(a) Market liquidity risk

40. Market liquidity risk is the risk that a position cannot be eliminated quickly by either liquidating the instrument or by establishing an offsetting position. Information that breaks out exchange-traded and OTC derivatives could further enhance supervisory understanding of an institution's market liquidity risk. Although exchange-traded and OTC markets both contain liquid and illiquid contracts, the basic differences between the two markets give an indication of the comparative difficulty of offsetting exposures using other instruments ¹². Among both OTC and exchange-traded products, information on broad risk categories (i.e., interest rate, foreign exchange, equities and commodities) and types of instrument would be useful in judging the market liquidity of an institution's positions. Accordingly, notional amounts and market values of exchange-traded and OTC instruments by type (and perhaps by maturity and by product) could enhance a supervisor's understanding of an institution's market liquidity risk. In addition, supervisors could gain important insights into an institution's market liquidity by taking into account the availability of alternative hedging strategies and closely substitutable instruments.

41. To understand the market liquidity risk arising from an institution's derivatives activities, supervisors would benefit greatly from a picture of the aggregate size of the market in which the institution is active. This is particularly important for OTC derivatives, which are generally tailored to the specific needs of customers and for which marking to market is more difficult than for standardised products with liquid markets. As a result, it may be difficult to unwind or offset a position in an appropriate time frame because of its size, the availability of suitable counterparties, or the narrowness of the market. Currently available information on notional values of derivative instruments provides, at best, an incomplete indication of the aggregate size of the market for a particular derivative instrument or of an institution's participation in that market. An alternative, yet still imperfect, measure of market size would be the gross positive and gross negative market values of contracts by risk category or product. Such data would provide an indication of the economic or market value of the derivative instruments held by banks and securities firms in a particular market at a point in time and an institution's concentration in that market.

(b) Funding risk

42. Funding risk is the risk of derivatives activities placing adverse funding and cash flow pressures on an institution. Funding risk stemming from derivatives alone provides only a partial picture of an institution's liquidity position. In general, funding risk is best analysed on an institution-wide basis across all financial instruments. However, it is also important for supervisors to understand the impact of derivatives on an institution's overall liquidity position. In unusual circumstances, some derivatives activity can be indicative of underlying funding pressures. Unusual increases in the volumes of options written and the presence of swaps structured to generate a net cash inflow at inception can be, but are not at all necessarily, signs of an unusual or urgent need for cash.

43. Separate analysis of notional contract amounts of exchange-traded and OTC instruments (as described earlier) should augment supervisory awareness of funding risks, particularly given the requirements for margin and daily cash settlement of exchange-traded instruments and the resulting demands for liquidity that large positions in these instruments may entail. For example, significant positions in OTC contracts hedged with exchange-traded instruments could result in liquidity pressures arising from the daily margin and cash requirements of the exchange-traded products. Data on OTC contracts with collateral or other "margin-like" requirements may also be necessary for assessing liquidity risk. In addition, information about the notional amounts and expected cash flows of derivatives according to specified time intervals would be helpful in assessing funding risk.

44. Information on OTC contracts subject to "triggering agreements" provides further information about funding risk. Triggering agreements generally entail contractual provisions requiring the liquidation of the contract or the posting of collateral if certain events, such as a downgrade in credit rating, occur. Substantial positions in contracts with triggering agreements could increase funding risk by requiring the liquidation of contracts or the pledging of collateral when the institution is experiencing financial stress. Accordingly, information on the total notional amount and replacement cost of OTC contracts (aggregated across products) with triggering provisions provides supervisors with important information about liquidity risk.

45. Supervisors should also consider evaluating information based on institutions' sensitivity analyses of the effect of adverse market developments on their funding requirements. This information would shed light on the potential for additional margin or collateral calls associated with exchange-traded and OTC derivatives positions due to changes in market variables such as interest rates and exchange rates.

Footnote(s):

12. Market illiquidity may stem from the customised nature of some OTC contracts which can include fundamental elements of market risk in combinations that may not be easily replicated using standardised exchange-traded contracts or other OTC instruments.