Central Clearing Is Riskier than You May Think, OFR Papers Say

WASHINGTON — Two reports issued Thursday by the Treasury Department's Office of Financial Research suggest regulators have not considered all the potential risks from central swaps clearing and more steps may be needed to mitigate those risks.

Unlike the bilateral deals that threatened the system during the crisis, the Dodd-Frank Act requires derivatives deals to pass through a central counterparty, or clearinghouse, that acts like a firewall for the marketplace by assuming the terms of a contract if one of the participants defaults. To help offset the central counterparty's risk, original counterparties must post collateral, known as "margin."

But the papers question whether existing margin requirements are adequate to contain the systemic risks building within the largest clearinghouses — such as InterContinental Exchange and CME Group — from their roles backstopping the system. In addition to the participants' individual default risks, central counterparties also want to ensure that positions can be wound down without adversely affecting asset or commodity prices or creating a run on contracts.

"These papers suggest the need for attention to concentration risks in central clearing to strengthen CCPs and to guard against threats to financial stability from disparities in clearing member size and their portfolio liquidation impacts," Greg Feldberg, OFR's acting deputy director for research and analysis, said in a statement.

In one paper, "Hidden Illiquidity with Multiple Central Counterparties," researchers examine the effect that the presence of multiple CCPs in a single jurisdiction has on those CCPs' ability to examine their collective liquidity risk.

Under existing rules, CCPs assess their per-contract margin level based on what would be necessary to simultaneously liquidate the positions of the clearinghouse's two largest members. But the paper says that in areas where there is more than one CCP — such as the U.S. and Europe — market participants will have positions with multiple CCPs, "effectively 'hiding' potential liquidation costs from each." As a remedy, the researchers said, CCPs should be subject to annual "stress tests" that not only considers the clearinghouse's own performance but how it would respond to contagion threats from other competing CCPs.

"CCPs and clearing members need to share information about positions across CCPs," the paper says. "Our analysis points to the need for each CCP's stress scenarios to include the actions of other CCPs. This would be in contrast to the current regulatory stress tests for banks, which treat each bank in isolation."

The authors in the second paper, "Systemic Risk: The Dynamics under Central Clearing," suggest that market participants should pay CCPs more than the standard margin requirement in order to account for the systemic risks posed by swaps dealers. The paper pointed out that, while the swaps market allows financial companies to hedge risks — such as fluctuating prices or interest rates — those risks become concentrated in a central clearing environment.

"Capital costs of members' hedging positions depend on those of all other members," the paper says. "Hedging, while risk-mitigating on the individual level, contributes to the emergence of size externalities on the systemic level."

The papers come as regulators are increasingly concerned about the potential systemic risks posed by CCPs. The largest U.S. CCPs — ICE, CME and the Depository Trust & Clearing Corp. — were designated as Financial Market Utilities by the Financial Stability Oversight Council and so are examined for systemic risk concerns. Fed Gov. Daniel Tarullo said in January that risks posed by CCPs are at best poorly understood, and how to measure margin for central clearing mechanisms may need to be reexamined.