cleared OTC Derivatives (e.g. Standardized Swaps)	Bilateral OTC Derivatives (e.g. Customized Options)
Contract Terms	Fully standardized (e.g. size, expiry, underlying)	Standardized economic terms, some flexibility	Fully customized and privately negotiated
Counterparty	Central Counterparty (CCP)	Central Counterparty (CCP)	Original counterparty
Liquidity	High	Moderate to High	Low to non-existent
Price Transparency	High (publicly quoted)	Moderate (reported to repositories)	Low (private)
Risk Management	Standardized margining by CCP	Standardized margining by CCP	Bilateral collateral agreements

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The Impact of Regulation

The global financial crisis of 2008 highlighted the systemic risks posed by the OTC derivatives market. In response, regulators around the world have implemented a series of reforms aimed at increasing transparency and reducing risk in this market. One of the key pillars of these reforms has been the introduction of mandatory clearing for certain standardized OTC derivatives. The goal of these reforms is to move as much of the OTC derivatives market as possible into central clearing, where risks can be more effectively managed.

These reforms, however, have also recognized the importance of preserving the ability of end-users to access customized OTC derivatives for hedging purposes. As a result, the clearing mandate has been carefully calibrated to apply only to those products that are sufficiently standardized to be suitable for central clearing. This has created a two-tiered market for OTC derivatives, with a clear distinction between cleared and non-cleared products. This distinction is likely to become even more pronounced in the years to come, as regulators continue to refine the rules governing the OTC derivatives market.

Dodd-Frank Act (U.S.) ▴ This legislation introduced a comprehensive framework for the regulation of OTC derivatives, including a mandatory clearing requirement for certain swaps.
European Market Infrastructure Regulation (EMIR) ▴ This regulation introduced similar requirements in the European Union, including a clearing obligation for certain classes of OTC derivatives.
Margin Requirements for Non-Cleared Derivatives ▴ In addition to the clearing mandate, regulators have also introduced new margin requirements for non-cleared OTC derivatives. These requirements are designed to reduce the systemic risk posed by these products by ensuring that they are adequately collateralized.

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Execution

The operational mechanics of central clearing are predicated on a high degree of automation and standardization. From trade execution to settlement, the entire process is designed to be as efficient and frictionless as possible. This is only possible when the products being cleared are standardized. The unique nature of customized OTC derivatives makes it impossible to automate the clearing process in the same way.

Each contract requires a high degree of manual intervention, from the initial negotiation of the terms to the final settlement of the trade. This makes the clearing of these products prohibitively expensive and operationally complex.

The valuation of customized OTC derivatives is another major operational challenge. The value of a standardized derivative can be easily determined by reference to the market price. The value of a customized derivative, on the other hand, is much more difficult to determine. It depends on a variety of factors, including the specific terms of the contract, the creditworthiness of the counterparties, and the prevailing market conditions.

This makes it very difficult for a CCP to accurately value a portfolio of customized derivatives and to calculate the appropriate level of margin to hold against it. This valuation uncertainty is a major source of risk for the CCP, and is one of the primary reasons why these products are unsuitable for central clearing.

The operational infrastructure of a CCP is built for the high-volume, low-touch processing of standardized contracts; it is fundamentally ill-suited for the high-touch, bespoke nature of customized derivatives.

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The Challenge of Risk Modeling

A CCP’s risk model is its first line of defense against a member default. The model is used to calculate the amount of initial margin that each member must post to the CCP. The initial margin is designed to cover the potential losses that the CCP would incur if a member were to default on its obligations. The accuracy of the risk model is therefore critical to the safety and soundness of the CCP.

The development of an accurate risk model is a complex and challenging task, even for standardized products. It is exponentially more difficult for customized derivatives.

The unique features of each customized derivative make it impossible to develop a single, standardized risk model that can be applied to all products. Each contract has its own unique risk profile, which must be carefully analyzed and modeled. This requires a deep understanding of the product and the market in which it trades.

It also requires a significant amount of data, which is often not available for customized products. This lack of data makes it very difficult to backtest and validate the risk model, which is a critical step in the model development process.

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Table of Risk Management Challenges

Risk Factor	Standardized Equity Products	Customized OTC Derivatives
Valuation	Based on transparent, observable market prices.	Based on complex models with multiple, often unobservable, inputs.
Liquidity	High, with active two-way markets.	Low or non-existent, making it difficult to exit positions.
Default Management	CCP can easily auction off a defaulted member’s portfolio.	Difficult to find a buyer for a defaulted member’s unique portfolio.
Legal Risk	Standardized legal agreements.	Bespoke legal agreements, with potential for disputes.

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The Default Waterfall

In the event of a member default, a CCP has a pre-defined set of procedures for managing the situation. This is known as the “default waterfall.” The default waterfall is designed to ensure that the CCP has sufficient resources to cover the losses from a member default, and to prevent the default from spreading to other members. The default waterfall typically consists of the following layers of protection:

Defaulting Member’s Margin ▴ The first layer of protection is the initial margin posted by the defaulting member.
Defaulting Member’s Contribution to the Default Fund ▴ The second layer of protection is the defaulting member’s contribution to the CCP’s default fund.
CCP’s Own Capital ▴ The third layer of protection is the CCP’s own capital.
Surviving Members’ Contributions to the Default Fund ▴ The final layer of protection is the contributions of the surviving members to the default fund.

The default waterfall is a powerful tool for managing risk in a central clearing environment. It is, however, only effective if the CCP can accurately value the defaulted member’s portfolio and quickly liquidate it. This is a major challenge for customized OTC derivatives. The lack of liquidity in these products makes it very difficult for the CCP to sell off a defaulted member’s portfolio in a timely manner.

This can result in significant losses for the CCP, which can then be passed on to the surviving members. This is a risk that most CCPs are unwilling to take.

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References

ISDA. “Central Clearing in the Equity Derivatives Market.” 2014.
Tabb Group. “EQD clearing provisions raise questions over role of OTC contracts.” 2014.
ISDA. “Non-Cleared OTC Derivatives ▴ Their Importance to the Global Economy.” 2013.
PwC. “Derivatives and hedging.” 2023.
Ghamami, Samim, and Paul Glasserman. “Does OTC Derivatives Reform Incentivize Central Clearing?” Office of Financial Research Working Paper, 2016.
Hull, John C. “Options, Futures, and Other Derivatives.” Pearson, 2022.
Duffie, Darrell, and Henry T. C. Hu. “Swaps, Central Clearing, and Financial Stability.” The Journal of Legal Studies, vol. 44, no. S2, 2015, pp. S93-S126.
Cont, Rama, and Amal El Hamidi. “Risk management in central counterparties ▴ A survey.” HAL open science, 2021.
Pirrong, Craig. “The Economics of Central Clearing ▴ Theory and Practice.” ISDA, 2011.
Norman, Peter. “The Risk Controllers ▴ Central Counterparty Clearing in Globalised Financial Markets.” Wiley, 2011.

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Reflection

The distinction between cleared and non-cleared derivatives is a reflection of the inherent tension between standardization and customization in financial markets. While the post-crisis regulatory reforms have made significant strides in mitigating systemic risk through the expansion of central clearing, they have also wisely preserved the vital role of bespoke OTC contracts. The continued existence of a vibrant non-cleared market is a testament to the fact that a one-size-fits-all approach to risk management is neither desirable nor feasible. For sophisticated market participants, the ability to precisely tailor a hedge to a unique risk profile remains an indispensable tool.

The challenge for these participants is to navigate this bifurcated market landscape with a clear understanding of the trade-offs involved. A superior operational framework is one that can seamlessly integrate both cleared and non-cleared products, allowing for the optimal execution of a given strategy, regardless of where it falls on the standardization spectrum.