Derivatives Intermediation

Lastly, we will have to cover how collateralised financing is used in derivatives intermedi-ation by dealer banks and how their balance sheets are affected. In both matched-book

6 The margin rate paid by HF1 is assumed to be net of compensation for lending out securities and the interest rate earned by the dealer,r^shortis assumed to be net of the rebate rate, wherer^OIS > r^rebate.

repos and internalization, we had that the dealer would fund the initial trade by re-hypothecating the collateral to obtain funding resulting in two off-setting trades. With derivatives, there is not an initial large exchange of cash for securities but rather a margin exchange and for CDSs, possibly an upfront exchange of cash. The exchange of margin and daily mark-to-market settlement of the CDS have been explained in detail in Section 7.2. We now have to add, how the dealer funds the initial margin when intermediating in CDSs to complete the picture.

We assume that both CDS trades are fully collateralised. For non-financial counter-parties, derivatives are sometimes not fully collateralised but we will not go into that case and thus assume that the two contracts are similar in terms. In Figure 8 below, we can see the exchanges of cash from each party. We have the hedge fund buying protec-tion from the dealer. The dealer then funds this by entering into an offsetting CDS with another dealer. In this example we leave out the CCP. Recall when entering into to a centrally cleared trade, the CCP will not pay initial margin, only the dealer will pay to the CCP. In that case, the dealer cannot fund the initial margin it has to pay the hedge fund from initial margin received on the offsetting CDS. Our example will thus be with a dealer as counterparty on the funding/hedging leg.

[D’Errico et al., 2018] illustrates aflow of risk, where the credit risk from selling a CDS is flowing across counterparties. Since some counterparty in the end must take on the credit risk that is flowing through the system from dealer to dealer, e.g. another hedge fund, the CDS intermediation is thus somewhat similar to internalization. Instead of another counterparty taking the opposite CDS position, one could also argue that some financial intermediary will hedge the short CDS by shorting the underlying bond and thus entering into a positive basis trade. However, for a negative basis trade opportunity on the entity, the positive basis trader will need to collect large fees and interest payments for this to be profitable, we will therefore stick to the flow of risk approach described before. For the initial dealer, the exchange of cash for the CDS is illustrated below:

Figure 8: Dealer Intermediation of CDS

As we can see above, all cash flows are completely hedged for the dealer. From Section 7.2, we are familiar with the mechanics of the long CDS trade but we now see it from

the perspective of the facilitator of the trade. This perspective will also have a different balance sheet, as the dealer has fully hedged and funded the initial margin.

Assets Liabilities

CDS with positive value max(u_a,0)+ CDS with negative value max(−u_a,0)+

max(−u_b,0) max(u_b,0)

Receivables N·2m+max(−ua,0)+ Payables N·2m+max(u_a,0)+

max(ub,0) max(−ub,0)

Total u_a+u_b+N·2m Total u_a+u_b+N·2m

Table 13: Dealer’s balance sheet after intermediating CDS trade

In our example with the dealer being the arbitrageur, the dealer was long the CDS. With the hedged CDS, the intermediary will have both a positive valued CDS and a negative valued CDS as asset and liability and for the variation margin paid and received, the dealer will also have a payable and receivable. The upfronts on the two CDSs will be determined by the bid-ask spread. The dealer will then buy a CDS from another dealer and pay an upfront of ub and sell a CDS to the hedge fund and receive an upfront of u_a. From Table 7, we know that when the value of the CDSs is settled-to-market, the MtM will be paid on both CDSs and the fair value will return to zero. Notice that the end-of-day settlement will be at the same quoted price for both CDSs as it is identical se-curities. Therefore, since the dealer has bought at the bid-price and sold at the ask-price when the CDSs settle-to-market the dealer will free up cash equal to the bid-ask spread,

∆u, which we assume will earn some rate similar to that of ∆h - a rate for excess cash⁷. The settlement means that the balance go from Table 13 - which may seem somewhat complicated - to just the bid-ask spread in cash and the initial margins. This is also what we will use going forward. From then on with fully hedged CDSs, the dealer will then receive and pay an equal amount of cash for a net cash flow of zero.

In terms of the off-balance sheet exposure, the CDS trades are with different counter-parties and therefore no netting is allowed under the SLR. However, the written CDS is fully offset by the bought CDS. Recall from Section 6.1 that offsetting a written CDS re-moves the off-balance sheet exposure from the CDS as PFE add-on can also be deducted.

The only off-balance sheet exposure for the two CDSs is thus the long CDS. Here, we still have the add-on ofN·0.05 for investment grade bond andN·0.1 for high yield bonds.

The off-balance sheet exposure coming from the EAD is equal to zero as stated in Section 6.1. This is because the individual exposure from the two CDSs is identical except for

7 This will be elaborated later

the sign. The sum of exposures on each entity will then sum to zero. There will thus be no derivative exposure under the RWA requirement, making the calculations simpler.

Since the risk weight on cash is zero, the initial cash margin and freed-up cash from the bid-ask spread. The derivatives intermediation thus results in zero risk weighted assets.