Are Central Counterparties the Next Systemic Threat?

WASHINGTON — Since the Group of 20 nations agreed in 2009 to route most over-the-counter derivatives through central counterparties, or CCPs, regulators have been increasingly concerned that those centers could pose a catastrophic risk to financial stability if they fail.

But a years-long standoff between regulators in the U.S. and Europe over how to regulate the swaps market is also stalling initiatives to shore up CCPs and to keep the international swaps market afloat. The stalemate is making the situation worse, especially considering that an enormous proportion of the entire global swaps market flows through just a handful of CCPs.

Tim Massad, chairman of the Commodity Futures Trading Commission, which is tasked with writing most of the regulations concerning swaps, said recently that CCP recovery and resolution planning is "at the top of our agenda" and that the commission is working with regulators overseas to coordinate its rules. But the primary goal is to keep CCPs from defaulting at all, he said.

"While we must engage in recovery and resolution planning, our goal is never to get to a situation where either of those is necessary," Massad said. "That is why risk management is so important in the first place."

There is little doubt that a CCP default or failure — particularly a large CCP — would have a deep and profound effect on financial stability worldwide. The Financial Stability Oversight Council said for the first time in its annual financial risk report in May that the "increasing importance of CCPs has heightened … the potential threat to financial stability in the event of a CCP failure."

Many observers are growing increasingly concerned.

CCPs "are the ultimate 'too big to fail,' " said a regulatory attorney who spoke on the condition of anonymity. "There's just no way that central counterparties can be allowed to fail."

There is also reason to be worried that CCPs may not yet be collecting enough collateral to ride out an extremely high-stress event. The Office of Financial Research issued a pair of papers in May that said the standardized approach to calculating margin may not adequately protect CCPs from the risk of clearing member default.

And Federal Reserve Gov. Daniel Tarullo noted the possible shortcomings of CCP capitalization rules in a speech in January, saying that it is "worth considering whether this standard is adequate when hypothesizing stress throughout the financial system."

Negotiations have so far not yielded any breakthroughs, however, either on CCP resolution plans specifically or on swaps regulation in general. U.S. regulators met earlier this month with their European counterparts to discuss cross-border swaps regulations, and the outcome was notably vague; regulators "held productive discussions" that "were continuing in a constructive manner" and "discussed the evolving E.U. and U.S. approaches and options for cross-border cooperation," according to a Sept. 23 report from the Treasury.

The Bank for International Settlements and the International Organization of Securities Commissions similarly issued a status update on their work on a CCP work plan on Sept. 22. The update said the groups were examining existing resilience and resolvability practices and expects a report on that examination to be completed sometime in the middle of next year.

But observers said the conflict between the U.S. and Europe over swaps regulation is hotter than it appears on the surface. The U.S. has moved faster on derivatives regulation than Europe and has proposed, in some cases, to have swap dealers register with the CFTC if they want to access U.S. markets. Europe, for its part, has withheld recognition of U.S. clearing houses and exchanges over concerns that their margin collection is inadequate. CFTC and Treasury officials did not respond to requests for comment on the state of negotiations with European regulators.

"Big picture, this is about a trade war," the regulatory attorney said. "At the end of the day there are only two rules that really matter, capital and margin. If somebody has an advantage on either of those two rules, it is a massive competitive advantage."

The Dodd-Frank Act was among the first laws worldwide to require the central clearing of certain over-the-counter derivatives, also known as swaps — a previously unregulated market that greatly contributed to the "financial contagion" effect of the 2008 crisis.

Swaps are a contractual agreement whereby one party accepts a fluctuating benchmark — such as a price or interest rate — in exchange for a fixed benchmark, generally for a fee. In effect, swaps act as a type of insurance, allowing firms to backstop their strategies by outsourcing the risk that an input price may change, an asset may cease to perform or an interest rate may go up or down. They allow firms to control for variables.

Many companies, notably American International Group, collected huge positions in credit-default swaps on mortgage-backed securities leading up to the financial crisis, and when those assets ceased to perform, the swaps sucked up a tremendous volume of liquidity out of the firm, requiring hundreds of billions in bailouts from the Fed. The experience led regulators to conclude that they had to end the Wild West era of swaps trading, and central clearing was a major part of their answer as to how to bring the market into the light. A former regulator who spoke on condition of anonymity said that was in part because clearing houses are so stable and weathered the financial crisis fairly well.

"CCPs have been remarkably resilient and good at weathering all manner of financial crises, and Dodd-Frank tightened up on CCPs even though they function incredibly well," the former regulator said. "The banks didn't do a very good job of managing that risk, or at least the banks and the insurance companies together, so it makes sense from a policy point of view to utilize them because they have been so good and stable in the past."

Central clearing works like this: Two parties want to enter into a swap. When they execute the trade, they go through a central counterparty, which then contractually owns both sides of the transaction — in essence, each party has a legal agreement with the CCP rather than with one another. If one side of the contract defaults, the other can still carry on because the CCP will hold up the defaulted party's end of the contract. In this way, the failure of a market participant will not infect the rest of the market. The central counterparty is also then responsible for winding down the failed participant's portfolio, selling off its positions until it has been resolved.

In the U.S., there are seven CCPs that are regulated as systemically important financial institutions — CLS Bank International, the Chicago Mercantile Exchange (or CME), Depository Trust Company, Fixed Income Clearing Corp., ICE Clear Credit LLC, National Securities Clearing Corp. and the Options Clearing Corp. In Europe, the largest CCPs are London's LCH Clearnet and Germany's Eurex. Interest rate swaps make up the largest category of derivatives cleared, and according to the Future Industry Association, LCH Clearnet is the clear leader in that arena, clearing $388.5 trillion in swaps in 2014. CME, by contrast, cleared $36.3 trillion in interest rate swaps in 2014, and ICE Clear Credit cleared $10.2 trillion in credit-default swaps.

CCPs collect fees from each transaction in order to keep enough liquidity on hand to cover the cost of winding down a failed participant's position. In the U.S., clearing members have to retain enough capital to cover their losses over a single day of trading — known as "one day gross" margin. Europe, by contrast, requires members to retain enough margin to cover two days of losses, but allows members to offset losses with other clearing members' positions, known as a "two-day net" margin standard. U.S. regulators maintain that for the most part, a one-day gross margin call is larger than a two-day net margin call, and so if the EU's concern is that U.S. CCPs will not have adequate margin, those concerns are misplaced. The former regulator said Europe's withholding of an equivalency determination on the grounds of the differences in margin rules shows that the argument is more political than methodical.

"They have withheld the equivalency determination from CME and ICE because they want to have a lever to utilize so that they can extract something in this negotiation," the former regulator said. "This is just showing how blatantly political they are."

The Bank for International Settlements and the International Organization of Securities Commissions also require the CCPs themselves to retain enough capital to cover the simultaneous failure of its two largest participants — a so-called "cover 2" capital principal. The international regulatory bodies are also examining standard stress testing guidelines for CCPs or procedures for resolving illiquid or orphaned positions.

The International Swaps and Derivatives Association, a trade association representing derivatives traders and clearing members, and consisting largely of banks, in January published a proposed framework that lays out a methodology for CCPs to use to recover from high-stress events.

CCPs already collect initial margin and retain capital in a default fund to absorb losses from large defaults of clearing members. The ISDA proposal suggests that, should those resources be unable to absorb the failed clearing member's losses, the CCP should auction their position to other clearing members — a process called loss allocation. Should there be no willing buyers for the failed member's positions, the ISDA proposal suggests that those contracts should be divvied up among clearing members by the CCP — a process called position allocation.

The main point of contention between CCPs and clearing member is the idea of CCPs having "skin in the game." That is a concept whereby, after a defaulting clearing member's initial margin and the collective default fund are exhausted, the CCP itself should have a fund of its own to firewall more drastic recovery measures like loss allocation or position allocation. ICE and CME, the largest U.S. CCPs, have some skin-in-the-game funds allocated already, but the conflict between how large that fund should be relative to initial margin is a source of disagreement between banks and the CCPs.

The European Securities and Markets Authority already has some skin-in-the-game requirements for central counterparties, and Massad said in his Sept. 29 speech that similar requirements are under consideration at the Commodity Futures Trading Commission.

But Karen Shaw Petrou, managing partner at Federal Financial Analytics, said where that line is drawn and how different it is on either side of the Atlantic is a major feature of the overall discussions.

"Where does the risk stop at the CCP and start at the banks? There are some really strong differences of opinion there based on whether you're a CCP or a bank," Petrou said.

It is doubtful any of these issues will be resolved soon, but the concern is that the swaps markets — the vast majority of which trade between London, New York and Chicago — will become increasingly fractured and disjointed. What is more, the push for central clearing has concentrated risk into a handful of institutions without a well-considered or uniform set of prudential standards to offset that concentrated risk, Petrou said.

“You’ve pushed the financial system in one end, and something always comes out on the other, because markets are infinitely adaptable,” Petrou said. “Maybe with CCPs you’ve cured the opacity, arguably the self-interest … but you’ve created systemic utilities that are now too big to fail with an uncertain prudential regime. The framework is very, very patchy and incomplete.”