The clearing mandate, requiring central clearing of standardised OTC derivatives, is well and truly upon us. Despite this, there is clear concern as to whether OTC clearing will really make financial markets safer. Regulators appear to view central counterparties (CCPs) as a panacea, and their advantages are commonly stated, yet little consideration is given to the potential disadvantages and inherent weaknesses in channelling a large volume of OTC products through CCPs. A typical statement regarding the benefits of central clearing is [Note 1]  “The primary advantage of a CCP is its ability to reduce systemic risk through multilateral netting of exposures, the enforcement of robust risk management standards, and mutualization of losses resulting from clearing member failures”. Whilst comments such as this may indeed prove to be generally correct, there are a number of important points to discuss.

First, due to the reduction of bilateral netting between clearable (CCP) and non-clearable (bilateral) trades spread over more than one CCP, exposure reduction through multilateral netting is not an inevitable consequence of the clearing mandate (for example, Duffie and Zhu 2011 [Note 2]). Mandatory clearing can actually increase exposure due to this bifurcation which would presumably then imply a commensurate increase in systemic risk. Of course, multilateral netting efficiency can be improved by having only a small number of CCPs and, potentially, also with interoperability arrangements. However, the resulting too-big-to-fail implications are clearly less than ideal. Furthermore, multilateral netting is not a magical technique for reducing exposure but instead merely redistributes exposure from one place to another [Note 3] . In a default scenario, multilateral netting improves the claim of OTC derivatives creditors at the expense of other creditors. Hence, reduction, if any, of systemic risk is confined to the OTC market and not necessarily the financial markets in general.

Regarding “robust risk management standards” (the sort of expression often applied to large banks in the run up to the last financial crisis), it is still to be defined what these really are. Taking the initial margins of CCPs as one example: a typical calculation might require that initial margin is sufficient to cover the average of the worst 6 losses in the last two and a half thousand days (10 years). In technical terms this can be defined as a 99.8% expected shortfall (VAR’s inconsiderably more intelligent cousin). Being 99.8% confident of having enough initial margin sounds like robust risk management. However, the problem with the thousands of days of market data changes that are analysed in order to define the initial margin is that on virtually none of them have any CCP members (i.e. banks) actually defaulted. Predicting the market volatility in the aftermath of a default event using data when defaults don’t happen is dangerous. The worst six days in the above example are actually pretty much the only days of interest, given that at least some of these represent the last significant OTC default scenario (Lehman Brothers). However, taking the average is less than “robust” and would imply significant probability of losses exceeding initial margin and spilling over into default funds. At such a point, whilst the CCP may not fail, clearing members will be subject to losses and therefore this does constitute some form of default scenario. 

Second, loss mutualisation in the default fund can indeed be an efficient risk sharing arrangement but also has some problematic side effects due to moral hazard issues. For example, when executing an OTC transaction that will be central cleared, the identity and credit quality of the original bilateral counterparty is almost [Note 4] completely insignificant since the effective counterparty will be the CCP. Bilateral trades will therefore be executed without fear of counterparty risk, and weaker counterparties will not be clearly penalised for their relatively low credit quality. The auctions held by CCPs in the aftermath of a default are crucial for OTC portfolios which are relatively illiquid and subject to complex multidimensional risk factors. The mutualisation of losses from the default management process also relies on some combination of loss allocation methods that are fair and create the right incentives and discourage a prisoner’s dilemma. This leads to some quite extreme methods, such as variation margin gains haircutting (VMGH), forced allocation and tear-up which, whilst preventing a potential CCP failure, can hardly be viewed as creating any stability in the aftermath of a significant default(s). Luckily, we have recently been reminded that CCPs “probably” have enough of their own capital at risk [Note 5] (by the way, it probably won’t rain tomorrow).

Of course, CCPs have advantages such as reducing the interconnectedness in OTC derivative markets. None of the above points prove that the clearing mandate will be inefficient or not lead to a reduction in systemic risk. However, views are often heavily divided between whether an OTC CCP will be something closer to a panacea or nostrum. Surely there needs to be more attention paid to the correct assessment of the relative advantages and disadvantages of central clearing in different regions, markets and product classes. Only then can we be sure that one of the most significant aspects of regulatory reform since the last crisis will indeed make financial markets safer. 

1. International Monetary Fund (IMF), 2010, “Making over-the-counter derivatives safer: the role of central counterparties”, Chapter 3, Global Financial Stability Report (GFSR) April, http://www.imf.org/External/Pubs/FT/GFSR/2010/01/pdf/chap3.pdf
2. Duffie, D. and H. Zhu, 2011, “Does a Central Clearing Counterparty Reduce Counterparty Risk?”, Review of Asset Pricing Studies, 1(1), pp 74-95
3. For example, see Pirrong, C., 2013, “A Bill of Goods: CCPs and Systemic Risk”, working paper, Bauer College of Business, University of Houston, http://www.bauer.uh.edu/spirrong/pirrong_bdf_boe_ecb_clearing_130506_pdf.pdf
4. There is a small possibility that through the loss allocation rules of the CCP that this may be relevant.  
5. “LCH and CME have enough capital, says Isda's O'Connor”, Risk Magazine, 24th September 2014.