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2. Che Sidanius Advisor Financial Stability ‘I think there is a world market for maybe five computers’ 2 - Thomas Watson (1943), Chairman of IBM

3. Agenda 3 Regulatory reforms OTC derivatives market Liquidity & capital standards Collateral impact: demand vs supply BoE approach OTCD market overview Estimating initial margin Multi-factor methodology (netting, rehypothecation, etc) Prefer range over single estimate Final thoughts Financial stability issues Market response

4. 4 Regulatory reforms OTC derivatives market Liquidity & capital standards Collateral impact: demand vs supply BoE approach OTCD market overview Estimating initial margin Multi-factor methodology (netting, rehypothecation, etc) Prefer range over single estimate Final thoughts Financial stability issues Market response

5. G20 commitments  Increased regulation & supervision of derivatives market participants, including pension funds and insurance firms;  Greater standardisation of derivatives contracts;  Mandatory clearing through central counterparties (CCPs)  Margin requirements for bilateral contracts  Increased transparency (pre- and post-trade) and trade reporting However, together with other regulatory reform...  Liquidity coverage ratio – promotes short-term funding  CCP default fund contributions (PFMI)  Basel III & Solvency II – increases need for high quality assets 5

6. Direct impact channel: increased demand for high-quality, liquid assets  As collateral for OTCD transactions (cleared and non-cleared)  As liquid asset buffers (Basel III liquidity regulation)  As collateral in securities and repo lending (shadow banking) Indirect impact channels: limitations on collateral velocity  Restrictions on collateral re-use/re-hypothecation (OTCD; shadow banking)  Greater use of account segregation (encouraged by regulation) 6

7. Direct impact channel: supply of high-quality, liquid assets  AAA/AA government-securities outstanding: US$33 trillion (IMF) o However, significant amount held by CBs, long-term investors, or repo markets o Sovereign debt considered safe could fall by US$9 trillion by 2016 Source: IMF (2012) Outstanding amounts of potentially safe assets (US$ trillions and percent in total) 7

8. 8 Regulatory reforms OTC derivatives market Liquidity & capital standards Collateral impact: demand vs supply BoE approach OTCD market overview Estimating initial margin Multi-factor methodology (netting, rehypothecation, etc) Prefer range over single estimate Final thoughts Financial stability issues Market response

9.  $650 trillion in notional amount outstanding (BIS) –More than 10x world GDP  IRS – around 78% of OTCD market –Highly standardised –USD, EUR, Yen, GBP: 83% of notional value (FRBNY) –Mostly short-term tenor (<1 yr)  CDS – around 4% of OTCD market –USD, EUR: 98% of notional value (FRBNY) –Significant activity in 5 yr maturities Source: BIS, IMF and Bank calculations (2012) OTCD notional outstanding and world GDP ratio 9

10. Several studies; however, different scope, assumptions and methodologies 10

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13. 13 Objective: Consider methodology carefully when estimating collateral demand? –Netting –Rehypothecation –Market conditions Our data sources: trade repositories & CCPs –Volume/value –Type of market participants –Margin models Benefit: transparency, modifiable, replicable & provides a range

14. Product scope: IRS & CDS (80% of total OTCD market) 1. Gross notional 14

15. Product scope: IRS & CDS (80% of total OTCD market) 1. Gross notional2. Netting ratio/proportion cleared 15

16. Product scope: IRS & CDS (80% of total OTCD market) 1. Gross notional2. Netting ratio/proportion cleared3. Apply VaR to estimate IM 16 Ten-day VaR

17. TR data breakdown: TriOptima for IRS: ~ 50% centrally cleared Gross notional in IRS 17

18. TR data breakdown: TriOptima for IRS: ~ 56% centrally cleared DTCC for CDS: ~ 10% centrally cleared Gross notional in IRS Gross notional in CDS 18

19. Total IM : US$200-800 billion 80% centrally cleared Netting assumptions Bilateral: no rehypothecation & 10-day VaR; Cleared: no rehypothecation & 5-day VaR 19

20. Total IM demand (US$ billions, ‘normal’ market conditions): netting matters 20

21. Total IM demand (US$ billions, ‘normal’ market conditions): Regulatory impact netting range 21

22. Proposed rule would limit rehypothecation (IOSCO) IRS market CDS market 22

23. Effect of market conditions - methodology Margin rates vary with market conditions ‘Normal’ market conditions – avg. volatility during 2006 -2011 ‘Tranquil’ market conditions – 2/3 of average volatility (e.g. January 2006) ‘Stressed’ market conditions – 2x average volatility (e.g. October 2008) 23

24. Under ‘stressed’ conditions - total IM for cleared and non-cleared may reach up to US$ 1.7 trillion –Haircuts applied to non-cash collateral IRS market CDS market 24

25. Clearing obligation & margin rules for non-cleared contracts expected to affect new contracts Pace of transition depends on maturity profile* 25

26. 26 Regulatory reforms OTC derivatives market Liquidity & capital standards Collateral impact: demand vs supply BoE approach OTCD market overview Estimating initial margin Multi-factor methodology (netting, rehypothecation, etc) Prefer range over single estimate Final thoughts Financial stability issues Market response

27. Financial stability issues  OTCD reform benefits: Counterparty credit risk Transparency  Collateral demand vs supply; asset encumberance  Fragmentation of clearing, reduction of netting  Pro-cyclicality issues Market response on-going – Compression, netting efficiencies, collateral transformation, cross- margining 27

28. Market response cont. 28

29. 29 Market response cont.

30. OTCD reform and collateral demand impact (BOE): http://www.bankofengland.co.uk/publications/Pages/fsr/papers.aspxhttp://www.bankofengland.co.uk/publications/Pages/fsr/papers.aspx Safe assets: financial system cornerstone (IMF): http://www.imf.org/external/pubs/ft/gfsr/2012/01/pdf/c3.pdfhttp://www.imf.org/external/pubs/ft/gfsr/2012/01/pdf/c3.pdf An analysis of CDS transactions (FRBNY): http://www.newyorkfed.org/research/staff_reports/sr517.htmlhttp://www.newyorkfed.org/research/staff_reports/sr517.html An analysis of OTC IRS derivatives transactions (FRBNY): http://www.newyorkfed.org/research/staff_reports/sr557.htmlhttp://www.newyorkfed.org/research/staff_reports/sr557.html 30