The Demand for Central Clearing – To Clear or Not to Clear?

Topic and Objectives

The Financial Crisis of 2007 and 2008 exposed a number of systemic weaknesses in financial market infrastructure in the market for over-the-counter (OTC) derivative securities. In particular, the market for credit default swaps (CDSs) is characterized by highly concentrated and interconnected positions that serve as conduits for the transmission of systemic risk in the event of counterparty failure.

The primary regulatory response to the threat of systemic counterparty failure is central clearing. The U.S. Congress signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) into law in July 2010, and the European Parliament and the Council of Ministers agreed to the European Market and Infrastructure Regulation (EMIR) in August 2012. Both reforms are designed to promote financial stability by improving accountability and transparency in the financial system. Financial regulators identified the OTC derivatives market as a key source of instability, and an overarching aim of the DFA and EMIR is to mitigate the buildup and transmission of systemic risk in the swaps market. Due to their interconnected nature of CDS counterparties, the failure of one counterparty can precipitate the sequential failures of other counterparties. Given the large size of the net economic exposures between swap dealers, the possibility of correlated counterparty failures is systemically important (Girardi, Lewis, and Getmansky (2015)).

The DFA imposes regulatory requirements to centrally clear standardized CDS contracts, the decision to clear, however, is voluntary until the DFA is finalized. Despite strong encouragement from the SEC, the number of contracts actually being cleared continues to be a relatively small fraction of total notional activity, even for those that are eligible for clearing. With this project, we focus on the following question: Why only some contracts have to be cleared and others not?  We investigate from a market-dealer perspective what are the drivers of this decision. This is important because it will make aware the regulators of how they are affecting the decision on this regard. This means that is also indicating what are the implicit costs the regulators are imposing with this rule, which are the unintended costs of regulation.

Key Findings

• Among CDS contracts that qualify for clearing, most are in fact cleared.
• The decision to clear depends on the cost of CCP margin against the additional capital required for un-cleared transactions.
• Dealers clear contracts that are safer and more liquid tend to flatten exposures to the CCP made between higher-risk traders.
• Less than half of dealer-to-dealer CDS trades’ notional value qualify for clearing.
• In the authors’ view, ICE would need to change eligibility requirements if CDS contracts are to be predominantly cleared.