Lynn Strongin Dodds assesses the different arguments over whether the CCPs are in danger of concentration risk.
As COVID 19 continues to wreak havoc on markets, central counterparties (CCPs) are playing a major role as systematically important market infrastructure providers. It is too early to determine the outcome but they have kept the clearing engines running despite significant surges in trading activity and increases in derivatives margins. However, once the dust eventually settles, concentration risk is likely to re-emerge as a key topic.
There is no doubt that they are being tested in the current environment. A record $10.7trn in interest-rate swaps traded in the week ended March 6, according to data provided by the International Swaps and Derivatives Association (ISDA). Over 90% – or US$9.7trn – was cleared through CCPs. To date, there has been no glitches and CCPs have triggered continuity plans enabling remote working and working from secondary sites to ensure their wheels keep turning. It is a similar scenario for the largest clearing member banks, which have far higher capital reserves than 12 years ago.
Despite the achievements, there are a few clouds on the horizon. During March, when markets plummeted by 30%, the CME Group auctioned off the portfolios of Ronin Capital, one of its clearing members, after the firm was unable to meet its capital requirements. In addition, ABN AMRO announced a $200m net loss after a US client of the Dutch lender’s clearing division couldn’t meet a margin call on a loan. There are concerns over further defaults as well as spikes in margin calls, particularly for listed derivatives.
“Concentration risk is still a big issue but I am not sure it has ever gone away,” says Christian Lee, Partner at consultancy Sionic. “We are in the post clearing mandate world with the vast majority of OTC derivatives being centrally cleared. This means that there are pools of concentration driven by liquidity. CCPs have the requisite levels of internal controls and safeguards in the case of extreme scenarios. We are currently in the middle such an extreme market event and, so far, the CCPs and its members appear to be coping. It will be interesting to see what the outcome over the next few weeks.”
A heavy burden
In fact, it wasn’t that long ago – March 10 – before volatility truly hit the markets, that nine heavy hitting financial institutions published a paper – A Path Forward for CCP Resilience, Recovery, and Resolution, calling on regulators to improve the “safety and soundness” of CCPs. The report noted a recent default by a Nasdaq Clearing AB member as an event that raised again wider concerns regarding CCP governance and default management practices.
In the report, industry stalwarts Allianz, Blackrock, Citi, Goldman Sachs, Société Générale, JP Morgan, State Street, T. Rowe Price and Vanguardstated that “although regulators had made progress in enhancing a minimum level of CCPs pre-funded resources and setting risk management standards, several gaps in CCP resilience remained.” The report noted that these institutions had become too important to fail and highlighted the lack of a market-wide consensus on their recovery and resolution frameworks.
The report’s was that clearing members shoulder too much of the burden and that regulators should not only strengthen CCP default buffers but also improve their disclosure and corporate governance. They also recommended CCPs have more “skin in the game”, in order to bear the potential losses stemming from one or more of their clearing members going under. They noted that this would reduce the amount of additional funds clearing members, including systemically important banks, would have to contribute in such scenarios, and therefore avoid saddling healthy firms with hefty losses that could trigger a broader crisis.
The issue was also a topic of conversation at the recent Conference on CCP Risk Management held in Chicago in February.
In a speech at the conference, Fabio Panetta, Member of the Executive Board of the European Central Bank (ECB),said that more tougher approaches needed to be developed to meet funding needs in recovery and resolution. He also stated that the ECB supports the holding a workshop on credible CCP resolution funding which would involve the Financial Stability Board (FSB), the Committee on Payments and Market Infrastructures, the Board of the International Organisation of Securities Commissions (CPMI-IOSCO), and the Basel Committee on Banking Supervision before the FSB finalises guidance by the year end.
Panetta also suggested there could be more regulatory action to address the diverging interests around the allocation of losses in CCP recovery and resolution. “Given the high concentration of systemic risk in CCPs, a credible and effective framework and full stakeholder commitment are absolutely essential.”
The main CCPs, however, would argue their defences are strong and that they use conservative calculations for assessing customers’ exposures. In Europe, market participants believe that venues have enough resources set aside to withstand defaults by their two largest customers on the same day. Many also content that increasing the amount of money clearinghouses set aside would increase the cost of their service and the concentration risk is more evident in the clearing members.
Keeping the lines of communication open
“It is always good to have a continuous dialogue regarding topics such as concentration risk,” says Matthias Graulich, Member of the Eurex Clearing, Executive Board. “However, sometimes there is confusion regarding concentration at the CCP or bank level. From a CCP perspective, our concerns relate to the significant concentration of a few clearing members, as we are seeing, for example, in the global swaps clearing space. I see some level of concentration at CCPs as less problematic, as CCPs are risk managers who are not taking, in contrast to banks, market risk.”
He adds that “scale is an important factor for CCPs as it allows us to professionalize risk and default management much better than if you do not have this scale. The same is true for margin regimes, methodology and technology; our methods and systems have performed extremely well and reliable over recent weeks.”
LCH’s Chief Risk Officer, Dennis McLaughlin, agrees, adding “there is always a debate as to who pays but it’s important to recognise that larger CCPs tend to have good practices and oversight. The important thing is to ensure there are stringent membership criteria to prevent a member of lower credit quality joining the CCP. A diverse membership base is important as it means that a CCP does not need to rely on one or two members to participate in auctions in the event of a default. It is also important to mutualise the risks in default funds and ensure they are proportionate so that no one clearing member takes up more than half of the default fund.”
As to the current environment, LCH issued a statement reassuring clients it had “robust business continuity arrangements in place to ensure the safe and orderly conduct of our businesses and clearing operations around the world. LCH continues to operate as normal across all of its clearing services, notwithstanding the recent market volatility and trading volumes. “
LCH said it is closely monitoring the Coronavirus pandemic and is in close contact with our regulators, governments, international health organisations, and stakeholders around the world and will continue to adjust our response as needed.
Although it is too early to predict the fallout of COVID-19 and the long-lasting impact it will have on market infrastructure providers, CCPs are proving their mettle. However, this is likely to shine an even brighter light on the size and concentration risk within these behemoth organisations.
