Regulators have seized on central counterparty (CCP) clearing as a solution to some of the risks in the over-the-counter derivatives markets. But Kevin White of Ineum Consulting warns that they should be careful.
Regulators have seized on central counterparty (CCP)
clearing as a solution to some of the frightening risks they
perceived in the over-the-counter derivatives markets. But as
we draw closer to the moment when crucial decisions are
Kevin White, lead financial services
partner at Ineum Consulting, argues that the authorities should
Counterparty exposure, especially in the credit default swap
market, as reflected in the failure of Lehman Brothers and Bear
Stearns, has been deemed a potential cause of systemic risk.
Therefore, US treasury secretary Timothy Geithner has
proposed a plan to require the clearing of all over-the-counter
derivatives through a central counterparty (CCP). He has also
suggested the possibility of standardising OTC derivatives so
that they may be traded on exchanges.
But CCP clearing may not be the panacea that the market and
elected officials are banking on. It is vital that the
regulators consult fully with market stakeholders before
putting forward any recommendations.
OTC derivatives are bilateral contracts for good reason
– they are designed to hedge specific risks, or create
specific exposures. Standardised CCP contracts cannot meet the
very specialist demands of the OTC market. A hedger will face
basis risk when a standardised contract does not match his
specific exposure requirements. The greater the
standardisation, the higher the risk.
In addition, the potential liquidity risk may not be fully
appreciated by regulators. Margin calls on open exposures can
drain liquidity, so much so that they could trigger systemic
For example, it is reliably reported that the
lion’s share of the $180bn bailout of AIG related
to margin calls. In the absence of a bailout, the impact of the
margin calls would likely have been the collapse of AIG, and
potential systemic risk to the global financial system.
Liquidity is also required for accurate and transparent
valuation of derivatives. The recent lack of confidence in
financial institutions was caused by an inability to accurately
value their mortgage-backed securities holdings in an illiquid
So too, regulators, when standardising esoteric OTC
derivatives contracts, should be aware that markets may not be
sufficiently liquid to support transparent pricing.
CCPs manage risk through margin calls on open positions.
These margins are based on algorithms that take into account
historical volatility and correlation. Complex derivatives may
encompass multiple asset classes. Under the proposed plans,
CCPs will now be carrying correlation risk in their computation
of margin for cross-asset positions. So it is entirely feasible
that risk may be underestimated.
Finally, CCPs potentially introduce a central point of
failure. The policy may create institutions that are too big or
too connected to fail. In 2007, Jean-Claude Trichet, president
of the European Central Bank, stated that "the failure of a
central counterparty can severely disrupt markets." CCPs must
be sufficiently robust.
CCPs can be made to work if complex OTC contracts are traded
as bilateral contracts, then novated by both counterparties to
a CCP. The CCP will then manage the margins and become the
counterparty to each of the original transactions.
But it is essential that the market must be consulted on any
detailed proposals, lest key nuances are ignored.
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