Central Clearing “Task Far From Complete”, says Fed Governor

Federal Reserve Board Governor Jerome Powell said the move of OTC derivatives to central clearing “is far from complete”, calling for stricter oversight of central counterparties (CCPs) through coordinated stress tests.

Speaking at the 17th Annual International Banking Conference in Chicago on Thursday, he said clearing members that provide key custody and settlement services, as well as regulators and the broader market, should be aware of the risks involved with the move to central clearing “so they can take appropriate steps to mitigate them.”

Since the G20 mandate, increased importance has been placed on CCPs, otherwise named as clearing houses, in which previously unregulated derivatives are now required to be cleared through these institutions in order to mitigate risk and bring transparency.

However, this has led to concerns over a possible shift in systemic risk from systemically important banks to the CCPs themselves.

Powell argued that CCPs, such as CME Clearing and Eurex Clearing, should implement standardized stress tests to see whether they hold sufficient capital in times of a financial crisis. Furthermore he calls for greater clarity over how these stress tests are conducted in order to provide better transparency.

“Both clearing members and regulators need a more systematic view of what stress tests are performed, at what frequency, with what assumptions, and with what results.

“A greater degree of uniformity would be helpful to clearing members that are comparing test results across CCPs and to regulators that are considering system wide stability.”

In a white paper, J.P. Morgan called for CCPs to place significant amounts of their own loss-absorbing resources instead of using financial resources provided by its clearing members. This requirement, known as more ‘skin –in-the-game’, is intended to create incentives for the owners of CCPs to think carefully about new products for clearing, and adopt robust default waterfalls.

However, in his speech Powell was relatively cautious over his views on the amount CCPs should devote to its default fund.

“The issue is a complex one, however, and a number of factors would need to be considered in formulating such a requirement.”