OFR Working Papers Take New Approaches to Evaluating Central Counterparty Risks

The OFR released two working papers today that focus on the potential risks of central clearing of over-the-counter derivative transactions.

The Dodd-Frank Act mandated that many of these transactions be cleared through central counterparties.

Central clearing has the benefit of reducing the risk that the default of one market participant could create cascading losses among the participant’s counterparties. In central clearing, the central counterparty (CCP) becomes the counterparty to every buyer and seller, and thereby eliminates two-way exposures between counterparties. However, central clearing introduces other risks related to the resilience of the CCP itself.

The two OFR papers, which reflect the views of the authors and not the OFR or the Treasury, take novel approaches to evaluating the risks of a central clearing framework. (In February, the OFR’s Financial Research Advisory Committee recommended issues for OFR consideration regarding CCPs.)

In Systemic Risk: The Dynamics under Central Clearing, authors Agostino Capponi, W. Allen Cheng, and Sriram Rajan develop a model to focus on concentration risks to the CCP posed by large clearing members.

The model shows that, as banks hedge undesired risks by trading through the CCP, systemic risk can build up over time. Larger clearing members crowd out smaller clearing members, creating a concentration that increases the exposure of a CCP to the failure of its largest clearing members. This concentration increases the cost of capital and reduces the effectiveness of hedging. The authors propose a self-funding concentration charge to clearing members as a policy response for regulators and market participants.

In Hidden Illiquidity with Multiple Central Counterparties, authors Paul Glasserman, Ciamac C. Moallemi, and Kai Yuan focus on the challenges of managing systemic risks in markets cleared by multiple CCPs. Each CCP charges margins based on the potential impact on market prices if a clearing member were to default, resulting in the liquidation of a large position relatively quickly. These margin charges create incentives for swaps dealers to split their positions among multiple CCPs, effectively “hiding” potential liquidation costs from each CCP.

The authors find that CCPs need to take into account overlapping CCP membership in setting margin requirements. If a clearing member defaults at one CCP, it will fail at all CCPs of which it is a clearing member. In practice, the same major dealers tend to be members of many CCPs. The authors argue that addressing this problem requires some sharing of information between CCPs. A lack of coordination can lead to what the authors call a “race to the bottom” in which the CCP with the most optimistic view of liquidation costs drives competitors out of the market.

These papers suggest the need for attention to concentration risks in central clearing to strengthen CCPs and to guard against threats to financial stability from disparities in clearing member size and their portfolio liquidation impacts.

• Systemic Risk: The Dynamics under Central Clearing
• Hidden Illiquidity with Multiple Central Counterparties

Greg Feldberg is Acting Deputy Director for Research and Analysis at the Office of Financial Research