Speaking at the Annual International Banking Conference yesterday, Federal Reserve (Fed) governor Jerome Powell warned listeners that central clearing of derivatives was concentrating risk in the financial system and that we need to take action now to shore up what have become key focal points before the next crisis hits.
“Moving a significant share of the $700 trillion OTC derivatives market to central clearing will concentrate risk at CCPs. But the intent is not simply to concentrate risk, but also to reduce it–through netting of positions, greater transparency, better and more uniform risk-management practices, and more comprehensive regulation,” said Powell.
OTC derivative market still complex with CCPs
Before the financial crisis, Powell reminds us that the over-the-counter (OTC) derivatives market grew from $80 trillion in 1998 to nearly $600 trillion in 2008, an annual growth rate of more than 20%, with little oversight and a complex web of bilateral clearing that no one could have hoped to understand in any detail. Central counterparties (CCP) were supposed to replace that with a simple hub-and-spoke system where regulators could measure risk more clearly, and where risks could be at least partly netted out, but the real picture is still quite complex.
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“We do not live in a simple world with only one CCP. We do not even live in a world with one CCP per product class, since some products are cleared by multiple, large CCPs,” said Powell. “Also, significant clearing members are often members of multiple CCPs in different jurisdictions. The disruption of a single member can have far-reaching effects.”
Powell preparing CCPs for the next crisis
To prevent that kind of disruption, Powell first recommends increasing liquidity requirements for CCPs. He supports the Principles for Financial Market Infrastructures (PFMIs) requirement that CCPs should have at least enough liquidity to survive the collapse of the clearing member (and its affiliates) with the largest aggregate position. That way CCPs will be able to help absorb shocks instead of transmitting them through the financial system.
He also calls for more rigorous, and transparent, stress tests so that clearing members and regulators can have confidence that CCPs will be able to stay open even after a severe market shock. CCPs are running their own internal stress tests, but as we have seen with the Fed’s Comprehensive Capital Analysis and Review (CCAR), regulators often have a very different view of what constitutes an extreme, but realistic, shock.
Finally, Powell wants to find a way to ensure that CCPs have ‘skin in the game’, so that incentives guide them to monitor risks carefully, though he acknowledges that put such a policy into place isn’t a simple matter.