BIS Authors Identify Systemic Risks Due to Central Clearing

In a paper titled “Central Clearing: Trends and Current Issues,” Bank for International Settlements (“BIS”) officials identified increased systemic risks due to central clearing. Head of Policy Analysis Dietrich Domanski, Research Adviser Leonardo Gambacorta and Secretariat of the Committee on Payments and Market Infrastructures Cristina Picillo discussed the implications of central clearing for the financial system under normal and stressed conditions.

The paper identified potential risks regarding central clearing that included the following:

(i) Whether central counterparties (“CCPs”) “might spread losses in the case of defaults, or intensify deleveraging pressures in ways that add to systemic stress.”

(ii) Financial regulators do not really understand the interaction between CCPs and the rest of the financial system.

(iii) Risks relating to the function of a CCP, including risks that stem from the management of its activities (general business and operational risks).

(iv) The risk that a participant is unable to meet its trading obligations. This may give rise to liquidity risk if the CCP has to advance payments that a participant cannot make, and to counterparty credit risk if the participant is unable to cover losses on its positions because of its default.

(v) Larger CCPs have a relatively small number of clearing members, and fewer still that offer clearing to their clients.

(vi) A conflict of interests may arise when banks own CCPs and when they do not. The report finds that when clearing banks do not own the CCPs, the main objective for a non-user-owned CCP is to maximize profits and increase participation.

(vii) Economies of scale create incentives for concentration and favor larger CCPs; at the end of 2014, two CCPs accounted for nearly 60% of the total volume of cleared transactions.

(viii) Because of fixed CCP participation costs, many small banks or financial intermediaries with limited activity in centrally cleared markets choose indirect access to comply with clearing obligations.

(ix) As long as the negative shocks are sufficiently small, a more densely connected financial network enhances financial stability. Once losses exceed a CCP’s prefunded resources, the same features that make a financial system more resilient may become sources of instability. As a consequence, financial networks may be “robust-yet-fragile.”

(x) When a large number of clearing participants – potentially including the providers of liquidity lines – become liquidity-constrained, domino effects may be triggered. The activation of a CCP’s unfunded liquidity arrangements or other recovery instruments may impose financial strains on clearing participants. The result of the strain is unexpected liquidity demands that could impose stress on other clearing members and, in extreme cases, trigger a cascade of defaults (emphasis supplied).

(xi) Such a failure could have system-wide effects. Clearing participants might find it difficult to manage positions if a CCP fails, and all clearing participants would have to find alternative ways of closing trades at a time when there might be heightened uncertainty about the value of the underlying exposures and the associated market and counterparty risk.

(xii) Given the overlapping memberships of many CCPs, liquidity problems at one CCP may well coincide with similar issues at others, propagating systemic risk.

(xiii) On the other hand, an unexpected tightening of CCP risk management still could lead to liquidity pressures on participants that might ultimately trigger fire sales and a self-reinforcing deleveraging.

(xiv) In difficult times, a request for additional resources from a CCP could put pressure on participant banks and indirectly affect the rest of the system.

(xv) A large decline in the market value of collateral – particularly if accompanied by high volatility in collateral markets – would reduce the value of initial margins posted to the CCP (also in a non-linear fashion) and trigger requests to members to replenish this value. This could force members to deleverage and lead potentially to fire sales at the precise moment when the rest of the system is under stress. The risk of such liquidity strains and deleveraging could be anticipated by the market, triggering “runs” on participants who were perceived as vulnerable and stoking expectations that became self-fulfilling.

Lofchie Comment: After discussing the risks of central clearing for approximately seventy-five pages, the paper concludes with a passage that begins with these words: “The shift to central clearing has started to mitigate the risks that emerged in non-centrally cleared markets before and during the Great Financial Crisis.”

Unfortunately, this conclusion has nothing to do with the rest of the paper. The authors make another statement that is more to the point, though it figures less prominently: “It is possible that CCPs can buffer the system against relatively small shocks, at the risk of potentially amplifying larger ones.”

In other words, CCPs may be of some use in situations where they are not needed at all, but in situations where they are truly needed, CCPs risk making things much worse.

People who are interested in the subject of this report also may be interested in the writings of the “Streetwise Professor,” a/k/a Craig Pirrong. Professor Pirrong has been discussing the risks of central clearing for at least five years.