Tensions at for-profit CCPs could put them at risk

Demutualised CCPs must find a way to keep clearing members engaged in risk management

tug of war threatens both parties
Incomplete demutualisation is behind the growing tensions

Robert Cox and Robert Steigerwald are senior policy advisers at the Federal Reserve Bank of Chicago

Clearing members’ concerns about the risk management of some central counterparties (CCPs) have shown themselves recently in areas such as product offerings and emergency powers. This growing tension is the product of incomplete demutualisation, in which ownership – but not ultimate risk-bearing – has been demutualised.

The root problem is that clearing members feel they lack control over CCP risk management. In particular, bank or bank-affiliated clearing members, which dominate the open interest at CCPs, have expressed this concern. This is not surprising, since those clearing members bear the largest share of CCP credit loss mutualisation. Failure to strengthen a mature and responsible working relationship in CCP governance may result in continued antagonism over particular aspects of CCP risk management. More importantly, it may prevent successful navigation of a CCP through another market crisis, which would rely on CCPs and clearing members working together, rather than against each other.

CCP business models have evolved into two main categories: the mutual CCP, owned by its clearing members and operated as a utility with loss mutualisation among its members; and the demutualised CCP, operated as a for-profit enterprise and primarily guaranteed by loss mutualisation among its clearing members. Risk management governance is the responsibility of the clearing members in the mutual model and a hybrid of clearing members and the CCP operator in the demutualised model.

There have been fundamental changes in regulatory and financial stability policies in the wake of the 2008–2009 crisis, which have led clearing members to reassess their role in CCP default management. But demutualised CCPs have been on the clearing landscape from the early 1990s without significant evidence of clearing member concerns about their risk management. What happened to change this?

Two events seem to have altered the equilibrium between demutualised CCPs and bank clearing members: the financial crisis and the 2009 decision by Group of 20 countries to seek to ensure that standardised over-the-counter derivatives were centrally cleared.

Before the crisis, clearing members had generally been less focused on CCP risk: perceptions varied from bank to bank, and in most cases there was an assumption that CCPs of true systemic significance were ‘too big to fail’. Banks even failed to price their guarantee of client positions to the CCP in their revenue models, despite explicit capital requirements in some jurisdictions for client margin at risk. After the crisis, however, governments explicitly ruled out using public funds to support a CCP rescue. This emphasised to CCP members that they were at risk of carrying substantial losses from a CCP failure.

OTC derivatives markets evolved alongside the listed derivatives markets, and became a major risk transfer mechanism. A symbiotic relationship developed between the two markets, but this relationship frayed with the implementation of the clearing mandate. Credit risk was transferred to the CCPs. Clients no longer needed to select OTC trade counterparties on the basis of their credit profile. This levelled the playing field for dealers with weaker credit ratings, and encroached on what had been a relatively exclusive and highly profitable domain of the largest bank dealers.

The conflict over CCP product selection continues. As for-profit, demutualised CCPs extend their product base of cleared OTC derivatives, the dealer community is faced with the prospect of further diminution of profitability. As a result, CCPs are facing challenges to their plans to clear new product classes, such as inflation-linked swaps and swaptions.

Other issues of risk management also have emerged in the post-crisis environment: standardised universal stress testing, collateral eligibility, so-called ‘skin in the game’, and standards for clearing membership, as well as the bespoke nature of CCP rule books. However, the central issue is ownership and control: clearing members, as the ultimate underwriters of CCP risk, seek more control over CCP governance. And here the preservation of goodwill between CCPs and their members is paramount.

No matter how carefully designed, the ex ante rules and procedures of CCP risk management cannot possibly anticipate all potential sources of risk and provide appropriate rules-based responses. In some cases, simply applying CCP rules to the letter could be systemically destabilising, as could be the case with contagion-generating tools, such as the forced allocation of defaulted positions or contract tear-up. Crises will require a flexible response, and this will in turn rely on co-operation between the CCP and its clearing members.

The fundamental conflict can only be resolved by clearing members' acceptance of their critical role in risk mutualisation

The necessary role that CCP clearing members play in underwriting risk beyond their default fund contributions has implications for CCP governance. Speaking at a symposium held by the Chicago Fed in April 2014, former Bank of England deputy governor Paul Tucker said: “The quid pro quo has to be involvement in risk policies and practices. Some of their staff, subject to Chinese walls, need to be able to see inside the box of the clearing house's risk management and exposures. The top management and boards of the big global banks and dealers should select their firms' representatives on CCP boards and risk committees with scrupulous care."

Failure to strengthen a mature and responsible working relationship may result in continued antagonism over particular aspects of risk management and could preclude a successful CCP recovery or resolution.

While some issues may be resolved by regulatory fiat, the fundamental conflict can only be resolved by clearing members' acceptance of their critical role in risk mutualisation. That, in turn, is dependent on responsible and significant participation by clearing members in CCP governance. Either the industry must find a way to keep CCP clearing members engaged – even when they do not participate in the CCPs' profits – or it will have to move towards another model.

This article is based on a paper due to be published in the Journal of Financial Market Infrastructures in March. The opinions expressed are those of the authors and do not necessarily represent those of the Chicago Fed or the US Federal Reserve Board

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