Clearing hurdles: diversifying to solve CCP systemic risk

Jonathan Boyd

The G20 leaders summit in 2009 kick-started a crucial yet complex process towards central clearing for derivatives. Implementing EMIR, defining consistent rules for CCPs and introducing the clearing obligation are all major tasks. The next logical step is to tackle any risk associated with the new structure – and with the European Commission due to release technical standards soon, recovery and resolution is high on the agenda.

CCP capitalisation

A big part of that debate is each CCP’s ability to absorb losses. This relates to the role of CCPs to manage risks including their own contribution to the finance waterfall, the so called “skin in the game” (SITG).

One way to address the issue with capitalisation is for CCPs to expand their finance waterfalls to include a senior tranche. This provides an efficient tool that acts as a buffer in the waterfall in order to manage swings in volatility and, therefore, changes in the required capital levels. A by-product of doing this is that CCPs can increase their total SITG in relation to the overall financial waterfall.

Encouraging higher percentages of CCP capitalisation is what the industry participant is looking for. However, arguably, it’s not about capitalisation of the waterfall – the CCP contribution is really there to align the risk incentives between the CCP and its members. Even if everyone would agree on the right levels of SITG, it perhaps side-steps the heart of the risk challenge – market structure

Efficient use of collateral

European firms will by now be very familiar with Basel III and, in particular, the CRD IV package. While the aim is to increase resilience in the banking sector, the greater capital requirements could have the opposite effect through clearing.

One way for banks to manage costs is to maximise the netting and pooling of collateral at the CCP level and across a broad portfolio of trades. In a climate where firms are searching for greater efficiencies, that is an understandable and sensible approach. The problem is the unintended consequences.

To get the full cost advantage would mean pushing volumes towards just one clearing house. However, aggregating trades in this way accelerates and magnifies systemic risk. When there is a heavy reliance on one or two CCPs and something goes wrong, there is no recovery plan in the world able to solve the problem.

Diversification of exposure

Perhaps the most valuable, yet often overlooked, mitigation technique is diversification of exposure – and that means encouraging the spread of volumes across a broad palette of CCPs. The challenge is that capital efficiencies and diversification are, in some ways, direct opposites. Therefore, the trick will be finding the right balance between the two.

A wide collection of clearing houses offering a range of competitive services in fungible OTC instruments has to be the preferred route. This structure allows – and promotes – competition among CCPs, which will encourage a wider range of services to help firms optimise their collateral. Firms can then meet crucial capital requirements while sustaining a robust clearing infrastructure.

Collaborating on recovery

Greater collaboration between those CCPs is going to be crucial when it comes to the actual recovery mechanisms. Every recovery situation will be different and, therefore, having a one-size-fits-all approach would backfire. Forcing mandatory transfers from one CCP to another, for example, could simply transfer the risk if that recipient is not equipped to take on the positions.

An alternative would be a voluntary recovery arrangement for fungible OTC contracts that are cleared by all CCPs. This would allow the market to find the best fit in any particular scenario – but means that no CCP can operate in isolation.

Recovery and resolution is a contentious subject with plenty of strong and often conflicting views. Debate is healthy as it will help refine the best approach for all concerned. And ultimately, all parties are working towards the same goals of stability and cost efficiency. To get there, it’s important to invest in the technical detail, such as SITG, while taking into account the bigger picture. It is only by solving both that the industry will be truly ready for when the clearing obligation arrives.


Fredrik Ekstrӧm is president at Nasdaq Clearing

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