How Portfolio Netting Deters Diversification and Competition in the Derivatives Industry

Derivatives are financial instruments used to shift risks, such as risks of interest rate or foreign exchange rate fluctuations or changes in the value of assets such as stocks, bonds, metals, or agricultural or energy products. Derivative products are unlike loans, bonds, shares and other financial instruments because of the potential that either party to these instruments may be the payor or the payee. As a result, a portfolio of derivative transactions has the potential to perform differently on a gross as opposed to net basis. From an ex ante statistical perspective, if the transactions’ cash flows are independent, some may offset others. This potential for offset is recognized in creditors’ rights law through a combination of state and federal legal regimes and, specifically, contract law, state law governing offset, and federal bankruptcy law. However, these legal regimes apply differently where a derivative market participant’s portfolio consists of transactions with one counterparty as opposed to where the portfolio combines transactions across multiple counterparties. Generally, netting is only permitted when transacting with the same counterparty. As a result, credit risk mitigation through netting is only available when a market participant engages in repeat business with an intermediary as opposed to diversifying across derivatives service providers. This article makes the contribution of identifying these dynamics and relating them to observed concentration among derivative market intermediaries. It then identifies key components of the derivatives regulatory regime, with a focus on margin requirements, which intervene in these dynamics and modulate the extent to which netting impacts competition for derivatives services. These rules are both technical and consequential. Taking a primarily descriptive approach, this article contributes to an understanding of why trading relationships within derivatives markets are sticky and how federal financial regulators tweaking rules ostensibly aimed at credit risk affect the level of lock-in between customers and derivative service providers.