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Anu Munshi, partner at B&B Structured Finance, explores concerns about concentration risk among CCPs. Comments from a DerivSource podcast “The Unintended Risks of a New OTC Marketplace.”
Currently a small number of central counterparties (CCPs), such as the InterContinental Exchange (ICE), CME Group (CME) and LCH.Clearnet’s SwapClear dominate the central clearing of OTC derivatives including credit default swaps (CDS) and interest rate swaps (IRS). These clearing houses face the key market participants, many of whom are dealers who in turn act as clearing members for smaller market participants. So it is imperative that the risk management methods and systems put in place by the CCPs are stringent and robust because the biggest risk to derivative markets now is if a CCP fails.
Unfortunately, the CCPs’ risk management methods and systems are not widely known including their stress testing, the size of their default funds and how they operate. For example, we don’t know how big the default fund is and if it would be adequate if two or three large dealers default at or around the same time. This is the issue of systemic risk which CCPs are intended to address. But do we have sufficient information on whether they will operate as they are intended to? Are their risk management practices given the same scrutiny as a large dealer would? Or is there a bit of complacency on this front stemming from the comfort of a central counterparty with a lot of offsetting trades?
Add to this the immense pressure from regulators and politicians for more derivatives to be cleared centrally and as soon as possible, when the CCPs are already working flat out on implementing a completely new way of operating for OTC derivatives. The risk I see is that CCPs are not ready to clear all the products they are supposed to clear, and that is a scary prospect because if something goes wrong, it will go wrong in a big way. It is in the CCPs’ interest to have as many products cleared through them as possible but even senior officers at CCPs have spoken out in the last year to caution against pushing too much onto exchanges of clearing houses too quickly. Such words of warning speak volumes.
Given the concentration risk of single CCPs and product types, there is some support for a multiple CCP environment; however, multiple CCPs means multiple ways of clearing and risk managing trades, so there isn’t a uniform system for a product globally.
As the majority of CCP clearing members are dealers, who in turn provide clearing services for smaller market participants, dealers are still left with counterparty risk to these market participants. So dealers have counterparty risk to the CCPs on one hand, and to their clients on the other hand, which means OTC derivative risk is concentrated between the CCPs and dealers. If we want to move to the model where the CCP faces market participants directly, each market participant needs to be a clearing member to do so. But that means the capital requirement for clearing members needs to be lowered than it is currently set by some of the CCPs. Today ICE and SwapClear both have minimum capital requirements of $5 billion. CME Clearing has a minimum of $500 million on CDS and $1 billion on IRS.
Last year the US Commodities Futures Trading Commission (CFTC) proposed the minimum capital requirement to be capped at $50 million, which sparked huge debate on whether this number was too low. On one side, existing clearing members claim that poorly capitalised members are unlikely to be able to meet emergency calls to top up default funds if there was a series of failures, which would weaken the stability and the purpose of the CCP. On the other side, smaller institutions feel that the high capital requirements are a way for the CCPs and large dealers to keep smaller players out of the profitable clearing space, and that an institution’s capital base is not a good indication of its risk management capabilities. My own view is that a $50 million capital requirement is too low as the default fund does need contributions from clearing members in the case of failures so members need to be sufficiently capitalised to meet these contributions. But I also think that a $5 billion capital requirement forces the current model that we have. The correct figure is somewhere in between. Ultimately it should be up to the CCPs to use objective risk-based tests to determine eligibility as this should be an economic risk-based decision not a regulatory or a political one.
Anu Munshi is a Partner at B&B Structured Finance Limited, a consortium of former market professionals that provides financial product training, strategic consulting and financial expert witness services. Anu has 14 years experience in financial markets. At B&B, Anu has undertaken various consulting projects, provided an expert opinion in several litigation cases, and conducted numerous training assignments globally. Prior to joining B&B in 2005, Anu worked for 8 years in structured credit at JPMorgan in the US, Asia and Europe. Her roles at JPMorgan included structuring and marketing structured credit products, educating investors on credit derivatives, ABS and CDOs, and developing products such as CDS options.