Need help to understand the risks of OTC derivatives (2 mechanisms illustrated)

Hi everyone !

Im planning to do my master thesis on EMIR (new european regulation on otc derivatives). Before to discuss to which extent this framework can “reduce” risks, I need to be sure I understand where are the risks in a “traditional system”

Everywhere I go I can read that there are two main dangerous mechanisms, one considering a downgrade in the dealer’s rating (1) and one considering than the extremity of a “daisy chain” can’t provide insurance for the cds he has contracted.

(1) We have a lot of investors who want to invest in structured debt including mortgage backed securities but they cannot has their prospectus or internal rules provide that they can only invest in AAA. AIG (FP) comes in the game and propose to all those investors to insure their investment (CDS). As AIG is AAA it all works fine. AIG (FP) is not in insurance nor a bank and is not regulated concerning capital requirement, and investors do not always ask for collateral (AIG is AAA after all). Then a few default occurs in the payment of the loans composing the structure debt and AIG has to provide some collateral to the investors that they have insured (here it starts to be unclear). This leads to a lack of liquidity for AIG which sees its rating be downgraded. Not being AAA anymore, they have to provide a lot of collateral (I don’t understand here), they cannot, bankruptcy. If they are not helped investors have to “unwind” their positions to meet their capital requirements and this leads to a lot of selling, a drop in asset prices and a general problem. So as you see its not all clear and I think I need a bit of help

(2) Imagine that a factory contracts a loan with a local bank. This local bank enters into a CDS to insure this loan with a dealer A, the dealer A enters in a CDS to insure the loan with a hedge fund B, the hedge fund B enters into a CDS with an institution C and so on. I understand that if the guy at the other end of the daisy chain cannot fill his obligation of insurance in case of default of the factory, all the chain is “goes to bankruptcy or is forced to sell assets” (and here one more time, I’m a bit lost, what force them to sell assets ?)

So if some of you guys can help me to make this smooth and clear in my head, I would be really grateful !

Thank you all !


I didn’t read all of that, but to answer your last question, in general collateral calls due to changes in MTM or being unable to roll over repo transactions could force you to sell assets.