03 June 2011

ISDA publishes a discussion paper 'The Economics of Central Clearing: Theory and Practice'

Regulations requiring the clearing of certain OTC derivatives through central counterparties are causing profound changes in market structure and trading practices. This paper by Craig Pirrong discusses how CCPs are structured and what effects increased use of them will have on the financial system.

The principal risk in the financial system which CCPs seek to address is counterparty credit risk. CCPs intermediate between OTC derivatives counterparties, and thus face substantial counterparty risk. This is partially mitigated as CCPs demand collateral (or 'margin') from their counterparties, through the netting of positions, and through other forms of credit enhancement.

Due to the size and importance of the risks that they bear, CCPs must have strong risk management practices to ensure that they can correctly value, call for margin on, and control the risks of all cleared positions. In order to facilitate this, and since complex or illiquid products can impose substantial risks on a CCP, OTC derivatives clearing should focus on liquid, standardised products.

Firms directly clearing with a CCP are known as clearing members. If a clearing member fails, the CCP may facilitate the orderly replacement of its cleared positions by, for instance, auctioning the defaulting member's portfolio to other clearing members. Thus CCPs can reduce the disruptive effects of default.

CCPs are important inter-connectors in the financial system and thus likely to be systemically important financial institutions. Their operations transform systemic risk. They can both decrease it (for instance by reducing the impact of clearing member failure), and increase it (for instance by increasing margin requirements during a period of financial stress). It is vital to understand the various mechanisms by which CCPs affect the financial system in order to assess their contribution to financial stability. This is particularly true as CCPs have failed in the past.

It may be the case that a CCP, while solvent, cannot meet immediate demands for the return of clearing member collateral (or other cash calls made on it). Central banks should be aware of this risk and make provision to mitigate it. This could, for instance, include either direct CCP access to central bank funding, or central bank lending to clearing members. To avoid the moral hazard problems that such lending mechanisms can create, it is essential that CCPs be subject to close prudential oversight of the same standard as that which applies to other large systemically important financial institutions.

CCPs are a risk pooling and sharing mechanism. In particular, clearing members provide funds to the CCP for a default fund which can bear the costs of counterparty non-performance should margin provide inadequate. The use of a default fund results in risk mutualisation. Like most such mechanisms, clearing is susceptible to moral hazard and adverse selection issues. These become more significant if CCP membership is more heterogeneous or if more complex products are cleared. Thus CCPs are best served by relatively high membership criteria which are still consistent with equitable access to clearing.

Central clearing is subject to strong economies of scale and scope arising from netting economies and diversification effects. These scale and scope economies favour the use of a small number of 'utility' CCPs. Fragmentation of clearing on jurisdictional lines will increase the costs and risks of clearing, including systemic risks.

The governance of CCPs is an important issue: CCPs should be organised so as to align the control of risks with those who bear the consequences of risk management decisions. Failure to align rights with risk bearing will tend to decrease the effectiveness of CCPs in reducing systemic risk.

Some derivatives counterparties will not be CCP clearing members. If they wish to clear, these parties will have to find a clearing member to act for them. Margin will still be required on their portfolio, and thus they could potentially be exposed to the default of that clearing member. There are two key mechanisms by which CCPs can reduce the impact of this:

- CCPs can adopt a variety of rules regarding the segregation of client margin. These rules not only affect the allocation of the risk of clearing member (and client) default, but also the incentive which clients may have to monitor the credit quality of their clearing members.

- CCPs may facilitate the ability of clients to port their positions from one clearing member to another. This can reduce client exposure to default losses, and discourage customers from engaging in destabilising runs, but reduces their incentive to monitor the riskiness of their clearing firms.

Note, though, that central clearing is subject to some potential legal risks, notably relating to segregation and netting. It is vital that CCPs have the highest level of confidence that their purported arrangements here will perform as advertised during and after a default.

Clearing mandates will affect the behaviour of market participants on many dimensions, including: trading behaviour, the sizes of positions, funding strategies and needs, and capital structure (leverage). Many of these effects will be unintended, and in fact often reverse (at least partially) the intended effects of clearing mandates. These indirect, unintended effects are difficult to predict in advance of the implementation of mandates, but are likely to be widespread and profound, and have important systemic implications. Policymakers should be acutely aware of the potential for such effects, monitor them carefully, and be prepared to adjust policies in response to them.

Full discussion paper

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