White papers addressing issues involving derivatives clearing organizations and other financial clearing entities.
- Central counterparties (CCPs) are market risk neutral as a normal course of business. CCPs do not engage in trading, lending, or any other market risk creating activities.
- CCPs serve a crucial market function by ensuring participants do not have “too big to fail” consequences.
- Monitoring participants to ensure they have sufficient skin in the game to support their activities is a fundamental aspect of a CCP’s role.
- CCPs with a “systemically important” designation main tain resources at least large enough to cover the default losses of their two largest clearing members.
- A CCP’s most important contribution to managing systemic risk is the management of concentration risk among their largest participants.
From the executive summary:
This paper explains LCH.Clearnet’s approach to three areas: risk management, recovery and resolution. Recent debate on these issues has focused on a CCP’s total loss-absorbing capacity and the size of a CCP’s own resources. In our view, this debate has not been clear as to the distinction between clearing members’ risks and resources, and those of the CCP operator. For the members, a CCP is essentially a risk management system through which they can mitigate their counterparty risk and benefit from other services; e.g., portfolio compression. The CCP operator is responsible for the design and functioning of this system, and primarily has operational and business risks.
ISDA’s assessment, taking into account the views of the broad range of market participants that comprise its membership, is that certain issues warrant further discussion and remediation. These issues can be broken down into two basic themes:
- The adequacy and structure of a CCP’s loss-absorbing resources; and
- Crisis management planning in the form of a clearly defined and transparent recovery and resolution framework (R&R) for CCPs when losses threaten to exceed their loss-absorbing resources.
This paper examines these issues, outlines some common principles and highlights key items for discussion
The report was written by Daniel Heller and Nicholas Vause on behalf of the Monetary and Economic Department of the Bank for International Settlements (BIS).
The paper estimates the amount of collateral that CCPs should demand to clear safely all interest rate swap and credit default swap positions of the major derivatives dealers. The results suggest that "major dealers already have sufficient unencumbered assets to meet initial margin requirements, but that some of them may need to increase their cash holdings to meet variation margin calls." Default funds worth only a fraction of dealer equity "appear sufficient to protect CCPs against almost all possible losses that could arise from the default of one or more dealers, especially if initial margin requirements take into account the tail risks and time variation in risk of cleared portfolios."
To view the report, along with a summary of the report and its conclusions, click the link below.
The report, chaired by Timothy Lane of the Bank of Canada, was submitted by a study group established by the Committee on the Global Financial System.
Among the conclusions from the study:
- Expanding direct access to CCPs may reduce the concentration of risk and increase competition among direct clearers, which may yield greater choice and lower fees. As direct access is broadened, risk management practices become more critical.
- Safe and efficient indirect clearing also broadens access to CCPs, making it an important complement to direct clearing.
- Domestic CCPs for some types of OTC derivatives may become an important part of the global infrastructure for clearing standardised contracts.
- Development and adoption of international standards will be essential "to avoid regulatory arbitrage and promote effective crossborder monitoring of infrastructure and participants."
- As links among CCPs clearing OTC derivatives remain a new and untested area for markets and
policymakers, authorities "should encourage industry participants to suggest solutions for
the legal, financial and operational risks posed by links and cross-margining practices."
- Timely monitoring of the system-wide effects of access configurations by international organisations such as IOSCO will help promote the safety and efficiency of markets as G20 jurisdictions work towards expanded use of central clearing in OTC derivatives.
This 34-page white paper consists of:
- An overview of OTC clearing regulations in the U.S., Canada, European Union, and the Asia Pacific region;
- an overview of the OTC trade process in both the bilateral and cleared OTC markets;
- an analysis of market participants' operational readiness; and
- an evaluation of processing system features and integration challenges.
The paper concludes with several summary tables, including a country-by-country regulation analysis, a list of active clearing houses, and a list of different affirmation platforms.
From the white paper:
"The Dodd-Frank Act signifies the biggest US regulatory change in several decades. According to experts, Dodd-Frank will have a substantial influence over an estimated 8,500 investment managers, all the 10–12 US exchanges and alternative execution networks...this white paper is confined to the new regulations that specifically relate to the central clearing of OTC derivatives, and the repercussions for confirmation/settlement flows, reporting and risk management. The main purpose of this paper is to address these issues by listing the principal functionalities an investment manager must consider when choosing and using a business system to meet these requirements."
The white paper includes:
- a brief history and overview of Dodd-Frank provisions for OTC derivatives;
- required business system support for Dodd-Frank compliance, with a "Business System Capabilities Checklist that includes:"
- straight-through processing ("STP");
- transaction workflow transparency;
- broad instrument coverage; and
- reporting requirements.
Discussion Papers Series, Number One - May 2011
This paper, which was written by University of Houston finance professor Craig Pirrong, is the first in what will be a series of white papers covering "key topics derivatives, public policy and financial regulation," aimed at "informing debate, encouraging discussion and illuminating public policy options as the derivatives markets evolve."
Among the paper's conclusions:
- CCPs can successfully reduce and reallocate counterparty risk through rigorous preparation for, and management of, member defaults;
- CCPs can also create systemic risk, and it is imperative they have strong and conservative risk management and sufficient financial resources to withstand stressed markets. They also require close supervision by regulators;
- The margin policies of CCPs can pose risks to the efficient functioning of the financial system. Mandatory clearing of OTC derivatives will lead to a large amount of liquidity being tied up as margin at CCPs. Increases in margin requirements by CCPs during a crisis could be destabilizing;
- CCPs should generally align control, governance and membership requirements with the interests of participants that absorb their risks and share their losses.
- ↑ ISDA Publishes “The Economics of Central Clearing: Theory and Practice,” A Discussion Paper on Clearing Issues. ISDA. Retrieved on June 1, 2011.
- ↑ Isda paper tackles the economics of central clearing. Finextra. Retrieved on June 1, 2011.