EU Central Banker Applauds Derivatives Regulation as Key to Containing Systemic Risk
As legislation regulating the OTC derivatives markets advances in the EU and the US Congress, a member of the European Central Bank said that it is critical to regulate the market for credit default swaps since it is systemically important. In remarks at an ECB workshop at Frankfurt am Main, Gertrude Tumpel-Gugerell said that the default of one major counterparty can put the whole financial system under severe strain.
Thus, legislation establishing central counterparties for credit default swaps is crucial in order to address the high degree of interconnectivity between credit default swap markets and credit and cash securities markets, as well as the high leverage embedded in these financial instruments and the significant concentration of related risks in a small group of major market players. In her view, the effective implementation of central clearing of derivatives will facilitate a significant reduction in counterparty risk, thereby addressing some of the negative externalities that stem from the over-the-counter network that has formed over the years.
More broadly, the central banker praised the draft legislation in the US and EU creating a systemic risk regulator. A European Systemic Risk Board will be established with the mandate to map financial risks and their concentration at the system level for macro regulation of systemic stability. A similar council of financial regulators, including the SEC and the Fed, seems likely to be created in the US.
The central banker defined systemic risk as the possibility that a triggering event such as the failure of a large financial institution could cause widespread disruption of the financial system, including significant difficulties in otherwise viable institutions or markets. An important aspect of the analysis of systemic risk is that an apparently robust system may in fact be very fragile. This comes from the fact that a high number of interconnections within the network will serve as shock-amplifiers rather than as absorbers.
According to the central banker, critical to the success of the systemic risk regulator will be network analysis that can identify linkages between market participants. Network analysis offers a relevant tool for focusing on interconnectedness and on systemically important market players. For example, network analysis can help the systemic risk regulator understand the systemic connections in many different segments of the financial markets, ranging from money markets to networks of credit default swaps, and from large-value payment systems to cross-sector exposures in the euro area financial system.
Network analysis is also crucial for the identification of systemically important financial institutions and markets which are critical market players in the web of exposures. A particular financial institution might not only be critical to the functioning of financial markets because other institutions are financially exposed to it, she noted, but also because other market participants rely on the continued provision of its services.
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