Friday, November 22, 2013

German Central Bank Calls for Strong Risk Management at Derivatives Central Counterparties

A report by the German central bank found that the close and opaque ties in the over-the-counter derivatives markets are a potential source of danger to the stability of the financial system. The antidote to this potential threat to financial stability is the creation of derivatives central counterparties, who bear the default risks. Thus, the Deutsche Bundesbank views as a positive development the ever greater use of central counterparties for clearing under both the Dodd-Frank Act and EMIR.  The report noted that, in the case of new index credit default swaps arranged between major derivatives traders, more than half are now being cleared through central counterparties.
However, the central bank cautioned that as central counterparties assume this systemically important role the need for safety barriers arises. In this regard, regulators must adopt and ensure strict requirements globally for risk management at central counterparties. In addition, suitable recovery and resolution regimes for central counterparties must be established. Regulators and policy makers must not allow new systemic risks to build up at central counterparties.
Central counterparties. The Bundesbank report observed that a primary goal of the regulation of the derivatives markets is to reduce systemic risk mainly by involving central counterparties, which act as a contractual counterparty for derivatives buyers and sellers. They thus assume default risk in the derivatives market, which will, it is hoped, allow them to dampen the shock waves sent out by the default of a large market participant by acting as a breakwater. In addition, trade repositories are to ensure greater transparency with a view to facilitating the timely identification of risk concentrations.

However, the report cautioned that the regulation of the OTC derivatives markets is advancing only slowly. While international standard-setting, national implementation and the application of the regulations are making definite progress, acknowledged the central bank, the aim of having the new regulations fully in place by the end of 2012 has not been achieved.

It would have been desirable, said the Bundesbank, for the international agreements to have been implemented close to simultaneously in all countries. But this did not happen, and there are marked differences in the national implementation to date.

Requirements for central counterparties in the various jurisdictions should not be contradictory, cautioned the central bank, and must not be permitted to trigger regulatory arbitrage and a concomitant race to lower standards. In addition, as derivatives central counterparties are assigned a systemically important role, their risk management should be subject to strict rules at the global level. Indeed,  every central counterparty should have robust risk management structures in place.

All that said, the central bank noted that progress is being made in the field of central clearing of derivatives. The entry into force of various obligations to use central counterparties in Japan in November 2012 and in the United States in March 2013 provided a catalyst.