OTC DERIVATIVES: SETTLEMENT PROCEDURES …

1 BANK FOR INTERNATIONAL SETTLEMENTSOTC DERIVATIVES: SETTLEMENT PROCEDURES ANDCOUNTERPARTY RISK MANAGEMENTR eport by the Committee on Payment and SETTLEMENT Systemsand the Euro-currency Standing Committeeof the central banks of the Group of Ten countriesBasleSeptember 1998 The present publication is also available on the BIS World Wide Web site ( ). Bank for International Settlements 1998. All rights reserved. Brief excerpts may be reproduced ortranslated provided the source is 92-9131-066-2 FOREWORDIn recent years, both the Committee on Payment and SETTLEMENT Systems and the Euro-currency Standing Committee have published reports on the implications of the very rapid growth ofover-the-counter (OTC) derivatives markets in terms of risks to banks and other counterparties tothose transactions and risks to the financial system as a whole.

2 However, none of these reports hasprovided a comprehensive survey and analysis of the practices and PROCEDURES that participants inthese markets actually use to manage their counterparty risks . The two Committees jointly organised astudy group to fill this gap. This report presents the study group s study group, chaired by Mr. Patrick Parkinson of the Board of Governors of theFederal Reserve System, was given two specific objectives. First, it was to coordinate a survey ofOTC derivatives dealers designed to develop a clear and comprehensive understanding of existingpolicies and PROCEDURES for documenting, processing and settling OTC transactions and for managingthe associated counterparty risks .

3 Secondly, it was to identify any weaknesses in practices that appearto exacerbate counterparty risks significantly or even possibly pose risks to the financial systemgenerally, and to consider changes in practices, including new services, that could mitigate those study group coordinated interviews with 30 leading dealers in OTC derivatives ,including two or more from each of the G-10 countries. Overall, the results of the interviews indicatethat practices for processing trades and managing counterparty risks are broadly similar in all the G-10countries. Standard legal agreements and confirmation templates are used to document mosttransactions.

4 Transaction processing, from data capture through to confirmation and SETTLEMENT , isincreasingly automated, although the more structured transactions still usually require manualintervention. Netting and, to a growing extent, collateral agreements are used to mitigate counterpartycredit risks . Finally, the vast majority of OTC transactions are settled bilaterally between thecounterparties, rather than through clearing potential weakness in practices that was identified in the interviews was the existenceof significant backlogs of unsigned master agreements and outstanding confirmations.

5 The degree towhich risks are exacerbated by these practices cannot be reliably assessed on the basis of the interviewresults. Given the size of some of the reported backlogs, this clearly deserves further attention. Thestudy group recommends that both derivatives counterparties and prudential supervisors review thebacklogs, assess the risks entailed and take appropriate steps to ensure that the risks are development that the study group believes could significantly mitigate risks in OTCderivatives transactions is the rapidly expanding use of collateral.

6 However, to ensure that the benefitsconcerned are realised, counterparties must effectively manage the liquidity, legal, custody andoperational risks of using collateral. The study group recommends that counterparties carefully assessthese risks and that prudential supervisors consider developing supervisory guidance in this expansion of clearing houses for OTC derivatives may also reduce counterpartyrisks. The study group recommends that counterparties assess the benefits of clearing, taking intoaccount the effectiveness of the clearing house s risk management PROCEDURES and the effects ofclearing on credit risks on uncleared contracts.

7 National authorities should ensure that there are nounnecessary legal or regulatory impediments to clearing and that clearing houses adopt effective riskmanagement Committees are indebted to Mr. Parkinson for his excellent leadership in chairing thestudy group. Able assistance in editing and publishing the report was provided by the Hartmann, Chairman, Yutaka Yamaguchi, Chairman,Committee on Payment and SETTLEMENT SystemsEuro-currency Standing Committeeand Member of the Directorate and Deputy Governorof the Deutsche Bundesbankof the Bank of JapanMembers of the Study Group on OTC DerivativesChairmanMr.

8 Patrick Parkinson,Board of Governors of theFederal Reserve SystemNational Bank of BelgiumMr. Johan PissensBank of CanadaMr. Fred DanielBank of EnglandMr. Ian TowerBank of FranceMs. Marie-Sybille Brunet-JaillyMr. Fr d ric HervoDeutsche BundesbankMr. Roland NeuschwanderBank of ItalyMr. Pietro StecconiBank of JapanMr. Haruhiko SaitoMr. Satoshi KawazoeNetherlands BankMr. Pim ClaassenSveriges RiksbankMr. Martin AnderssonSwiss National BankMr. Christian BraunBoard of Governors of theFederal Reserve SystemMs. Patricia WhiteFederal Reserve Bank of New YorkMs. HaeRan KimMr. Theodore LubkeBank for International SettlementsMr.

9 Masao OkawaMr. Benjamin CohenTable of AND and objectives ..1 Existing policies and PROCEDURES ..1 Analysis of key issues and concerns ..3 Recommendations .. AND SOURCES OF RISK .. 11 Overview .. 11 Credit risk .. 11 Liquidity risk .. 13 Market risk .. 13 Legal risk .. 14 Operational risk .. 14 Custody risk .. 14 Systemic risk .. AND PROCEDURES FOR MANAGING counterparty RISKSO verview .. 15 counterparty credit limits .. 15 Master agreements .. 16 Transaction processing and SETTLEMENT .. 18 Close-out netting .. 21 Collateralisation.

10 22 Other bilateral approaches to credit risk mitigation .. 25 Clearing houses .. OF KEY ISSUES AND CONCERNS .. 26 Delays in documenting and confirming transactions .. 26 Rapidly expanding use of collateral .. 31 Clearing houses .. 36 ANNEX 1: Glossary .. 41 ANNEX 2: Questionnaire and list of dealers interviewed .. 45 ANNEX 3: ISDA documentation .. 53 ANNEX 4: Details of various new and existing services offered to market participants .. 59 ANNEX 5: Bibliography .. 65- 1 AND RECOMMENDATIONSB ackground and objectivesIn recent years, the various committees of the Group of Ten (G-10) central banks havepublished numerous reports on the implications of the very rapid growth of over-the-counter (OTC) derivatives activities in terms of risks to banks and other counterparties to those transactions and risksto the financial system as a whole.