Unity of Purpose :Unity of Purpose Why Financial Trading Institutions Should Welcome Centralized Clearing of Derivatives Trades And How This Should be Done The “Holistic Theorem” Phil Kongtcheu


The Emerging Political Consensus :The Emerging Political Consensus Regulatory Reform Should Include Mandatory Centralized Clearing of Derivatives Trades


The Underlying Assumption :The Underlying Assumption This is a necessary cost of doing business in other to protect the entire system from systemic risks, i.e. problems that may cause the entire system to collapse The Question: Is It Really So?


Our Main Argument :Our Main Argument This is an opportunity for financial institutions to save counterparty risk management costs while bringing transparency to trading risks


Slide 5: 2 4 6 8 10 12 14 16 18 20 There is No Central Counterparty Each double arrow between Ti and Tj stands for Ti,j and Tj,I . Since there are 10 such arrows, there are 20 credit risks to manage.


Slide 6: There is A Central Counterparty O manages and grants credit to the counterparties Ti , all of whom trade with one another through O. Since there are 5 h arrows, there are 5 credit risks to manage if O is structurally default-free or 10 credit risks to manage otherwise .


General Result :General Result Without a centralized clearing system, if there are p counterparties, there are p(p-1)  counterparty risks to estimate. With a central counterparty clearing system, overall there are only p (or 2p if the clearing counterparty may default) counterparty risks to estimate. i.e., In a centralized clearing system, counterparty risk management costs grow linearly with the number of participants while with a bilateral counterparty system, those costs grow quadratically.


Central Counterparty With Credit Risk :Central Counterparty With Credit Risk


Fig.1 Review :Fig.1 Review With less than c=3 counterparties, there is no point in having a central counterparty For p>c=3, positive externalities accrue in the setup of a central counterparty system, allowing centripetal benefits to outweigh centrifugal benefit The industry thus achieves a “value of p(p-1) at a cost of 2p” It is assumed the cost of setting up and operating the Central Counterparty is equal to the cost borne by each individual counterparty and that the central counterparty itself


Central Counterparty With Credit Risk :Central Counterparty With Credit Risk


Central Counterparty with no credit risk :Central Counterparty with no credit risk


“Network Effects” Holistic Theorem :“Network Effects” Holistic Theorem The structure of these benefits is similar to what is known in communication economics as "network effects". If the number of counterparties > 2 (or 3 if the clearing counterparty may default) and the cost of estimating a counterparty credit risk is constant, a central counterparty system results in less overall costs. In this sense, this organizational structure is optimally informationally efficient and this result may be stated as a “holistic theorem”


Critical Mass Analysis :Critical Mass Analysis Fig 3. c = 3(1+v(1+4s/9))/2 the critical mass number of counterparties as a function of the central counterparty setup cost s when the central counterparty is default free. Note that c the critical mass level starts at c=3 counterparties when there are no setup costs s=0


Practical Implementation Issues :Practical Implementation Issues Ideally there would be a single central and default free clearing entity that would keep netting ALL trades and granting trading limits. The only viable pretender is a default free sovereign government backed entity. The practical hurdle is that such an entity would most likely lack the internal expertise to timely and cost effectively value and assess the risks of all potential contracts with its various counterparts.


Practical Implementation Solution : Transparent Inter-connected Layered Hierarchical Structure :Practical Implementation Solution : Transparent Inter-connected Layered Hierarchical Structure Trading institutions trade with one another through central clearing institutions. Sharing of counterparty aggregate information at each level insures virtual central counterparty effect and efficient netting Trading Institution T1 Clearing Counterparty C1 Central Bank Entity for Currency 1 BIS or Global Central Clearing Entity Central Bank Entity for Currency …. Central Bank Entity for Currency c Clearing Counterparty C2 Clearing Counterparty C… Clearing Counterparty Cn-1 Clearing Counterparty Cn Trading Institution T2 Trading Institution T… Trading Institution T… Trading Institution T... Trading Institution T… Trading Institution T… Trading Institution Tp-1 Trading Institution Tp


Practical Architecture Details :Practical Architecture Details Clearing institutions share with the central bank backed entity for each currency the respective assets and liabilities position of each trading entity in that currency in order to set trading limits and/or margin requirements. Other intermediary layers may be added aggregating lower levels balance sheets.


Layered Guarantees/ Layered Information Aggregation :Layered Guarantees/ Layered Information Aggregation Each layer guarantees the liabilities of the layer under in exchange for supervisory authority which includes original trading counterparties aggregate balance sheet information transmittal. Hence the central bank backed entity shares the aggregate information for each institution with other clearing institutions in its currency and the global clearing entity (such as the Bank for International Settlements (BIS)) to help them set trading limits and/or margin requirements.


Practical Implementation Solution : Transparent Inter-connected Layered Hierarchical Structure :Practical Implementation Solution : Transparent Inter-connected Layered Hierarchical Structure The global clearing entity (BIS) shares the aggregate information for each institution with other central banks . Trading Institution T1 Clearing Counterparty C1 Central Bank Entity for Currency 1 BIS or Global Central Clearing Entity Central Bank Entity for Currency …. Central Bank Entity for Currency c Clearing Counterparty C2 Clearing Counterparty C… Clearing Counterparty Cn-1 Clearing Counterparty Cn Trading Institution T2 Trading Institution T… Trading Institution T… Trading Institution T... Trading Institution T… Trading Institution T… Trading Institution Tp-1 Trading Institution Tp


The number of clearing parties and overseers is very small compared with number of counterparties :The number of clearing parties and overseers is very small compared with number of counterparties This ensures that the “network effects” benefits of the “holy theorem” remain . If there are n overseers and p counterparties, n<

What If Not ? :What If Not ? Lack of live balance sheet transparency will simply result in excess margin requirements or reduced trading or trading limits to account for extra uncertainty Creating congestive transaction costs due to structural inadequacy. Or reducing healthy economic activity.


Slide 21:Thank You 4 Watching! This presentation is in part an expansion on the “Holistic Theorem” p. 192 - 195 of the book BICs 4 Derivatives Volume I: Theory relating to “Credit Markets Organization” published in 2005 Phil Kongtcheu a.k.a. Obi Wan Yoda