Managers Using More OTC Derivatives

Dodd-Frank, with a few exceptions, now requires most of these contracts to go through a clearing process in a public environment. Clearing is seen by many as a way to reduce counterparty risk as two parties have to produce assets to ensure that a trade can be completed. Most OTC transactions have to be completed, Dodd-Frank stipulates, in a CCP/clearinghouse. Some swaps can’t and probably never will be because there is not enough volume.

Those thinly traded contracts—the so-called custom derivatives contracts—are unlikely to ever go through a clearing process and will likely continue to use the bilateral, dealer-to-dealer method. However, under Dodd-Frank, parties to the trade will require huge amounts of collateral to ensure against counterparty failure.

DoubleLine’s Sherman says the firm’s policy is to use these contracts only if they “provide an inherent advantage to the client. But we will never allow our funds to grow so large that we expose them to counterparty default risk embedded in swaps just so we can get more fee income off a bloated assets under management.”

Are players who use these contracts now less exposed to the risks of 2008? Could a market meltdown, triggered or caused in part by OTC derivatives, happen again? Sherman says he thinks Dodd-Frank’s protections are helpful but there is no guarantee that they will prevent another financial crisis.

How could it happen? Even the lawmakers who designed a solution concede the solution could fail.

“Large financial institutions would own and control the clearinghouses and effectively set rules for their own derivatives deals,” according to the wording of Dodd-Frank. The lawmakers called on the clearinghouses to “reduce systemic risk,” but managers say Dodd-Frank has only reduced risk, not eliminated it.

Indeed, one bond manager who uses OTC derivative contracts as a hedging device privately warned “that the rise of those using these CCPs, here and in Europe, could lead to a different kind of risk, the risk of one of them [a clearing house] failing. This is something that all market participants must heed.”

He cautions that with competition, each CCP could operate differently. One could set margin requirements lower to attract more business, and that might mean some CCPs are less careful than others. “It is very important,” the manager said, “for market participants to carefully select, and subsequently monitor, each CCP.”

And what happens, Sherman asks, in the next financial crisis, when a CCP or a clearinghouse fails?

“If we had another day like the crash of 1987, the movement that day could wipe people out and then the clearinghouse has a problem,” says Sherman, though he thinks Dodd-Frank has added some protection.

Dodd-Frank “was built with some guardrails on it,” he says. “But if you’re driving your Ferrari too fast down a twisty road, you can still go through the guardrails.”