Federal Reserve Governor Jerome H. Powell gave a speech discussing recent regulatory efforts to reform the OTC derivatives markets and, in particular, those reforms which are intended to strengthen market infrastructure by expanding the use of central clearing counterparties (“CCPs”) and introducing margin requirements for bilateral OTC derivatives. With respect to the role of CCPs, Governor Powell touted their ability to mitigate risk exposure and improve market transparency, but acknowledged that concentrating risk in a central counterparty could create a single point of failure. To that end, Governor Powell set forth three keys to ensuring that CCPs could effectively mitigate systemic risk:
- enhance central counterparty supervision and regulation by, for example, strengthening the minimum risk management standards applied to infrastructures such as CCPs;
- promote sound credit risk and liquidity risk management; and
- promote the stability of central counterparty members through enhanced capital and liquidity requirements, such as Basel III.
On the subject of noncleared derivatives, Governor Powell noted that the Basel Committee and the International Organization of Securities Commissions recently finalized a framework for margin requirements on noncentrally cleared derivatives, and that regulatory authorities in participating countries are in the process of developing margin rules in light of that framework.
Lofchie Comment: The speech linked below highlights some of the risks created by central clearing, including that of “concentrating risk in a central counterparty [that] could create a single point of failure for the entire [financial] system.” One of the problems raised is that the central clearing party will not have sufficient margin to withstand a liquidity crisis. A related concern is that, in a time of market crisis, the central counterparty will demand excessive margin from its clearing members so as to keep itself safe. Those margin demands will have the potential to suck liquidity out of the rest of the financial system. What makes this particularly troubling is that market participants cannot protect themselves by contract from the demands of a central counterparty; i.e. the counterparty has the right to increase its margin levels at any time.
Another admission highlighted in the Governor’s speech relates to the probability that the CFTC may mandate that all swaps of a certain type be forced off of the OTC markets and onto SEFs. The Governor said: “It should also be noted that these margin requirements are new to the market and their effects cannot be fully understood before they become effective. There is simply no substitute for experience.” In light of that observation, does it really make sense to force all OTC trading of rates on SEFs in one fell swoop? What happens if there is a problem?
See: Governor Powell’s Speech.