Hedging in Commodities S&T
For commodities S&T how do banks manage counterparty risk when making OTC transactions? I know they will hedge using futures from the merc, but isn't there still a risk of the other party not meeting their obligations on the OTC (hence the reason why centrally cleared exchanges exist)?
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They have an ISDA.
From my experience, when I was market making OTC, the moment I trade with a broker from ICAP, I immediately put that on my risk profile even though the positions aren't reflected on my screen because at the end of the day, it will be cleared through the clearing firm. There really is no risk, albiet I traded mostly delta one products.
I guess the only risk was clearing and settlement issues. Sometimes, the trades aren't fully reflected in books by next morning and I called my clearing firm and told them to figure it the fuck out. I put on ALOT of positions across the curve either through via spreads or fly trades, so there might be a small delta residual and if the market moved against me, that could be bad on PnL on paper. My biggest bullshit moment was when they fucked up on their end and gave me a bunch of outright I was long and short across the curve and I HAD to calculated my spread risk and you NEED to know how to calculate it on the fly, especially when you're making markets.
So OTC is done through a broker? Is there any cases where the bank does everything direct with the counterparty?
So when I was on the cash equities desk, the traders are agency traders so they execute large trades for hedge fund and asset managers and the sales traders/sales people are the ones who directly talks to the the client. Albeit, cash equities is a different kind of business. The risk taking traders never directly talk to the clients, they have brokers for that like TPICAP. I personally was never a risk taking trader for a bank, until I got to a hedge fund, making markets but I directly didn't have clients. I did in a way... because a bunch of brokers reach out to me to make a market of whatever product I was specializing in and if I don't give a price, they will just go to someone else who is more reliable. Essentially, they are kind of like my clients but not directly.
Sure, banks will deal directly with a counterparty when trading commodities. They’ll have an ISDA setup and will make you a market in whatever. Won’t often be a good one but a 2 way none the less. For smaller players who have shit credit/can’t access the broker market or go direct to other counterparties/don’t have the capital to post margins and exchange clear the bank quotes are often the best they can get. They hit a bid or lift an offer and the bank will turns around and go to the broker market or Exchange and lays the risk off.
Based on what I’ve seen in my first few months on the desk, not sure if applicable to all banks. The bank will have a credit line extended to the counterparty, commodity hedging desk can draw on this credit line for OTC swaps, options, etc. There’s a trading desk in the bank that manages counterparty credit risk. This desk charges the commodity desk some amount of money when they execute the trade based on the size, duration, volatility of underlying, etc. Never had it happen but assume this desk would make up any losses associated with failure to settle OTC swap obligations.
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