Central Counterparties Help, But Do Not Assure Financial Stability
Central counterparties (CCPs) provide derivative markets with benefits of multilateral netting and better collateralization, assurances of trade finality and settlement, and help bolster the market integrity.
Strengthening CCPs is a necessary but hardly sufficient condition to ensure financial system stability. Macroprudential policy should supplement the work of CCPs with attentive monitoring and rapid resolution procedures:
Market liquidity conditions must be monitored vigilantly to ensure effective price discovery and market continuity. Regulators and supervisors must stand ready to support illiquid financial intermediaries if CCPs and markets threaten to seize.
A fast and certain recovery and resolution procedure of a failed CCP is essential. It would facilitate the CCP’s recapitalization and its ability to resume its function within the financial system.
By stepping into the middle of trades, a CCP becomes “the buyer to every seller and seller to every buyer,” providing several benefits to market participants and promoting financial stability via multilateral netting and centralized default management.
Since the reform, CCPs have become an indispensable part of the infrastructure for derivative trading. Around Central counterparties (CCPs) play a pivotal role in the post-crisis reforms of derivative market trading, especially for over-the-counter (OTC) derivatives. 75 percent of swaps are now cleared through clearinghouses, compared with just 15 percent before the 2007-2009 financial crisis.2 Such an increase in the concentration of trading exposure led regulators and market participants to worry about the resilience of CCPs to systemic shocks. The first regulatory reaction was to designate the largest CCPs as systemically important financial market utilities (SIFMUs), and to develop stress tests to evaluate their robustness and identify vulnerabilities. Furthermore, a default waterfall—a cascade of risk-mutualization backstops—is being designed to minimize the risk and the impact of a CCP member’s failure.
Despite their critical role in ensuring trades, regulators may become over-reliant on CCPs to safeguard the financial system. This note highlights some commonly held misconceptions and overly-complacent conclusions about CCPs’ ability to stabilize financial markets, especially in the presence of systemic shocks. The current framework has been successful in reducing bilateral counterparty risk and securing CCPs’ ability to clear securities trading. Yet, still missing is a full assessment of the consequences of CCP operations on other segments of the financial ecosystem, apart from their impact on derivatives trading.
Strengthening CCPs is a necessary but hardly sufficient condition to ensure financial system stability. In a post-crisis environment that is still reformulating and issuing new regulations, macroprudential regulators should be mindful of policies aimed at improving CCP functioning, inducing unintended consequences. Policymakers should also evaluate the potential for CCP margin requirements to be pro-cyclical, especially as CCP members become more interconnected among themselves and with other parts of the financial system. Policies that impose added responsibilities to CCPs may tax their ability to raise additional capital or liquidity during stressed market conditions. It is vital that in implementing new policies, assessments include how changes in CCP and market behavior affect third parties. Indeed, the new policies may induce undesirable and destabilizing system-wide behaviors.
Proactive measures by supervisors and regulators are needed to supplement the enhanced role of CCPs and related changes to other parts of the financial infrastructure. Despite the potential for CCPs to ensure that derivative markets function smoothly, vigilant oversight by the public sector over systemically important functions of CCPs may still be needed to ensure the continuity of the trading system. Regulators and supervisors need to monitor market liquidity conditions, ensure effective price discovery, and stand ready to support illiquid financial intermediaries if CCPs and markets threaten to seize.
The remainder of the note briefly summarizes the role of CCPs and their benefits before identifying some key issues that will shape macroprudential policymaking going forward.