Risk Management and Financial Institutions, 4th Edition

CHAPTER 18 Managing Credit Risk: Margin, OTC Markets, and CCPs

Credit risk arises from the possibility that borrowers, bond issuers, and counterparties in derivatives transactions may default. An important way of managing credit risk is by requiring collateral. When a financial institution makes a loan to a company, there may be a requirement for collateral involving of a pledge of fixed assets owned by the company or a floating charge on the company’s working capital. In the case of derivatives transactions, collateral consisting of cash or marketable securities is often required.

Derivatives exchanges have always understood the importance of collateral—or margin as it is referred to by them. If a trader enters into a contract where he or she could owe money at a future time, the exchange insists that the trader posts enough collateral (cash or marketable securities) to cover future obligations with a high degree of certainty. New rules are making collateral much more common in the over-the-counter (OTC) derivatives market. Indeed, we will argue in this chapter that the traditional differences between OTC and exchange-traded derivatives markets are disappearing.

Chapter 5 provided some introductory material on the way derivatives are traded on exchanges and in the OTC market. In this chapter we provide more details. We discuss the role of margin/collateral, the distinction between bilateral and central clearing, and the rules on derivatives trading that have been introduced ...