Thursday, July 10, 2008

Derivatives: OCC Edition (Alea)

OCC Deputy Comptroller for Credit and Market Risk Testifies Before Senate Subcommittee on Securities, Insurance, and Investment

It is the OCC’s view that bank derivatives businesses are appropriately concentrated in these large national banks because they have the resources, including risk management expertise and control systems, to control derivatives-related risks in a safe and sound manner.

OCC Supervision of Derivatives

Our supervisory goal is to ensure banks have sound risk governance processes given the nature of their risk-taking activities. At these large banks, resident teams of OCC specialists in capital markets and credit risk, supplemented by PhD economists trained in quantitative finance, engage in evaluations of the suite of risks arising from derivatives activities in general, and also credit derivatives activities specifically.

Central Counterparties and Exchanges

One initiative under consideration by supervisors and industry participants is the development of a central counterparty for the clearing of credit derivatives. This is a concept that would enhance risk mitigation by providing for multilateral netting among the major dealers. A central counterparty could facilitate the management of counterparty credit risk exposures and reduce operational risks across the industry. The central counterparty would manage both counterparty credit and operational risks by truncating the volume of trades among counterparties via a multilateral netting process and by implementing forward-looking margin requirements. Multilateral netting permits long and short positions among multiple counterparties to “net down” to a much smaller volume of open transactions because the central counterparty serves as the seller to every buyer, and the buyer to every seller. With a smaller volume of contracts to be tracked and managed left outstanding, the clearinghouse helps to reduce operational risk.

A clearinghouse model provides a central counterparty and involves ownership guaranty funding and participant margin structure to protect against counterparty credit risk. Given a variety of system, standardization, risk analysis, and pricing issues that may need to be resolved, a clearinghouse might initially have limited application to only index trades and there may be additional challenges that would need to be addressed as it progresses to other credit derivatives products.

Another issue under consideration is an exchange concept for credit derivatives.

It is our understanding that the introduction of an exchange structure to the OTC credit derivatives market would require significant standardization and potentially transform the nature of that market. Given the proven success of the OTC derivatives markets to deliver customized financial products, and current market-based efforts underway to address credit and operational risks, we do not see a need for the OCC to favor one solution over another.

No comments: