The International Swaps and Derivatives Association (ISDA) has published an in-depth discussion and analysis of the purposes, function and issues associated with central clearing of over-the-counter (OTC) derivatives.
In the paper, The Economics of Central Clearing: Theory and Practice, ISDA says central clearing provides significant benefits to the stability of the financial system.
The paper points out both the benefits and potential issues related to central counterparty clearing facilities (CCPs). ISDA concluded:
– 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.
The association says approximately 50% of the interest rate swaps volume outstanding has been cleared, as well as more than $17 trillion of credit default swaps.
Rowena Romulo, head of direct custody and clearing at J.P. Morgan, recently told Global Custodian that central clearing is a positive step for the industry, but warned of the potential concerns involved. “There is a flipside to everything, she said. So for example, there are some CCPs that are starting to position themselves by offering cheaper collateral requirements for membership. That is obviously a worrying development since this goes against the grain of creating a more secure system. There is also a visibility of in terms of the size of OTC derivatives markets and the fact as to whether those markets are liquid enough to warrant a CCP and what value it will add to those markets.”
Walt Lukken, CEO of New York Portfolio Clearing the derivatives clearing house joint venture between DTCC and the New York Stock Exchange gave Global Custodian an exclusive look last month at the new organization. Click here to watch the interview on GCTV.
The ISDA paper, The Economics of Central Clearing: Theory and Practice, is authored by Craig Pirrong, professor of finance at the Bauer College of Business at the University of Houston. The full report can be downloaded at ISDA here.
(CG)