Financial Stability Paper No 18: OTC derivatives reform and collateral demand impact

In an effort to strengthen the over-the-counter (OTC) derivatives market, regulators have mandated central clearing of standardised OTC derivatives and work is ongoing on prospective margin requirements for transactions that are not centrally cleared. These reforms are widely expected to increase demand for high-quality assets to use as collateral. This paper expands on our methodology as presented in the Bank of England’s June 2012 Financial Stability Report in order to estimate the potential magnitude of the demand for collateral. Recognising that there is considerable uncertainty around how market participants will adapt, we constructed a model that provides a range of quantitative estimates of the total initial margin associated with both centrally cleared and non-cleared (bilateral) OTC derivatives transactions. Our approach allows for factors such as netting assumptions, the impact of restricting rehypothecation, and different market conditions. We limit the product scope to interest rate swaps (IRS) and credit default swaps (CDS) as they account for over 80% of the OTC derivatives market and are particularly suitable to central clearing due to their high degree of standardisation. Our baseline estimates indicate that under normal market conditions and holding the current gross notional amount outstanding fixed, the total initial margin for cleared and non-cleared trades in the IRS and CDS markets may reach between US$200 billion and US$800 billion if 80% of trades are subject to central clearing. The wide range reflects the sensitivity to assumptions around netting efficiency. The demand for collateral, however, will rise only gradually as the OTC reforms will only affect new contracts.