The IMF report shows that properly regulated CCPs reduce counterparty risk among OTC derivatives market participants. Systemic risk is also in part reduced due to the ability to net transactions across multiple counterparties. However the short-run costs of moving contracts to CCPs are high.
The report shows that soundly run and properly regulated CCPs reduce counterparty risk— the risk in a bilateral transaction that one party defaults on its obligations to the other—among OTC derivatives market participants. Importantly, systemic risk—the risk of knock-on failures from one counterparty to another—is also reduced due in part to the ability to net transactions across multiple counterparties.
CCPs also have other risk-mitigating features that ensure that payments to others occur when counterparty defaults. Nevertheless, movement of contracts to a CCP is not a panacea, since it also concentrates the counterparty and operational risk associated with the CCP itself.
The chapter makes recommendations for best-practice risk management and sound regulation and oversight to ensure that CCPs will indeed reduce risk. This may mean that existing CCPs will need to upgrade their risk management practices and that regulations will need to be strengthened. A big part of this is making sure that there is coordination among regulators and other overseers on a global basis to ensure that the playing field is level and that it discourages regulatory arbitrage. Contingency plans and appropriate powers should also be globally coordinated to ensure that the financial failure of a CCP does not lead to systemic disruptions in associated markets.
To achieve the multilateral netting benefits of a CCP, a critical mass of OTC derivatives needs to move there. However, this will be costly for some active derivative dealers. CCPs require that collateral (called initial margin) be posted for every contract cleared through them, whereas in the OTC context dealers and some other types of participants tend not to currently adhere to this practice. As a result, active OTC derivative dealers, those likely to be members of CCPs, will incur costs in the form of the increase in posted collateral and, if enacted, potentially higher regulatory capital charges against remaining derivatives contracts on their books. Hence, without an explicit mandate to do so there is some uncertainty as to whether dealers will voluntarily move their contracts and whether enough multilateral netting can be achieved. An approach that uses incentives based on capital charges or a levy tied to dealers’ contribution to systemic risk could be used to encourage the transition.
The analysis in this chapter shows that CCPs can reduce systemic risks related to counterparty risks that are present in the bilaterally cleared OTC contracts, but that the short-run costs of moving contracts to CCPs are indeed far from trivial. Hence, because the relevant institutions are already challenged to raise funds and capital in the post-crisis period, a gradual phase-in period is warranted.
© International Monetary Fund
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IMF on OTC derivatives chap3.pdf
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