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 made, Kevin White, lead financial services partner at Ineum Consulting, argues that the authorities should be careful.

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 risk.

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 market.

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.