Eighty percent of institutional investors believe that mandatory central clearing of derivatives has reduced systemic risk in global financial markets.
A lack of understanding about the processes clearinghouses use to manage defaults is contributing to a widespread belief that additional measures are needed to mitigate risk, according to a new report on systemic risk and central clearing by Greenwich Associates.
Almost 70% of institutional investors interviewed by Greenwich Associates believe the major clearinghouses have adequate financial resources to handle a major multiple bank default. That finding represents a strong vote of confidence in both the risk frameworks and the clearing firms operating them. Fewer than one in five say they have a clear understanding of the default management waterfalls at the CCPs that clear their trades.
“Investors recognize the many benefits of central clearing, including counterparty risk reduction, improved transparency, better mark-to-market pricing, and a more efficient OTC derivatives market,” says Kevin McPartland, Head of Market Structure and Technology Research at Greenwich Associates. “While major clearinghouses have been transparent about their stress testing and risk management procedures, there is an overall lack of understanding among market participants about clearinghouse default management processes.”
When asked what additional steps clearinghouses can take to further limit the possibility of a bank failure, the two most frequent suggestions from investors include: providing clearinghouses with access to central bank liquidity and requiring them to have more “skin-in-the-game.”
Clearinghouse Requirements Not Well Understood
Central bank liquidity has broadly been addressed and the Bank of England has, in fact, provided registered CCPs with access to its Sterling Monetary Framework. In the U.S., the major clearinghouses have been designated Systemically Important Financial Market Utilities (SIFMU), which while burdening them with additional regulatory oversight and capital requirements, also allows the U.S. Federal Reserve to provide them with liquidity in the event of a crisis.
Clearinghouse capital and “skin-in-the-game” requirements are more complicated issues. The cost of holding extra capital will ultimately be passed on to clearing members and their clients. With the cost of clearing already a sore spot for institutional investors, a structural change like increasing “skin-in-the-game” requirements for CCPs must be examined carefully.
“Institutional investors should take the time to fully understand the risk management practices of central clearing in general and the competing clearinghouses in particular,” says McPartland. “Ensuring clearinghouses’ incentives are properly aligned with robust risk management practices is critical, but limited knowledge of individual default waterfalls could result in a push for market structure change that, over the long term, could prove detrimental to the derivatives market as a whole.”
Throughout 2014 Greenwich Associates interviewed 4,036 global fixed-income investors about their dealer relationships and use of various fixed-income products, including interest-rate derivatives. In the fourth quarter of 2014, Greenwich Associates conducted an additional 72 interviews with key research participants to more deeply understand their views on systemic risk, the impacts of central clearing and their expectations for the interest-rate derivatives market. These results are available in a new Greenwich Report (commissioned by LCH.Clearnet) entitled Systemic Risk and the Impacts of Central Clearing.