Derivates : The Risk is shifting to CCPs

At the annual general meeting of the International Swaps and Derivatives Association in Singapore concluded

June's multi-colored eyes

yesterday,a group of panelists highlighted the lack of clarity over resolution for failed Central counterparty (CCPs) as a significant concern for the G20 objectives of eliminating systemic risk.

Central counterparty clearers stand to be the next “too-big-to-fail” institutions and could pose an acute threat to the
financial system if regulators stall on plans to manage the potential failure of a clearing entity.

There are two main processes that are carried out by CCPs: clearing and settlement of market transactions. Clearing relates to identifying the obligations of both parties on either side of a transaction. Settlement occurs when the final transfer of securities and funds occur.

CCPs benefit both parties in a transaction because they bear most of the credit risk. If two individuals deal with one another, the buyer bears the credit risk of the seller, and vice versa. When a CCP is used the credit risk that is held against both buyer and seller is coming from the CCP, which in all likelihood is much less than in the previous situation.
The G20 objectives agreed in 2009 deem that no financial institution should be considered too big to fail and thattaxpayers should not bear the costs of resolution for any institution that does fail.
While regulators have been busy penning rules to deal with the problem of too-big-to-fail banks, concerns are shifting to clearing houses, and the increased concentration of risk held in them as the Dodd-Frank Act in the US and the European Market Infrastructure Regulation push an increasing number of standardised over-the-counter swapsthrough central counterparties.

“We’re getting very close to solving too big to fail globally for banks, but I worry that this risk could move to CCPs. I’m not convinced that we have made CCPs deeply resolvable yet – we have to do that to address systemic risk issue in a thorough way,” Wilson Ervin, vice-chairman of the group executive office at Credit Suisse told IFR.

While the Financial Stability Board addressed basic principals for clearing house resolution in June 2012, the issue remains on the back burner with many regulators as they continue to get to grips with a workable bank resolutionregime.

“We’re still grappling with how to deal with the failure of a financial institution and there’s a lot more work to do on CCPs,” said William Coen, deputy secretary of the Basel Committee on banking supervision at the Bank for International Settlements.

The Financial Stability Board has penned some initial principals for resolution of clearing houses in the event of failure in June and has garnered high level public sector support on the topic from the Bank of England and Bank of Canada,but until a solution is agreed, some believe that the risks associated with clearing could be outweighing the benefits.

Adding to those concerns is the fear of changing risk dynamics of clearing as the addition of buyside in the clearing model raises the number of CCPs involved in the clearing of OTC swaps, causing greater fragmentation.

CCPs have some positive attributes – it’s good to have better information and clearing transparency. But the original notion that a clearing house would net out most of the world’s credit exposure could be undermined if CCPs proliferate, and frustrate the original idea of getting lots of risk reduction by running all trades through a central body.

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