15 April 2012

New York Federal Reserve Chief, William Dudley: How we will stop derivatives magnifying future crises

Dudley argues that the Lehman episode was only one example of the shortcomings in the $19 trillion over-the-counter derivatives market exposed by the financial crisis. In the boom years, the opaque nature of the market allowed large concentrations of risk to grow, out of sight of regulators.

When the crisis broke, the same opacity made it impossible for market participants to assess the true health of other financial firms. There were strong incentives for counterparties to demand more collateral or to move their trades at the first sign of trouble. This process drained liquidity from stressed businesses in a modern-day version of an old-fashioned bank run.

To address these and other weaknesses, regulators have been working to strengthen incentives to standardise trades and to clear them through central counterparties, while improving transparency through mandatory reporting of all OTC trades to official repositories.

Requiring that derivatives trades be cleared through central counterparties – institutions that stand between the two parties to a derivatives trade and guarantee its performance – can improve financial stability. They reduce “run risk” since participants no longer have direct exposures to a firm whose financial health is uncertain. And gross exposures – the bilateral claims of each dealer against all other dealers – can be netted down to a much smaller set of claims against the central counterparty.

This is where a set of new global standards, released today by the Committee on Payment and Settlement Systems and International Organisation of Securities Commissions, come in. They toughen requirements for how central counterparties manage risk. For example, they impose rigorous stress testing and margin requirements to guard against potential exposures even in extreme conditions.

The new standards do this by providing four safeguards. The first is a framework for international oversight of central counterparties. The second is a requirement that global central counterparties must allow open access on terms that promote competition. The third is a standard that a central counterparty must have adequate emergency liquidity in all the currencies in which it operates. And the fourth is a requirement that each central counterparty builds in procedures by which – in the highly unlikely event its own viability became threatened – it could be recapitalised or wound down in an orderly manner.

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