Report examines risks in centralized clearing of OTC derivatives

The move to central clearing is intended to increase the safety and resilience of the global financial system. However, as the report explains, achieving those objectives will depend importantly on the arrangements through which market participants obtain access to central clearing.

The options could include increased use of existing global central counterparties (CCPs); establishing domestic CCPs in a number of jurisdictions; and the possible construction of links between CCPs. The report analyses the potential implications for financial stability and efficiency of these arrangements.

“The conditions under which market participants can obtain access to central clearing could have important systemic implications,” it says. For example, it notes that the existing access criteria for some major OTC derivatives CCPs means that direct access to CCPs is dominated by the largest global dealers, with between five and 15 firms dominating turnover in all instruments within each derivative class.

“This raises the concern that the move to clear all OTC derivatives centrally could potentially further reinforce the concentration of risk in those global dealers,” it says.

Alternatively, expanding direct access to CCPs may reduce the concentration of risk in the largest global dealers. It may also increase competition among direct clearers. But, the report notes that, as direct access is broadened, it is essential that CCPs’ risk management procedures evolve to ensure their continued effectiveness, which may put a greater burden on their management to maintain safe risk control practices.

It also says that enhancements to strengthen the safety and efficiency of indirect clearing that comply with international standards should be considered by CCPs and the authorities.

Domestic CCPs for some types of OTC derivatives may also become an important part of the global infrastructure for clearing standardized contracts, the report says. This could strengthen the ability of local authorities to exercise oversight and regulation of derivatives trading activity in their own jurisdictions, as well as to perform crisis management and resolution if needed. However, a global market with numerous domestic CCPs “could lead to greater system-wide demand for collateral assets than if a global CCP were to centralise all clearing, as well as to the fragmentation of trading and financial positions across numerous CCPs,” it notes.

Given that various domestic CCPs will probably play a role in meeting the G20 commitments, the report says it will be essential to develop international standards to avoid regulatory arbitrage and promote effective cross-border monitoring of infrastructure and participants.

Finally, it says that creating links among CCPs has the potential to preserve the network advantages of concentrating clearing activities, but that this would also lead to distinct risks, “particularly in the form of operational and legal challenges as well as credit and liquidity risks associated with the connections between CCPs.”

“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,” it says.

Additionally, it calls for increased monitoring of the effects of various access configurations. “Such monitoring could include the monitoring of changes in access arrangements as they occur and a review of the systemic implications once the work to fulfil the G20 mandate for central clearing of all standardized OTC derivatives has been completed,” it concludes.