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.