Mitigating against a Clearing House collapse
“All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.”
These comments from the G20 in 2009, following the financial crises, encouraged a rush among financial institutions to centrally clear OTC derivatives where possible.
Central Clearing Counterparties (CCPs) sit in the middle of a cleared transaction, becoming the buyer to every seller and the seller to every buyer. They centralise the credit risk of the transaction whilst maintaining a flat risk position, lowering the likelihood and severity of contagion effects across the market in the case of counterparty default.
The process of centrally clearing derivatives isn’t new. The basis for the G20’s focus on clearing was the resilience shown by the CCPs in response to Lehman Brother’s collapse in 2008, and the agility they displayed to ensure that their clients were not subject to the same scale of loss as those parties within the OTC bilateral market.
As a result, trust is being placed in centrally cleared derivatives and the services of clearing houses are in high demand. Although European mandatory clearing regulation will not come into force until late 2015 at the earliest, ISDA estimates that 90% of the global interest rate derivatives market that can and will be mandated for clearing have already been cleared today. That’s over $200 trillion worth of notional outstanding cleared within a single asset class. Banks, therefore, have certainly made progress in reducing the wider effect of counterparty default by increasing their volume of cleared transactions.
However, as greater and greater risk becomes concentrated on just a few players in the market, John Dizzard of the FT argues that we – the taxpayer – are at risk of being responsible for a grand-scale bail out of those very institutions that we have turned to in order to mitigate against financial turmoil. I believe it’s more likely that, in the event of collapse, CCPs will be left with their empty hands outstretched in the direction of their member banks who already contribute significantly to loss absorbing funds, but even this could fall upon the taxpayer in the long run.
In light of this threat and following discussion across the industry, ISDA released a paper in November 2014 titled Principles for CCP Recovery. The paper details a number of best practice principles to minimise the risk of CCPs reaching, what they term, the Point of Non-Viability: when the CCP’s default management process has failed and the clearing house is no longer in a position to match transactions. Summarised, these five principles are:
1. Make all risk activities transparent to market participants
2. Regular stress testing of risk management methodologies to ensure their adequacy
3. CCP contributions to the loss absorbing pool to incentivise proper risk management
4. Robust plans to ensure that recovery of a CCP is less disruptive than full wind up
5. Understand the process for clearing service termination if steps to recover the CCP cannot be made
Standalone, these principles appear fairly straightforward; sensible even. Together, they certainly form a comprehensive approach to addressing concerns that risk management models haven’t evolved since 2008 and to ensuring that the CCPs do not find themselves in a state of financial distress.
Only time will tell if this advice is implemented consistently across CCPs, and indeed the effectiveness of it, but it is reassuring that the market is at least conscious of the potential risk bomb that clearing houses will represent as their importance continues to grow. If – or indeed when – it does go off, let’s hope that the CCPs, the banks and their clients are prepared.