Central Clearing of Derivatives Entails Significant Systemic Risks

Unregulated competition of central counter parties (CCPs) may endanger the entire financial system / New SAFE white paper calls for a centralization of CCP regulation and supervision

New regulation in the U.S. (Dodd-Frank-Act) and in Europe (EMIR) renders the involvement of a central counter party (CCP) mandatory for standardized OTC derivatives’ trading. An estimated 50% of all interest rate and credit derivatives are currently cleared via a CCP. In a new SAFE policy white paper, Jan Pieter Krahnen and Loriana Pelizzon, both Professors at Goethe University Frankfurt and the Research Center SAFE, argue that although the involvement of CCPs is suitable to reduce contagion risks, it also creates a potential systemic risk that may undermine the stability of the entire financial system. Despite this extreme risk, regulation and notably supervision of CCPs has remained quite fragmented to date. Jan Pieter Krahnen: “It is high time that politicians and regulators take into consideration the systemic risks that may evolve from central clearing. In order to delimit the emergence of financial crises, an internationally coordinated regulation and supervision of CCPs is indispensable.”

Derivative transactions are intertemporal by nature and thus require some sort of credit relationship between the counterparties. If one defaults on the deal, the other may suddenly turn out to be unhedged. In order to avoid contagion effects among the trading parties, the regulators in the US and in the EU have stipulated the obligatory involvement of a CCP in the trading of standard derivative contracts – implying risk adequate collateral postings from both parties.

Thus CCPs dramatically reduce the risk of system-wide instability, which otherwise would prevail in a world of financial institutions interconnected through derivative contracts. However, despite the great improvement brought about by CCPs, there is also a downside: A default of the CCP itself, should it ever happen, is likely to have pervasive consequences for financial stability worldwide.

Risks emerging from competition and consolidation

According to Krahnen and Pelizzon there is an odd couple of factors increasing CCP-induced stability risk: the growing competition among CCPs worldwide, which goes hand in hand with CCP consolidation. The default risk results from the fact that CCPs are competing for market share. Such competition may induce CCPs to apply “predatory margining”: a reduction of collateral requests in order to be cheaper than competitors and, thus, to increase market share. As the stability of a financial system critically depends on collateral requirements, an unregulated competition endangers the entire system.

Moreover, the default risk of CCPs is all the more relevant for the financial system, the more consolidated its CCPs are. Thus, competition and consolidation work hand in hand, increasing the systemic relevance of CCPs – and hence the likelihood that there will be a government bailout, should push comes to shove.

Lessons for regulation and supervision

As a consequence, supervision of CCPs, which is currently organized in a decentralized setting, urgently needs to be supra-nationally coordinated. Supervisory standards and practice should be the same for all CCPs, irrespective of their location, in order to avoid a race to the bottom of regulatory standards, as well as protective behavior towards national champions by their local supervisor.

Therefore, the authors suggest to centralize CCP regulation and supervision in one agency covering as many economies as possible in which CCP counterparties are domiciled, thus encompassing the whole set of countries that would ultimately face the bailout bill should a systemic risk event ever happen. Given the current institutional set-up in Europe, the single supervisor for CCPs could well be the European Securities and Markets Authority (ESMA), the Single Supervisory Mechanism for banks (SSM), or a newly established institution.

CCP of merged Deutsche Börse/LSE should be domiciled in the EU

This last point is also of relevance in the current debate about the future location of a merged Deutsche Börse-London Stock Exchange entity. As the authors argue, a consolidated CCP run by the merged entity – or both CCPs if LCH.Clearnet and Eurex.Clearing remain separate businesses – should be domiciled within the borders of the European Union, preferably the Eurozone, with a single EU-wide supervisory agency being in charge of monitoring CCP management, particularly its margining policy.

Download SAFE White Paper No. 41