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CCPs and the Risk of Concentration

Are the central counterparties that have taken risk out of derivatives markets shouldering too big a burden?

Friday, April 5, 2019

By Jeffrey Kutler

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Post-financial-crisis mandates for central clearing of derivatives have had the intended effect. Cleared U.S. interest rate derivatives volume, for example, exceeded 88% in 2018, according to the International Swaps and Derivatives Association (ISDA).

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That is, in a general sense, a good result, Stephen Cecchetti believes. But the central counterparty (CCP) clearing houses that have effectively “mutualized risk” in over-the-counter derivatives markets raise systemic-risk questions of their own. “These are important issues that we need to explore further and think much harder about,” says Cecchetti, who worked on post-crisis reform initiatives at the Bank for International Settlements and currently holds the Rosen Chair in International Finance at the Brandeis International Business School.

He points to the concentration of activity in relatively few CCPs - “behemoths” like CME Clearing and LCH - that, unless resilient to shocks, “can become a transmission mechanism in a network” and set off a potential systemic crisis.

Stress tests focus on counterparties, on the sufficiency of capital and other buffers, and whether a CCP can “survive the default of several clearing members all at once. The answer so far is basically yes,” Cecchetti says.

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The default last September of Norwegian power market trader Einar Aas was a glimpse into what can go wrong. The loss exceeded the guarantee fund of a Nasdaq clearing house, and member firms had to make up the difference, exceeding €100 million.

The incident prompted ISDA to produce a paper on CCP Best Practices, among them: aligning risk management with underlying product risk, and ensuring that cleared products are sufficiently standard and liquid.

CCPs are on the global policy agenda. The Financial Stability Board launched a consultation in November on “whether existing financial resources and tools are adequate to implement resolution strategies for individual CCPs.” A European Parliament proposal on CCP recovery and resolution drew a mostly favorable response on March 28 from the European Association of CCP Clearing Houses.

During his presentation at the GARP 20th Risk Convention in February, Cecchetti polled his audience on the question of how to manage CCP risk. No one responded that “there is no problem.” The other answers:

- Increase loss absorption (margin, capital, prepaid guarantees), 52%

- Convert CCPs to public utilities, 35%

- Require disclosure of potential clearing-member assessments, 11%

- Eliminate central clearing requirements, 2%

In his blog at moneyandbanking.com, Cecchetti summarized: “While the post‐crisis regulatory reforms are a big step forward, we still have work to do to make the system resilient. In two important categories - bank capital and the resilience of CCPs - we need bigger buffers.”

Video production by DeLisa White

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