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I will look at measures to improve the clearing of OTC derivatives through the expanded use of central counterparties (CCPs) and the introduction of margin requirements for those OTC derivatives that remain bilateral. In the United States, several agencies are working together to implement these reforms. The Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) are responsible for establishing the regulatory regime for and supervising CCPs as well as determining which swaps must be centrally cleared. The Federal Reserve and six other agencies are responsible for establishing margin requirements for derivatives that are not cleared through a CCP. The Federal Reserve shares with the other members of the Financial Stability Oversight Council (FSOC) an interest in CCP regulation and central clearing from a broader financial stability perspective. The Fed also plays a role in supervising financial market utilities that are designated as systemically important under Title VIII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank).
By design, central clearing offers important advantages over a bilateral market structure in which no participant can know the full extent of its counterparties' risk exposures. The hub-and-spoke structure of central clearing enables the netting of gains and losses across multiple market participants, which has the potential to significantly reduce each participant's aggregate counterparty risk exposure. Central clearing can also improve transparency, which is important in reducing incentives for market participants to pull away from other institutions in times of stress. Rather than trying to assess its exposure to all of its trading partners, a market participant would need to manage only its exposure to the central counterparty. And CCPs can also reduce risk by imposing more effective risk controls on clearing members. Since their origins in the 19th century, CCPs have evolved significantly, and that evolution has allowed them to survive and continue functioning through many crises, including the most recent one.
Of course, the other side of this coin is that concentrating risk in a central counterparty could create a single point of failure for the entire system. Given their heightened prominence in the financial infrastructure, if CCPs are to mitigate systemic risks they must hold themselves to - and be held to - the highest standards of risk management. In many respects, CCPs are the collective reflection of the financial institutions that are their members and the markets that they support. The credit and liquidity risks borne by a CCP arise from the clearing activities of its members. Those risks materialise when a clearing member defaults. Most of the financial resources to cover risk exposures will come from a CCP's members. And a member's default will require the CCP to work with surviving members in the context of prevailing market conditions. CCPs play a critical role in ensuring a robust risk management regime that fully takes account of this interplay among markets, institutions, and infrastructure. Regulators, clearing members, and their clients also must be engaged in making sure CCPs are safe and effective at managing the risks, interactions, and interdependencies inherent in the clearing process.
The PFMIs require that a CCP develop strategies to cover its losses and continue operating in a time of widespread financial stress. In particular, the PFMIs require that a CCP maintain financial resources sufficient to cover its current and potential future exposures to each participant fully with a high degree of confidence. CCPs must maintain additional resources to cover the failure of the clearing member with the largest exposure under extreme but plausible market conditions. In the case of CCPs with more complex risk profiles or those that are systemically important in multiple jurisdictions, the CCP must have adequate resources to handle the failure of the two clearing members with the largest exposures. Finally, the PFMIs require a CCP to identify scenarios that may potentially prevent it from being able to continue operations, including so-called end-of-default waterfall issues, and develop detailed plans for recovery or orderly wind-down. Regulators and industry groups are working to establish minimum expectations for CCP transparency of both qualitative and quantitative information that will allow key stakeholders to assess a CCP's risk management.
To measure and manage its liquidity risks, the PFMIs require a CCP to have effective methodologies to estimate its funding exposures under a variety of stressed conditions, to identify available cash resources, and to establish mechanisms for converting its noncash collateral to cash. The need to assure adequate liquidity presents a number of challenges. CCPs will need to mobilise cash within a matter of hours on the day of a large clearing member's default. Cash balances on deposit at a bank can be quickly accessed, but CCPs often put their cash resources in overnight investments to earn a return. The nature and mechanics of such investments, as well as prevailing market conditions, can critically affect the ability of a CCP to unwind those investments quickly enough to meet its cash needs. A similar challenge will arise with the need to convert noncash collateral, such as initial margin collateral, to cash. The PFMIs require CCPs to have in place prearranged and highly reliable funding sources to address this need.
While central clearing is important and is expected to increase substantially over time, a significant portion of nonstandardised, bespoke derivatives will never be suitable for central clearing. This bilaterally cleared part of the market was a principal source of systemic risk during the crisis. For noncentrally cleared derivatives, margin requirements will serve as the main tool to mitigate systemic risks. The Basel Committee on Banking Supervision (Basel Committee) and the International Organisation of Securities Commissions (IOSCO) have recently finalised a framework for margin requirements on noncentrally cleared derivatives that provides for harmonised rules and a level playing field, which is important given the global nature of derivatives markets. Regulatory authorities in participating countries are now in the process of developing margin rules for noncleared derivatives in light of the international framework.
The framework requires both financial firms and systemically important nonfinancial firms that trade derivatives to collect both variation margin and initial margin, as is the case for centrally cleared derivatives. The initial margin requirements represent a significant change to existing market practice and will undoubtedly impose some costs on market participants. As originally proposed, the new framework would have required most market participants to collect initial margin from the first dollar of exposure. The International Swap Dealers Association estimated that roughly an additional $1.7 trillion in initial margin would have been required globally. In light of this concern, the framework was released for public consultation on two separate occasions and the Basel Committee and IOSCO conducted a detailed impact study to determine the potential liquidity costs of the new requirements.
The financial crisis revealed significant flaws in the structure of the OTC derivatives markets that are now being addressed as part of a worldwide reform effort. Increased central clearing and margins for noncleared derivatives are foundational elements of the program. Together, these reforms can help create a system in which the OTC derivatives market infrastructure acts as a pillar of strength in the next crisis. To achieve this goal, it is imperative that international standards such as the PFMIs and the margining framework for noncentrally cleared derivatives be forcefully and consistently implemented across the globe.
Implementation of the new framework will present some real-world challenges. National rules still need to be written, including rules for margin requirements on noncentrally cleared derivatives. These national rules will need to deal with local legal regimes and markets, yet also be internationally consistent to ensure a level playing field. More broadly, international cooperation will be needed to ensure that the new framework works in practice.