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The central counterparties dominating the market for the clearing of over-the-counter interest rate and credit derivatives are globally systemic. Employing methodologies similar to the calculation of banks’ capital requirements against trading book exposures, this paper assesses the sensitivity of central counterparties’ required risk buffers, or capital requirements, to a range of model inputs. The authors find them to be highly sensitive to whether key model parameters are calibrated on a point-in-time versus stress-period basis, whether the risk tolerance metric adequately captures tail events, and the ability—or lack thereof—to define exposures on the basis of netting sets spanning multiple risk factors.
The market power of these major CCPs creates necessary conditions for them to be globally systemic financial institutions. Since the lion's share of these CCPs’ risk exposures is to the largest global banks, this also makes them especially effective shock transmitters. The post crisis commitment of the G20 countries to mandate clearing of all standardised OTC-D trades will, in the absence of a change to the market structure of global clearing services, serve to exacerbate the global systemic importance of these CCPs.
The enhancement of international prudential standards applying to internationally active banks—and their ongoing transcription into national regulation—are yet to find a parallel in the OTC-D CCP universe. While standard-setting bodies have upgraded the principles for regulation and supervision of financial market infrastructures including for CCPs, the standards—particularly those applying to advanced models and techniques for calculating risk buffers—are far from the level of detail and prescription that characterises the new standards agreed by the Basel Committee on Banking Supervision (BCBS) for banks using advanced internal models to capitalise their risk exposures.
Using conventional financial risk models and risk tolerance metrics, this paper conducts a range of sensitivity analyses to assess the impact of alternative model parameterisations on the size of CCPs’ required risk buffers.
The results indicate that capital requirements are very sensitive to a few key model inputs. The most important of these is the definition of the netting set used to determine a CCP’s outstanding exposures. The authors find that a widening of netting sets facilitated by use of model implied correlations and bases between (the market values of) derivatives instruments that map into different risk factor classes; (e.g. maturity or currency), considerably eases capital requirements. Using instead a methodology akin to the Basel 2.5 standardised approach, wherein netting sets are defined only up to a risk factor class, results in a first-order increase in the margin and the default fund requirements.
Other model inputs also exert a substantial impact. CDS contracts are characterised by discrete increases in loss experience when a default event occurs during a period of stressed markets. For CCPs clearing OTC-CDS, a departure from risk tolerance metrics that limit losses up to tail events towards metrics that limit losses in the tail can materially increase capital requirements. Calibrating returns, their volatility and market liquidity parameters on a stress period basis—similar to the stressed Value-at-Risk (VaR) capital charge against banks’ market risk exposures—significantly increases a CCP’s required margin and default fund. Capital requirements set by using VaR type metrics and based on point-in-time model inputs exhibit a high degree of procyclicality which can be mitigated by moving to stress period based parameter inputs. This has the benefit of attenuating the contagion impact on CCPs’ clearing members (CMs), and through them, also on the wider financial system.
The results suggest that there may be considerable benefits from prudential authorities adopting a more prescriptive approach that identifies acceptable risk tolerance metrics and sets a perimeter within which CCPs may calibrate key parameter inputs into their risk models. This process is already substantially further advanced for banks. Given banks’ dominant role in the market for OTC-D clearing, as the CCPs’ counterparties, there is a risk of providing them regulatory arbitrage opportunities if prudential standards for the same financial risks are different for banks and for CCPs. This concern may be brought into sharper relief going forward if BCBS’s on-going fundamental review of banks’ trading book capitalisation results in standardised supervisory approaches setting a floor for internal model based capitalisation.