NY Fed Study Says Derivatives Clearing Houses May Themselves Pose a Systemic Risk to the Financial Markets
As Congress moves toward the passage of legislation that would create a federal systemic risk regulator, a NY Fed study questions whether the central derivatives clearing organizations also envisioned by the legislation would themselves pose a systemic risk. If this is true, it raises the issue of whether very active derivatives clearing organizations should come under the purview the new Financial Services Oversight Council, which includes the Fed, SEC and the CFTC.
In the wake of the recent financial crisis, over-the-counter (OTC) derivatives have been blamed for increasing systemic risk. OTC derivatives markets are complex, opaque, and prone to abuse by market participants who take irresponsibly large amounts of risks. Although OTC derivatives were not a central cause of the crisis, weaknesses in the infrastructure of derivatives markets did exacerbate the crisis. As a result of failures of risk management, corporate governance, and management supervision, some market participants took excessive risks using these instruments. The complexity and limited transparency of the market reinforced the potential for excessive risk-taking, as regulators did not have a clear view into how OTC derivatives were being traded.
Counterparty credit risk rises to the level of systemic risk when the failure of a market participant with an extremely large derivatives portfolio could trigger large unexpected losses on its derivatives trades, which could seriously impair the financial condition of one or more of its counterparties. The antidote to counterparty credit risk is clearing, which means obtaining the effect of a guarantee by a central counterparty (CCP), sometimes called a clearing house. The CCP stands between the two original counterparties, acting as the seller to the original buyer, and as the buyer to the original seller.
The NY Fed study posits that, if a CCP is successful in clearing a large quantity of derivatives trades, the CCP itself becomes a systemically important financial institution. The failure of a CCP could suddenly expose many major market participants to losses. Any such failure, moreover, is likely to have been triggered by the failure of one or more large clearing members, and therefore to occur during a period of extreme market fragility. Thus, while robust operational and financial controls are paramount in reducing the likelihood of a CCP failure, emphasized the study, a CCP must also have methods in place for quickly recapitalizing, or for quickly unwinding its derivatives positions with minimal impact on counterparty risks and on the underlying markets.
The NY Fed study urges regulators to ensure that a CCP’s risk management design and financial resources are robust enough to allow the CCP to withstand extreme but plausible loss scenarios. Regulatory standards should ensure that CCPs remain resilient to a broader set of risks, including multiple participant failures, sudden fire sales of financial resources and rapid reductions in market liquidity. “Extreme but plausible” loss scenarios should encompass, at a minimum, the largest historical observed price movements in that market.
The Wall Street Reform and Consumer Protection Act, HR 4173, passed by the House late last year, would require OTC derivatives trading to be conducted through clearinghouses, which are set up to police derivatives trading.
The legislation addresses the concerns of the NY Fed study by implementing important corporate governance reforms in the derivatives markets. In addition to complying with several core principles listed in the Act, such as having adequate financial resources and effective risk management, registered derivatives clearing organizations must designate a compliance officer to review compliance with the core principles and establish procedures for the remediation of non-compliance. The compliance officer must also prepare an annual report, certifying its accuracy, on the compliance efforts of the derivatives-clearing organization. The compliance report will accompany the financial reports that the clearing organization must furnish to the SEC.
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