A paper, “The possible impact of OTC derivatives central clearing on counterparty risk” (draft, March 9, 2012), from David Murphy of UK consultancy Rivast caught our eye recently. The bulk of the paper described the interaction of single & multiple clearinghouses (as well as non-cleared bilateral trading) on initial margin and credit risk. The author does a nice job diagramming the permutations; although we are suckers for a spiffy set of boxes and arrows. But it was Section 4 “Central margin custodians” that piqued our interest.
Murphy realizes that by splitting the netting sets (e.g. the portfolios of transactions that are being margined), between (multiple) CCPs and non-cleared trades you introduce inefficiencies in margin. The paper introduces the idea of a “central margin custodian” or CMC to hold margin, well, centrally. The idea is to house margin for both cleared and non-cleared trades between two parties. It is not a mutualisation exercise – in the case of a default, exposures beyond what the margin could absorb are still bilateral. Everyone would still have to do their credit work. One downside, says Murphy, is a reduction in multilateral netting, although we wonder if trade compression won’t help on that score. The author suggests that CCPs can then be used to act as guarantor for exposure above the margin collected, similar to a derivatives product company.
One place to house a CMC might be the tri-party clearers. Much of the infrastructure is there already. We have heard talk about using tri-party to manage margin before. It certainly cleans up any re-hypothecation issues since once deposited in a t/p account, the collateral isn’t going anywhere.
We realize that there are lurking legal issues. Bankruptcy codes differ across jurisdictions. The ability to liquidate isn’t always cut and dry, trades can be subject to different master agreements, etc. etc.
Nevertheless, it is an interesting idea and might represent the next step in the evolution in margin and collateral management. A link to the paper is here.