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Spotlight on CCP risk

Published in Automated Trader Magazine Issue 37 Summer 2015

Regulators around the world are increasingly looking to central counterparty (CCP) clearing houses as a way to mitigate counterparty risk in the market. But is this just the next too-big-to-fail in the making?

Josh Galper, Managing Principal, Finadium

Josh Galper, Managing Principal, Finadium

CCPs bring counterparties together and manage the risk of financial transactions between them. But by becoming an essential infrastructure, CCPs can possibly pose significant systemic risk to the market.

The "heart of the issue", said Josh Galper, managing principal of consultancy firm, Finadium, can be found within the tangled network of bilateral and CCP transactions.

"The CCPs are not a direct cause of concern; CCPs are unlikely to fail because of poor internal risk management. The cause of concern is how much risk is concentrated among large clearing members who could potentially fail," said Galper.

One bank failing could strain, but not incapacitate a single CCP. But banks like JP Morgan, Citi or HSBC could be members of a dozen or more CCPs. In a worst case scenario, a number of major banks could fail and any CCPs in which they are members would have to liquidate positions.

"A collapse of one or more major CCP without an orderly regulation would create very substantial disruption in the financial market and in domestic economies," he said.


Proposals in both the US Dodd-Frank Act and the European Market Infrastructure Regulation (EMIR) stress the importance of having over-the-counter (OTC) derivative transactions cleared through CCPs, but a number of organisations, and in some cases, CCPs themselves, have raised concerns.

Diana Chan, CEO of EuroCCP, which provides equities clearing services on a pan-European basis, said bilateral transactions can create a web of unknown, opaque risk between financial market participants.

It is essential that transactions, particularly in the OTC derivatives world, can be unwound in an orderly way.

Source: Office of Financial Research

"Some of the OTC contracts are not liquid, they do not have easily available market prices to reference to, so it is very difficult to mark to market, which increases the possibility of an OTC derivative CCP being short of margin because it cannot calculate accurately how much it needs," she said.

The challenge of marking to market - the process by which contracts are reconciled and risk exposures identified among counterparties - is that the price and liquidity of OTC derivatives are not known for being transparent.

"When it is difficult to find a market price, it literally means it is impossible to mark to market," Chan said. "(A CCP) will then have to rely on assumed pricing based on mathematical models which may become invalid as correlations may change quicker than the underlying assumptions can be adjusted."


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