What Is Bilateral Clearing?
Bilateral clearing is a method of settling financial transactions, particularly over-the-counter (OTC) derivatives, where two parties directly agree upon and manage the terms, execution, and settlement of a trade. In this framework, the buyer and seller of a financial instrument are directly responsible for the performance of their contractual obligations to each other, without the involvement of an intermediary or a central clearinghouse. This approach is a fundamental component of financial market infrastructure for many non-standardized financial products.
Before significant post-crisis reforms, bilateral clearing was the prevalent method for a vast portion of the global OTC derivatives market. Each party in a bilaterally cleared transaction assesses and manages the counterparty risk posed by their direct trading partner. This often involves establishing credit lines and exchanging collateral to mitigate potential losses in the event of default. The terms of these collateral agreements, including types of acceptable collateral and frequency of margin calls, are negotiated directly between the two transacting entities.
History and Origin
Bilateral clearing has historically been the foundational method for settling transactions in less standardized markets, particularly in the nascent stages of complex financial instruments like OTC derivatives. Before the proliferation of organized exchanges and central clearinghouses, nearly all financial transactions were inherently bilateral, relying on the direct trust and creditworthiness between trading partners. As the OTC derivatives market expanded rapidly in the decades leading up to the 2008 financial crisis, bilateral clearing dominated, with participants managing risk through a web of individual agreements.
However, the global financial crisis exposed significant vulnerabilities within this bilaterally cleared landscape. The interconnectedness of financial institutions through numerous bilateral contracts led to a cascade of defaults and a widespread inability to ascertain true counterparty exposures, exacerbating systemic risk. In response, the Group of Twenty (G20) leaders, in their 2009 Pittsburgh summit, mandated comprehensive reforms aimed at increasing transparency and reducing systemic risk in the OTC derivatives market. A key pillar of this reform was the push for mandatory central clearing of standardized OTC derivatives, shifting away from the bilateral model for a significant portion of the market. Federal Reserve officials, including former Governor Daniel K. Tarullo, extensively discussed the benefits and implementation of these reforms, emphasizing the move towards central clearing to reduce systemic risk.8,7,6,5
Key Takeaways
- Bilateral clearing involves direct settlement and risk management between two trading parties without an intermediary.
- It is common for customized or non-standardized financial products, particularly in the OTC market.
- Parties in bilateral clearing manage counterparty risk by setting credit limits and exchanging collateral directly.
- The 2008 financial crisis highlighted the systemic risks of widespread bilateral clearing in OTC derivatives, leading to a regulatory push towards central clearing.
- While central clearing has become mandatory for many standardized derivatives, bilateral clearing remains relevant for bespoke or less liquid instruments.
Interpreting Bilateral Clearing
In the context of risk management, interpreting bilateral clearing involves understanding that each counterparty is directly exposed to the default risk of its trading partner. Unlike centrally cleared transactions where a central counterparty (CCP) steps in to guarantee trades, bilateral clearing places the onus of due diligence, credit assessment, and collateral management squarely on the shoulders of the transacting firms.
Financial institutions engaging in bilateral clearing must meticulously assess the creditworthiness of each individual counterparty. This includes evaluating their financial health, regulatory standing, and operational capabilities. The ongoing process of monitoring and managing bilateral exposures requires robust internal systems for tracking outstanding positions, calculating potential future exposure, and ensuring timely exchange of margin. The sophistication of these internal processes is crucial for mitigating potential liquidity risk and credit losses that could arise from a counterparty's failure.
Hypothetical Example
Consider two financial institutions, Bank A and Hedge Fund B, that agree to an OTC interest rate swap with a notional value of $100 million. In a bilateral clearing arrangement, there is no third party guaranteeing the performance of this swap.
- Agreement: Bank A and Hedge Fund B negotiate the specific terms of the swap, including the fixed and floating interest rates, payment dates, and maturity.
- Risk Assessment: Each party conducts its own credit assessment of the other. Bank A determines the maximum exposure it is willing to take on Hedge Fund B, and vice versa.
- Collateral Exchange: To mitigate counterparty risk, they agree to a bilateral collateral agreement. If the value of the swap moves against Hedge Fund B, it would be required to post collateral (e.g., cash or highly liquid securities) to Bank A to cover the mark-to-market losses. Conversely, if the swap moves against Bank A, it would post collateral to Hedge Fund B.
- Ongoing Management: Throughout the life of the swap, both parties continuously monitor the swap's market value and their credit exposure to each other. They perform daily or weekly calculations to determine required collateral adjustments and initiate margin calls as needed. If Hedge Fund B were to default, Bank A would directly face the loss associated with the unfulfilled obligations of the swap, minus any collateral it holds.
Practical Applications
While regulatory reforms have driven many standardized derivatives to central clearing, bilateral clearing continues to be applied in several areas of finance:
- Customized OTC Derivatives: For highly bespoke or illiquid derivatives, where standardization is difficult, bilateral clearing remains common. These contracts are tailored to specific needs and may not fit the standardized requirements of clearinghouses.
- Foreign Exchange (FX) Forwards and Swaps: A significant portion of the FX market, particularly FX forwards and swaps, are still predominantly bilaterally cleared due to the unique characteristics of FX settlement and varied regulatory approaches globally.
- Non-Financial Counterparties: Certain non-financial entities, such as corporate treasuries using derivatives for hedging operational risks, may still engage in bilateral derivatives transactions, especially if their volume does not trigger mandatory clearing thresholds.
- Commodity Trading: Some physical commodity transactions and their associated derivatives may still rely on bilateral clearing, particularly in less liquid or niche commodity markets.
The post-crisis regulatory landscape introduced stringent requirements for non-centrally cleared derivatives, including mandatory exchange of initial and variation margin. These rules, developed by bodies like the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO), aim to reduce the risks associated with bilateral contracts by requiring robust collateralization.4
Limitations and Criticisms
Bilateral clearing, despite its flexibility, carries several significant limitations and has been subject to considerable criticism, particularly after the 2008 financial crisis.
- Increased Counterparty Risk: In a bilaterally cleared environment, each participant is directly exposed to the default risk of its specific counterparty. If one party defaults, the other faces direct losses and the operational burden of unwinding or replacing the defaulted trades. This can lead to a domino effect across the financial system during periods of stress.
- Lack of Netting Efficiency: Bilateral arrangements often mean that offsetting positions with different counterparties cannot be netted as effectively as they would in a central clearing system. This leads to higher gross exposures and greater demands for collateral to cover potential losses.
- Operational Complexity and Costs: Managing a vast network of bilateral agreements requires extensive operational infrastructure for credit assessment, legal documentation (such as ISDA Master Agreements), and ongoing margin calls and reconciliations for each counterparty. This complexity can be expensive and prone to errors.
- Limited Transparency: Bilateral markets are often less transparent than centrally cleared markets, making it difficult for regulators and market participants to get a comprehensive view of aggregate exposures and potential systemic risk across the financial system.
- Procyclicality: In times of market stress, bilateral relationships can exacerbate procyclicality, as parties demand more collateral or reduce credit limits, potentially tightening liquidity risk and contributing to asset fire sales. Regulatory initiatives, such as those that impose higher capital and margin requirements for non-centrally cleared derivatives, aim to create a disincentive for bilateral clearing for standardized products, implicitly acknowledging these limitations.3,2
Bilateral Clearing vs. Central Clearing
Bilateral clearing and central clearing represent two distinct approaches to managing and settling financial transactions, primarily differing in the role of an intermediary.
Feature | Bilateral Clearing | Central Clearing |
---|---|---|
Counterparty Risk | Direct exposure between two transacting parties. | Mitigated by a central counterparty (CCP) through novation. |
Intermediary | No intermediary; parties interact directly. | A CCP acts as buyer to every seller and seller to every buyer. |
Netting | Limited netting, usually within a single legal agreement between two parties. | Multilateral netting across all participants, significantly reducing exposures. |
Standardization | Common for highly customized, non-standardized products. | Primarily for standardized contracts like many futures contracts, options contracts, and swaps. |
Collateral | Collateral exchanged directly between parties based on bilateral agreements. | Margin (initial and variation) posted to the CCP, with standardized rules. |
Transparency | Less transparent, as terms are private agreements. | Higher transparency due to standardized terms and reporting requirements to the CCP. |
Systemic Risk | Can concentrate and amplify systemic risk due to interconnectedness. | Designed to reduce systemic risk by mutualizing and managing default risk. |
The shift from bilateral clearing to central clearing for standardized derivatives was a direct response to the vulnerabilities exposed during the 2008 financial crisis, aiming to enhance the stability and resilience of the global financial system. Central clearing platforms aim to reduce systemic risk through multilateral netting, standardized risk management, and shared default waterfalls. The Securities and Exchange Commission (SEC) has, for instance, mandated central clearing for certain U.S. Treasury securities transactions to enhance market stability and transparency.1
FAQs
What types of financial instruments are typically cleared bilaterally?
Bilateral clearing is most commonly used for customized or non-standardized over-the-counter (OTC) derivatives, such as complex interest rate swaps or bespoke equity options, where the unique terms make them unsuitable for standardized central clearing.
How do parties manage risk in a bilaterally cleared transaction?
Parties manage risk in bilateral clearing through direct credit assessments of their counterparty, establishing credit limits, and negotiating collateral agreements that specify the types of acceptable collateral, valuation methods, and the frequency of margin calls.
Why did regulators push for a move away from bilateral clearing after the financial crisis?
Regulators pushed for a shift away from widespread bilateral clearing due to concerns about systemic risk. The crisis revealed that the opaque and interconnected nature of bilateral agreements made it difficult to assess aggregate exposures and unwind positions during widespread defaults, contributing to market instability.
Does bilateral clearing still exist?
Yes, bilateral clearing still exists, especially for non-standardized derivatives and certain market segments not subject to mandatory central clearing requirements. However, regulations post-2008 have imposed higher capital and margin requirements on these non-centrally cleared transactions to mitigate their inherent risks.
What is the main advantage of bilateral clearing?
The primary advantage of bilateral clearing is its flexibility, allowing parties to customize contract terms to meet their specific needs, which is often not possible with the standardized contracts required by central clearinghouses.