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Centralized Derivatives Clearing: Increasing Systemic Risk?

February 17, 2010

After the unprecedented events of the last 18 months, there has been a gathering tide that points to more regulation on much of the financial industry. Much of this has been hotly contested, but the one piece of regulation that seems to have avoided much of the hubbub is derivatives clearing.

The idea of centralized clearing is nothing new. Equity and option trades already flow through a centralized clearing agency (the DTCC and the OCC respectively) whose job it is to act as a neutral third party, guaranteeing that the purchased securities and proper payment are delivered to both parties. In the event that your counterparty goes out of business or otherwise fails to deliver what you are owed, you will still receive your half of the transaction. This counterparty risk caused tremendous concern for many market players in the depths of the market crash, when no one was sure that the firm to whom you just shipped millions worth of securities would actually deliver the money that was owed to you (or vice versa).

However, not until very recently has the idea of centrally clearing derivatives, the shadowy cousin of equities and options, gained traction. This is not particularly concerning until you consider the astounding values of these contracts: according to the Bank for International Settlements, there were $604.6 trillion worth of over-the-counter (OTC) derivatives outstanding as of June 2009. Of these, the vast majority ($437 billion, or just over 72%) were interest rate swaps, which are a fairly standardized form of derivative. Adding fuel to calls to regulate and centrally clear these instruments are the outsized role they played in this financial crisis: AIG was brought down by the large number of credit default swaps (CDS)  it had written that it was unable to pay out with the CDSs were called in. From a regulator’s perspective, centralized clearing makes sense because it forces the market to standardize many of these contracts, making them easier to understand by market participants and allowing the regulator greater latitude over what types of derivatives can be traded.

Given the outsized role and astounding notional value of these instruments, the case for central clearing seems to be a slam dunk. And in many ways, it does. A consortium of industry players has already gotten together to establish their own central clearing party which is already clearing many interest rate swaps. But there is still a lot of talk of making such clearing mandatory, and for additional asset classes, through establishing additional regulatory rules that all market participants must adhere to.

However, it seems to me that there is one big issue here that I haven’t seen addressed, and that could actually lead to increased systemic risk. Clearing agencies are able to guarantee transactions because they operate like an insurance company, charging each market participant a small fee on each transaction, and using these funds to pay out claims in the event that a counterparty defaults for whatever reason. The problem comes from two things:

  1. The tremendous value of some of these contracts that would have to be paid out in the event of default
  2. The relatively small number of transaction for the less common (i.e. non-interest rate swaps) instruments

These two things combined together mean that the clearing organization would have to collect a much larger fee per transaction from market participants in order to cover the risk of having to pay out in the event of default–more than may even be reasonable, or possible without completely gutting the market. Additionally, as we have seen with recent market events, particularly AIG, these derivatives tend to come due all at once, and in astronomical values, further increasing the risk that the centralized clearing agency would be unable to cover a failure to deliver.

If such an event were to occur, this would cause even further turmoil in the markets. Not only would there be the obvious issue of the failure to deliver rippling through the markets similar to what happened with AIG, but such an event would severely undermine confidence in the market. Additionally, market participants may likely have been lulled into a false sense of security by the presence of the central clearing agent guaranteeing the trades. Volumes (and notional values) would likely have gone up due to this sense of security, leading to an even larger downside in the event of an inability of the clearing agent to deliver. Firms may also be under-prepared to deal with this counterparty risk, given that they were under the assumption that the clearing agent was guaranteeing the trade. Combine all of these elements, and the systemic risk that these regulations are aimed at preventing still seems to be very much alive.

Ultimately, I do think that regulated centralized clearing for derivatives makes sense, particularly in the case of interest rate swaps, which make up the bulk of the market and are fairly standardized and high-volume, liquid assets. However, I do think that it must not be seen as a panacea, and that firms (and those that do business with these firms) should be aware that counterparty risk could still rear its head, particularly in a “perfect storm” event the likes of which we have witnessed over the last 18 months. As with all things–caveat emptor.

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From → finance, trading

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