Since 2009, when G20 leaders agreed that all standardised derivatives contracts should be funneled through CCPs, central clearing has rapidly evolved. So much so that by 2014 more than half of the notional amount outstanding of derivatives transactions was centrally cleared, Bank of International Settlements (BIS) statistics show, almost double the percentage of 2009.

Further clearing obligations in Europe are also set to boost the volumes of centrally cleared trades. A recent study by the FSB suggests there is ample room for the further expansion of central clearing, particularly for most of the basic interest rate contracts. Even larger increases could potentially take place for other contracts such as credit default swaps, for which the centrally cleared volume is relatively low globally at 34% at the end of December 2015.

Systemic risk

However, as the range of banks and other financial institutions that channel their transactions through CCPs continues to broaden, the growing interconnectedness is raising more and more questions as to whether CCPs themselves might spread losses in the case of default. They may simply alter where systemic risk is concentrated, rather than reduce it. 

“By their nature, CCPs are deeply interconnected with large financial companies and potentially with other CCPs,” says Hester Peirce, director of the Financial Markets Working Group, a diverse group of seventeen economists focusing on the causes of financial crises and their potential solutions.

“CCPs have direct relationships with clearing members and settlement banks, which tend to be large firms, and indirect relationships with clearing members’ customers, which may also be large firms,” says Peirce, who has worked on financial regulatory reform since the crisis has been involved in the oversight of Dodd-Frank Act implementation. “The intricacy of these relationships makes it difficult for market participants and regulators to get a good understanding of the risks associated with CCPs.” 

Piece cited the University of Houston’s Craig Pirrong in a 2016 research journal: he said clearing has turned out to be the “mother of all interconnections” due to every big financial institution being linked to all big CCPs, and because “pretty much everyone has to funnel the bulk of their derivatives trades through clearinghouses”.

The authorities, trade bodies such as ISDA and the CCPs themselves are fully engaged; they are well aware of the issues and are continuing with international workstreams related to CCP resilience, recovery and resolution. In April 2015 a workplan was agreed by the chairs of the BCBS, CPMI, FSB Resolution Steering Group and IOSCO. Two reports have been published so far, setting out the progress made in implementing the workplan and the timelines for what can be expected in 2017, which includes the development of more granular guidance for a CCP rescue scenario and analysis of central clearing interdependencies.

“The resilience of CCPs is back on the agenda,” says Philip Whitehurst, head of service development for SwapClear, LCH’s interest rate swap clearing platform. “However, there are perhaps some misplaced concerns as I would argue that a cleared environment is a much safer place than a bilateral world. That said, LCH fully supports efforts to strengthen the resilience of CCPs.”

Skin in the game

An LCH research paper published last year concluded that initial margin must remain the first and most important defence and must be sized, along with default funds, to ensure that sufficient resources are available to manage the risk of a member default. 

“We’re firm advocates of the defaulterpays model,” adds Whitehurst. “Our default waterfall is also set up so that if default losses are not fully absorbed by the defaulter’s own resources, the CCP’s capital takes the first hit before any losses are borne by non-defaulting members.”

Mariam Rafi, managing director, Americas, head of OTC derivatives clearing at Citi, agrees that a defaulterpays model is the appropriate away to manage risk in CCPs. “By that we mean the clearinghouse should cover risk via initial margin, as opposed to guaranteed fund amounts that are socialised,” she says. 

“Generally speaking, margin levels have been calibrated to be very conservative and tend to be higher than what was historically collected in the bilateral space. The leverage in the system has gone down. There’s a larger margin posted against transactions, making them safer.”

However, Rafi suggests more consideration should be given to the “skin in the game” of CCPs. “I think that they need to be dynamic and risk-based,” she adds. “A lot of clearinghouses have significant cleared activity but their own contributions remain fairly small and static. I don’t think that is appropriate considering they are commercial entities and are responsible for overseeing the risk in their CCP. Incentives should be aligned to keep clearinghouses as conservative, and based on a defaulterpays model, as possible.”

Gaspard Bonin, deputy head of derivatives execution and clearing at BNP Paribas, says the work around CCPs, much like other areas of reform, is intricate and will be time consuming. “There’s a general question mark across market, industry and regulators. How will the market work in the long term, i.e. how safe and sustainable is it with the new regulatory framework and how will it adapt? The recovery and resolution of CCPs has become an important and complex debate, touching upon such tail situations that are difficult to anticipate and properly frame.”

LCH’s paper also acknowledges the significant work being done by banks to strengthen their own balance sheets, adding that CCP recovery and resolution cannot be considered in isolation from the recovery and resolution regimes that have already been introduced for clearing members. 

“CCP resilience has benefited greatly from the general strengthening of banks’ balance sheets and the introduction of bank recovery and resolution regimes,” adds Whitehurst. “That said, there remains a pretty sharp incentive on us to make sure we have collected sufficient margin. If we haven’t, we’re next in line, and 25% of our capital goes into this skin in the game layer.” 

The latest progress report on CCP resilience from the FSB and other regulators, published in August, asserts that the CCPs have made “important and meaningful progress” in implementing arrangements consistent with the financial risk management and recovery standards of the Principles for Financial Market Infrastructure (PFMI) rules.

Some gaps and shortcomings have nevertheless been identified. In the area of recovery planning, in particular, a number of CCPs have not yet put in place the full set of recovery rules and procedures envisaged in the PFMI.

In the areas of credit and liquidity risk management, others have yet to put in place sufficient policies and procedures to ensure that they maintain the required level of financial resources on an ongoing basis, including adequate arrangements to ensure a prompt return to the target level of coverage in the event of a breach. 

Moreover, some do not include sufficient liquidity specific scenarios in their liquidity stress tests. For such CCPs, the report concludes these are serious issues of concern that should be addressed with the highest priority.