Saturday, December 07, 2013

Fed Gov. Powell Joins Global Chorus calling for Strong Risk Management at Derivatives Central Counterparties

Joining a growing global consensus for robust risk management at derivatives central counterparties, Federal Reserve Board Governor Jerome Powell said that these central counterparties must hold themselves to the highest standards of risk management, given that they could create a single point of failure for the entire financial system. In remarks at the Clearing House annual meeting, he noted that derivatives central counterparties must manage two distinct yet interrelated risks: liquidity risk and credit risk. Credit risk is the potential for the central counterparty to incur losses after it closes out a defaulter's positions and liquidity risk  is the possibility that a central counterparty will not have sufficient cash on hand to timely meet its payment obligations.

Recently, the German central bank, the Bundesbank, called for enhanced risk management at derivatives central counterparties. Andreas Dombret, the member of the Bundesbank Executive Board with oversight of financial stability, said that the Dodd-Frank Act and the European Market Infrastructure Regulation (EMIR) could turn derivatives central counterparties into “juggernauts” of the international financial system. As such, he advised every central counterparty to implement a robust risk management regime.

The credit and liquidity risks borne by a central counterparty arise from the clearing activities of its members, explained Gov. Powell, and those risks materialize when a clearing member defaults. Most of the financial resources to cover risk exposures will come from members, he noted, and a member's default will require the central counterparty to work with surviving members in the context of prevailing market conditions.

Central counterparties play a critical role in ensuring a robust risk management regime that fully takes account of this interplay among markets, institutions, and infrastructure. Gov. Powell emphasized that regulators, clearing members, and their clients also must be engaged in making sure that central counterparties are safe and effective at managing the risks, interactions, and interdependencies inherent in the clearing process

In his view, there are three key elements to ensuring that central counterparties are effective in mitigating systemic risks: 1) enhancing regulation; 2) strengthening risk management and governance; and 3) promoting the stability of clearing members. 

Enhancing central counterparty regulation. The decision to require central clearing of standardized derivatives as a foundation for reform has raised the stakes for central counterparties, clearing members, regulators, and the general public. At the international level, financial regulators have addressed this challenge by updating, harmonizing, and strengthening the minimum risk management standards applied to financial market infrastructures, including central counterparties.

The primary basis for the regulation of derivatives central counterparties are the European Market Infrastructure Regulation (EMIR) and Title VII of the Dodd-Frank Act. Both laws establish a framework for reporting, regulating, and clearing OTC derivatives transactions. They also call for international coordination on enhanced risk management standards for central counterparties. However, differences of implementation of EMIR and Title VII have emerged. Gov. Powell warned that governments must ensure that such differences do not lead to regulatory arbitrage or weakened standards.

More granularly, in addition to Dodd-Frank and EMIR, the globally-developed Principles for Financial Market Infrastructures have set a higher bar for risk management to strengthen these core market infrastructures and promote financial stability. Recently, the CFTC finalized its adoption of the Principles for the derivatives clearing organizations it regulates.

The Principles require that a central counterparty  develop strategies to cover its losses and continue operating in a time of widespread financial stress. In particular, a central counterparty must maintain financial resources sufficient to cover its current and potential future exposures to each participant fully with a high degree of confidence; and maintain additional resources to cover the failure of the clearing member with the largest exposure under extreme but plausible market conditions.

Governance of Risk Management. Gov. Powell strongly emphasized that managing credit and liquidity risk requires sound and effective governance, an important aspect of which is enhanced transparency. Clearing members bear primary responsibility for understanding the risks associated with participating in a central counterparty, including their potential exposures in the event of a default. This will require the central counterparty  to provide relevant and even firm-specific information to facilitate the members' analysis. Clearing members and their clients, regulators, and the broader public require transparency so that they can assess the adequacy of risk management at the central counterparty and its overall risk profile.

The Principles for Financial Market Infrastructures also have a key role to play in the sound governance of risk management. In this regard, Gov. Powell pointed out that, in order to promote credit risk management, the Principles require a central counterparty to collect variation margin from its members to limit the buildup of current exposures. In addition, they must also calculate and collect initial margin sufficient to cover potential changes in the value of each participant's position between the last collection of variation margin and the final closeout of a participant's position should it default.

Clearing members. Noting the critical role played by clearing members, the Fed official said that a central counterparty ultimately draws its strength and resilience from that of its members. And it is not a one-way street, he added, since strong central counterparties enable clearing members and their clients to significantly reduce their exposure to counterparty credit risk. Effective risk management by both a central counterparty and its clearing members should work in concert.