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BIS Quarterly Review, September 2009
45
 
Stephen G Cecchetti
stephen.cecchetti@bis.org 
Jacob Gyntelberg
 jacob.gyntelberg@bis.org 
Marc Hollanders
marc.hollanders@bis.org 
Central counterparties for over-the-counterderivatives
1
 
Wider use of central counterparties (CCPs) for over-the-counter derivatives has the potential to improve market resilience by lowering counterparty risk and increasing transparency. However, CCPs alone are not sufficient to ensure the resilience and efficiency of derivatives markets.
JEL classification: G01, G15, G18.
Through its Financial Products Group, headquartered in London, AmericanInternational Group (AIG) managed to sell enormous amounts of credit riskinsurance without the financial resources necessary to cover potentialpayments. By end-June 2008, AIG had taken on $446 billion in notional creditrisk exposure as a seller of credit risk protection via
credit default swaps (CDS)
.
2
A CDS contract is a credit derivative that, for a specified bond issuer,protects the buyer against a default or debt restructuring. AIG’s unhedgedsales of nearly half a trillion dollars of insurance represented a significantconcentration of credit risk in a market participant that ultimately did not havethe necessary loss absorption capacity. The widespread bond defaults duringthe recent crisis imposed substantial losses on AIG and other sellers of creditrisk insurance. The losses made clear the risks to both individual institutionsand the global financial system arising from the vast amount of CDS issuance – and showed that those risks were larger and more severe than anyone hadrealised. One result has been renewed calls from policymakers for a revision ofregulatory frameworks and improvements in the organisation of derivativesmarkets to reduce the potential for such risks to build up.Here we focus on an important emerging improvement in marketorganisation: the introduction of
central counterparties (CCPs)
for over-the-counter (OTC) derivatives, in particular for CDS. A CCP is an independentlegal entity that interposes itself between the buyer and the seller of a
1
The authors are grateful to Claudio Borio, Ingo Fender, Daniel Heller, Robert N McCauley,Frank Packer, Takeshi Shirakami, Philip Turner and Christian Upper for useful discussionsand comments. The views expressed in this article are those of the authors and do notnecessarily reflect those of the BIS.
2
Italicised terms appear in the Glossary, p 57.
 
 
46
BIS Quarterly Review, September 2009
 
derivative security. When trading through a CCP, the single contract betweentwo initial counterparties that is the hallmark of an OTC trade is still executed,but it is then replaced by two new contracts – between the CCP and each ofthe two contracting parties. At that point, the buyer and seller are no longercounterparties to each other – instead, each acquires the CCP as itscounterparty. This structure has three clear benefits. First, it improves themanagement of counterparty risk. Second, it allows the CCP to perform
multilateral netting 
of exposures as well as payments. Third, it increasestransparency by making information on market activity and exposures – bothprices and quantities – available to regulators and the public.
3
 We proceed by briefly documenting the dramatic growth in OTCderivatives markets in recent years and comparing different ways to organisederivatives markets. We move on to consider how a CCP addresses financialstability issues in OTC derivatives markets and report recent developments inthe introduction of CCPs. We then discuss the structural and regulatorychallenges related to the introduction of CCPs for trading CDS. The finalsection offers some concluding observations.
The growth of OTC derivatives markets
OTC derivatives markets grew continuously from their inception in the early1980s through the first half of 2008, when their growth was halted and thenreversed by the financial crisis. The first-ever decline of
notional amounts outstanding 
came in the second half of 2008 (Graph 1, left-hand panel). Evenso, by end-2008, outstanding amounts of all types of OTC derivatives contractsstood at $592 trillion, slightly below their level a year earlier.Despite the drop in notional amounts outstanding, large movements inprices meant that the
gross market value 
of contracts outstanding continued to
3
Some of these benefits may also be obtained through other mechanisms (see Ledrut andUpper (2007)).
Global OTC derivatives
By data type and market risk category, in trillions of US dollars
Notional amounts outstanding Gross market values and gross credit exposure
02004006008001,000H2 2006H1 2007H2 2007H1 2008H2 2008Foreign exchangeInterest rateEquityCommoditiesCDSOther
 
01234501020304050H2 2006H1 2007H2 2007H1 2008H2 2008Gross credit exposure (lhs)
Source: BIS Graph 1
… while exposuresincreasedDerivatives volumesdeclined due tocrisis …
 
 
BIS Quarterly Review, September 2009
47
 
rise dramatically, increasing by two thirds to almost $35 trillion at the end ofDecember 2008 (Graph 1, right-hand panel). These higher market values werealso reflected in higher
gross 
 
credit exposures 
, which grew by almost 30% to$5.0 trillion. Anecdotal evidence suggests that as a consequence of the crisis,market-makers – the major dealers who facilitate trading in the OTC derivativesmarkets – have increased the fees they charge (by widening bid-ask spreads)and have also scaled back the level of their OTC derivatives positions.Furthermore, bank managers as well as regulators have pushed to increasecapital allocated to counterparty and market-related risks, making derivativestrading more costly.
The organisation of derivatives markets
We can think of the organisation of derivatives markets as taking one of threeforms (Table 1). The first, the bilateral OTC market, is a fully decentralisedmarket in which participants trade – and clear their trades – directly with oneanother. The second is an OTC market with decentralised trading but withcentralised clearing through a CCP. In the third type, an exchange-basedmarket, both trading and clearing are centralised through an exchange that istypically linked to a CCP. As the last type of market organisation is well known,we focus on the first two.
Bilateral OTC market 
In a bilateral OTC market, participants trade directly with one another, eitherelectronically or via telephone. The management of counterparty risk – the riskthat the person or firm on the other side of the transaction will fail to live up towhat is contractually agreed – has two components: collateral and
bilateral netting 
.In the collateral component, the parties limit counterparty risk by requiringthe daily posting of collateral reflecting the mark to market changes in the valueof the contracts. Collateral agreements can be customised to reflect thecontracting parties’ assessment both of the riskiness of the position and ofeach other’s credit quality. The posting of collateral implies that actualcounterparty exposures are smaller than market values would suggest.Surveys conducted by the International Swaps and Derivatives Association(ISDA) indicate that roughly two thirds of OTC derivatives exposures arecollateralised and that the estimated amount of collateral in use at the end of2008 was approximately $4 trillion, of which almost 85% was cash (seeISDA (2009)).The second component of managing counterparty risk, bilateral nettingagreements, helps reduce collateral requirements. The ISDA margin surveycited above indicates that virtually all large banks rely on some form of bilateralnetting agreement to control counterparty exposures. In many cases, bilateralnetting agreements allow for netting across different contract types. BISstatistics on OTC derivatives suggest that the impact of bilateral netting is
 
… currently useover $4 trillion ascollateral ...Bilateral derivativesmarkets …… and haveuncollateralisedexposures of atleast $1 trillion
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