Clearing works best in the case of standardised products that trade in deep and liquid markets — and when clearing houses are backed by strong capital structures and robust risk-management capabilities. In these conditions, clearing can lower counterparty risk, reduce interconnectedness among banks and improve price transparency.

Yet in other markets, clearing houses can themselves become centres of concentrated risk and sources of contagion, amplifying systemic problems instead of alleviating them. They are particularly unsuited to complex, illiquid products that are susceptible to sudden and severe price gaps. Forcing central clearing on such markets can have serious repercussions.

Clearing reduces risk; it does not eliminate it, and much of the residual risk ends up concentrated in the clearing houses themselves. Economies of scale mean these institutions typically operate as monopolies or duopolies. Clearing houses are designed so that losses too big to be absorbed by their own thin slices of capital are mutualised among their members, most of which are banks. If one member is unable to meet its obligations, the others become liable. As a result, if clearing houses do falter, they may become new sources of contagion — the very problem they are meant to eliminate.

There are lessons here for regulators and the industry. First, product suitability is crucial. [...] Second, robust risk management cannot be sacrificed to competitive pressures. [...] Third, clearing houses need governance structures that put systemic stability ahead of competitive concerns. [...]

Ultimately, instead of seeing clearing as a panacea, regulators should take a more nuanced view that recognises its limits.

Fortunately, this shift may already be under way. Regulators are now considering recovery and resolution planning for clearing houses, probably because they recognise that some of them may already pose a risk to financial stability.

But focusing on recovery and resolution, while important, misses the main point. Regulators and the industry alike should instead maintain their focus on ensuring that the failure of clearing houses never becomes a real possibility. This would return clearing to its original form: an innovative source of risk reduction that promotes systemic safety.

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