A brief speech by ECB governing council member Benoît Cœuré summarizes problematic side effects of increased central counterparty clearing in derivatives markets. Systemic threats may arise from unprecedented risk concentrations in a few global central counterparties and participating banks, as well as from the mutualisation of losses and liquidity shortfalls across systemically important institutions.
“Risks in CCPs”, Speech by Benoît Cœuré, Member of the Executive Board of the ECB,Washington D.C., 23 January 2014
The below are excerpts from the speech. Emphasis and cursive text has been added.
[N.B. A CCP (central counterparty) is a corporate entity that provides guarantees to parties in financial transactions. If one party defaults the CCP steps in to honor that party’s contractual obligations. Through this service a CCP effectively centralizes counterparty risk management.]
“A recent quantitative impact study run by the Working Group on Margining Requirements of the Basel Committee on Banking Supervision and the International Organization of Securities Commissions estimated that the global volume of centrally cleared OTC derivatives could rise from a notional value of USD 142.7 trillion, or around 28% of OTC derivatives traded, to USD 268 trillion after migration to the clearing requirement, or 53% of OTC derivatives traded.”
The benefits of central counterparty clearing
“I see four main benefits that explain the market-driven and regulatory push for central clearing…(1) CCPs allow participants to trade with one a single counterparty (the CCP), which greatly facilitates the due diligence efforts and risk management burden…(2) CCPs offer state-of-the-art margining and risk management methods that do not exist to the same extent in the bilateral world…(3) by introducing default and clearing funds, CCPs are able to mutualise losses in a transparent and predictable way…(4) most importantly, central clearing allows for the multilateral netting of exposures so that a given level of risk protection can be achieved with a smaller amount of collateral.”
Side effects and risks in central counterparty clearing
“Risk concentration within CCPs will grow, both nationally and internationally. CCPs are increasingly turning into institutions of unprecedented systemic importance.”
“A growing number of banks will participate in key CCPs across the globe. It is essential that the financial institutions that participate in and rely on CCPs are able to conduct effective due diligence to understand the risks they face as members.”
“Owing to mutualisation, losses and liquidity shortfalls in the event of a member default may spread to other participants. Crisis propagation may be further driven by interdependencies of changing complexity. These can exist between CCPs and other financial institutions, for example, through interoperability arrangements [arrangements across CCPs so that a user of one CCP can execute a trade with a counterparty that has chosen another].”
“Existing differences in regulation may lead to regulatory arbitrage and potentially to a race to the bottom.”
“It appears that for many banks, indirect access is their preferred way to get access to clearing services so as to comply with the clearing obligation. Client clearing seems thus to be dominated by a few large global intermediaries. A factor contributing to this concentration may be higher compliance burdens, where only the very largest of firms are capable of taking on cross-border activity. This concentration creates a higher degree of dependency on this small group of firms.”