We provide estimates of the collateral gap in the global and Canadian OTCD markets. Using the latest available data as of December 31 2011, it is estimated that current exposures after netting are $3.9T globally and $71B in Canada. The estimated amount of available collateral after correcting for re-hypothecation in each market is $767B and $48B, respectively. Thence, the current gap in variation margins stands at $3.1T globally and at $23B in Canada. The initial margin that would be required to centrally clear OTCD is estimated at $4T globally and $104B in Canada. The rate of collateralization has increased globally, but specially in Canada. In 2001, 92% of global and 72% of Canadian current exposures were undercollateralized; currently, the figures are 80% for global and 30% for Canadian current exposures. The high level of collateralization and the lack of re-hypothecation could make the Canadian market more resilient to systemic shocks. Further, it is likely that the upcoming regulatory reforms will have a more subtle impact on Canadian banks than on banks elsewhere.
TopIntroduction
The global Over-the-Counter derivatives (OTCD) market has experienced very rapid growth in recent years; particularly during the first six years of the last decade (see Figure 1). A significant part of this growth was the product of financial deregulation during the late 1990s and early 2000s, which allowed investors to trade customized bilateral contracts that required little or no collateral to guarantee their performance1. Exchange traded derivatives (ETD), on the other hand, experienced a more moderate growth due to their more strict and standardized terms, which required firms to fully collateralize their exposures; thus, making them relatively more costly to trade.
Figure 1. Notional values of the OTCD and ETD Markets (in USD trillions)
Today, OTCD contracts exceed, in notional terms, exchange traded ones by a factor of ten globally and by a factor of five in Canada. Nevertheless, during the crisis of 2008, it became apparent that the global OTCD market did not have the transparency and stability of its exchange traded counterpart. The lack of standardization and traceability in this market prevented efficient netting, which complicated the efforts of regulators to restructure the positions of financially distressed institutions. More importantly, the absence of a consistent collateral policy left many contracts undercollateralized and several counterparties exposed to large credit losses.
The undercollateralization of the OTCD market, also known as the collateral gap, remains one of the main risks faced by the financial system. It is also at the center of the regulatory changes proposed by the members of the G20 in 2009, which aim at restructuring derivatives markets by migrating OTC derivatives to central counterparties (CCPs).
The objective of this chapter is to provide estimates of the collateral gap globally and in Canada. The collateral gap is usually defined as the amount of additional assets needed to collateralize current exposures (i.e., positive replacement values after netting) in the OTCD market. Current exposures correspond to the dollar amount that investors would lose in their OTCD positions if their counterparties suddenly defaulted. Defined this way, the collateral gap focuses on current collateral needs by measuring the additional amount of collateral needed to protect against immediate losses.
In recent years, however, due to the regulatory reforms calling for the central clearing of OTCD contracts, the collateral gap is sometimes defined as the amount of assets needed to collateralize potential future exposures. These exposures correspond to the maximum dollar amount that investors could lose in their OTCD positions during a pre-specified period of time (usually the next five to ten days), assuming a set of scenarios or distributions. Defined this way, the collateral gap focuses on future collateral needs by measuring the additional amount of collateral needed to protect against potential future loses.