Dr. Jan Pieter Krahnen, Professor of Finance at Goethe University Frankfurt’s House of Finance and also the Director of the Center for Financial Studies (CFS) and Research Center SAFE, discusses the systemic risk implications of the move towards CCPs, and the need for a single regulatory body to supervise these new entities. Comments shared during recent podcast.
Central counterparties (CCPs) bring significant benefits to the OTC derivatives markets. Following the global financial crisis, regulators on both sides of the Atlantic wanted to reduce the risk of contagion from a single shock in the opaque OTC financial markets. CCPs successfully shielded the cleared markets during the crash, and regulators decided that mandatory clearing for OTC derivatives would serve to protect that market too against a future crash. With robust margin and collateral requirements, CCPs greatly reduce the risk associated with the dense network of exposures in the OTC derivatives markets.
They also reduce financial firms’ overall collateral requirements, as firms no longer have to post collateral and margins with multiple entities. With a single counterparty, banks can start to net their exposures, requiring them to put up less idle capital as collateral overall.
However, there is a down side. With CCPs, counterparty risk is now concentrated in a very small number of institutions.
Concentration of Risk in CCPs
CCPs are now the counterparty for all standardized derivatives transactions. They require margins, and collateral from all their customers. The risk of default for a CCP is very small, but it exists. Should a CCP go into default, it would be a massive disaster. This is the biggest conceivable risk in the global financial markets today. The potential failure of a CCP is a risk that would remain with the fiscal authorities of the countries where the banks doing business with that CCP are located.
“Should a CCP go into default, it would be a massive disaster. This is the biggest conceivable risk in the global financial markets today.”
To use an analogy, the CCP is now like a big circus tent, which covers all the participants in the financial markets and protects them against small shocks. But the circus tent has only one pole—the CCP itself—and if it falls, the whole tent will come down and harm everyone sitting under it. It is therefore extremely important that the fiscal authorities of the host countries are aware of this risk, however small, and undertake all efforts to make sure the CCPs are very stable institutions.
Robust CCP Supervision is Vital
Supervisory agencies must make sure the collateral and margin requirements CCPs are asking from their clients are sufficient to ensure their stability and resilience. If there are several CCPs in the market, the supervisors must make sure they have an overview of all of them at once. There will inevitably be a lot of common exposure, and a lot of netting potential that the supervisor must take into account, when deciding if the margins and collateral being posted are sufficient.
Beware of Predatory Margining
In some countries, such as the US, there are small numbers of CCPs serving more as a utility. In Europe, there are currently around 30 CCPs operating either regionally or nationally. These are private, for-profit institutions, and competition is fierce. While some competition is a good thing—it drives down the average cost to consumers, increases innovation and keeps institutions efficient—30 is too many to be sustainable. There will likely be some consolidation over the coming years as smaller CCPs fail to compete and the larger players look to increase their market share.
“The danger of too much competition is that CCPs could end up trying to undercut each other in terms of price, or margin and collateral requirements, in a bid to win clients and increase their own market share.”
The danger of too much competition is that CCPs could end up trying to undercut each other in terms of price, or margin and collateral requirements, in a bid to win clients and increase their own market share. This is referred to as predatory margining, and it could lead to too little collateral being posted overall, and ultimately weaken the institutions that are designed to provide stability to the market.
There needs to be a single supervisory authority to oversee the prudent margining policies of all CCPs competing within the European Union, or at least within the Euro area. The ECB with its single supervisory capacity is a prime candidate for taking over this new responsibility.
This commentary was taken from a recent DerivSource podcast.
