But moving counterparty risk from banks to CCPs does not eliminate it. It means risk will instead be shifted from individual banks to new institutions similar to concentrated “risk nodes” in the financial system.
Little progress has been made on crisis resolution frameworks for unwinding large banks, let alone huge new institutions called CCPs that would house trillions of dollars in financial derivatives. Thus, the underlying economics of having more “too-big-to-fail” entities needs to be justified.
Financial statements show that each of the large banks active in the OTC derivatives market in recent years carries an average of $100 billion of derivative-related tail risk; that is, the potential cost to the financial system from its collapse after all possible allowable “netting” has been done within the bank’s derivatives book and after subtracting any collateral posted on the contracts. Past research finds that the 10-15 largest players in the OTC derivatives market may have about $1.5 trillion in under-collateralised derivatives liabilities, a cost taxpayers may have to bear unless some solution to the “too-big-to-fail” question can be proffered.
Housing derivatives in one single global CCP backstopped and regulated by the leading central banks would have been an ideal “first-best” solution as it would enhance netting, reduce collateral cost and “house” overall risk in one place. A “second best” solution would have involved a few linked CCPs scattered around the globe. However, local politics has resulted in the least-best outcome. A plethora of CCPs are being created because countries such as Australia and Singapore do not want to lose oversight to an overseas entity incorporated in a foreign country.
In a CCP world, a decrease in the reuse of collateral may be significant as there is increasing demand from some derivative clients for “legally segregating” margin that they will post to CCPs. The MF Global and Peregrine sagas have resulted in increased demand for segregation, so the collateral velocity or reuse within the OTC derivatives market will fall further, and may lead to a cottage industry in “collateral transformation” reminiscent of the mid-2000 securitisation in the housing market.
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