Do CCPs Concentrate Risk?

Terry Flanagan

Systemic risk could be increased by centralized clearing.

Taking issue with the stated goals of OTC derivatives reforms to reduce overall systemic risk, some market participants claim that he opposite will take place. That is, moving large volumes of bilaterally cleared and settled transactions to a centralized clearing environment will introduce new sources of stress.

“The concept of concentration is the cause of potential systematic risk, no matter what the capital requirements are,” Zohar Hod, vice president and head of the Americas for SuperDerivatives, told Markets Media.

“When you consolidate risk that was previously part of a bilateral transaction you incur more systematic risk,” Hod said.

If a broker-dealer and a hedge fund have an OTC transaction that is cleared through the broker-dealer’s clearing arm and the hedge fund failed, the exposure would be on that particular broker-dealer’s account.

On the other hand, if the transaction was cleared by CCPs in an omnibus account and the hedge fund failed, separating the specific account from the rest of the transactions would be difficult.

“Now, the CCPs will represent a hub for risk once trades fail rather than the current situation where trades are cleared and spread over many clearing houses,” Hod said.

The issue has come into the spotlight recently with a published report that said that MF Global improperly transferred customer funds into Depository Trust & Clearing Corp. to cover a margin call.

DTCC said that when a firm sends funds through DTCC to complete its transactions and settle trades, DTCC does not “hold back” any funds for purposes of collateral or margin — all funds are remitted to the parties to whom they are due.

In the normal course of business, DTCC handles member firms’ payments of funds related to two key activities: the settlement of transactions entered into by members on behalf of both their customers and their own accounts, and the deposit of collateral (“margin”) in relation to DTCC’s subsidiaries’ role as the central counterparty for the U.S. securities markets.

“DTCC is not a culprit in any way for the funds being transferred,” Hod said. “They only take instructions from clients as a central counterparty”

“Given the consolidation of newly proposed cleared OTC trades into several large CCPs, these types of problems are just going to get worse,” Hod said. “Centralizing the trades into clearing houses will possibly give more transparency, but on the other hand will increase systematic and operational risk tremendously.”

In the U.S., exchange-traded options and futures are traded on a regulated exchange and cleared by a regulated clearing house.  Under Dodd-Frank, OTC derivatives that become subject to new clearing requirements will also need to be traded on a SEF–swap execution facility.

Under the EU approach, European Market Infrastructure Regulation (EMIR) covers clearing requirements and trade repositories.   As proposed, EMIR would apply to OTC derivatives which would be defined as derivatives not executed on a regulated market as defined under MIFID.  Therefore, derivatives transacted on trading platforms governed by MIFID would not be covered by EMIR and would not be subject to mandatory clearing.

Under MIFID II, a greater portion of the derivatives market in Europe will move to regulated markets going forward.  Therefore, based on the current EMIR OTC derivatives definition, those derivatives moving to these regulated markets would escape the EMIR clearing requirement.

MiFID II will also require exchanges that also operate clearinghouses to provide access to their services on a non-discriminatory basis.

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