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Streetwise Professor Says OFR Annual Report Misses "Real Problems" of CCPs

Steven.Lofchie@cwt.com's picture
Commentary by Steven Lofchie

In a blog post titled "CCPs and RTGs: Devil Take the Hindmost?" University of Houston Finance Professor Craig Pirrong argues that the 2015 Annual Report to Congress by the Office of Financial Research ("OFR") "misses the real problems" concerning the systemic risks of central clearing counterparties ("CCPs").

Professor Pirrong asserts that the OFR highlighted benefits of clearing, i.e., the ability of CCPs and, through them, regulators, to get better information on derivatives positions and trading prices, "can be achieved by transaction reporting alone, without going the full Monty to clearing, which also entails . . . mutualization of default risk."

Professor Pirrong argued that the OFR "gets it wrong when it states that CCPs 'reduce the risk of counterparty default." CCPs reallocate rather than reduce such risk; they "redistribute the risk of the insolvency or illiquidity of a large financial institution away from its derivatives counterparties towards its other creditors." In other words, a CCP "protects one group of creditors at the expense of others. It is very much open to question whether this reallocation is systemically stabilizing," he stated.

Commentary

Professor Pirrong's analysis provokes important policy questions. Does the ability of the CCPs to demand more margin without being subject to contractual limits create a liquidity crisis (or exacerbate a downward spiral during a time of market volatility) when clearing firms and customers sell off positions to meet CCPs' margin demands? The risk that CCPs may damage other market participants is at least as great as that of a direct CCP failure. This does not seem to be a risk that the OFR or other governmental entities seem inclined to address which is difficult to understand precisely because the risk is straightforward. The concern is not speculative or fanciful in any way. In a time of market volatility, (i) it is difficult to raise cash, (ii) CCPs are not subject to any contractual limits on their power to demand cash collateral from clearing firms, (iii) CCPs are very motivated to demand cash collateral to protect themselves, and (iv) CCPs' demands drain liquidity from the market.

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