Federal Reserve Bank of Chicago Senior Policy Specialist Warns That CCPs Concentrate Risk
Commentary by Bob Zwirb
In an article titled "Central Clearing: Risks and Customer Protections," Federal Reserve Bank of Chicago Senior Policy Specialist Ivana Ruffini cautioned that the "concentration of risk" in central counterparties ("CCPs") "must not be underestimated, as CCP failures, while rare, do happen." The article examined the "impact of the market structure change and associated customer protection frameworks on risks faced by market participants, with a focus on the liquidity and credit risks that could arise in the aftermath of a potential [futures commission merchant] failure."
As part of the examination, the article provided (i) a brief overview of central counterparty clearing, (ii) the salient characteristics of intermediation in centrally cleared markets, (iii) key risks associated with the failure of a clearing member, and examples to illustrate the variability of exposures, and (iv) customer protection frameworks that are used to mitigate the impact of such identified exposures.
The author found that:
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even though the central clearing mandate and the legally segmented operationally commingled ("LSOC") framework were intended to reduce systemic risk, that risk was not eliminated entirely following the 2008 financial crisis;
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central clearing shifts risk, and sometimes reduces it, but does not eliminate it;
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central clearing concentrates risk into a CCP, and financial intermediation introduces new risks;
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although "some failures of financial intermediaries . . . were successfully managed by central counterparties, other failures have resulted in customer losses that occurred when customer funds were misused by intermediaries . . . and when a customer defaulted";
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central clearing does not protect customers of a defaulting futures commission merchant ("FCM");
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customer protection frameworks "offered under the traditional U.S. futures customer segregation and LSOC are somewhat limited" because "both frameworks rely on segregation of customer funds to protect customer assets"; and
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"under the U.S. Bankruptcy Code even individually segregated customer funds are treated as if they were held commingled in a single omnibus account."
Commentary
Following the global financial crisis of 2007-2009, one of the primary aims of regulators was to encourage more derivatives and other financial transactions to be cleared through CCPs, the development of which was touted as a way to reduce both counterparty and systemic risk, and greatly curtail the likelihood of another financial crisis. Recently, however, more sober analyses have recognized that central clearing, particularly mandated central clearing, creates its own set of risks that undercut the notion that it is a bulwark against systemic risk. Ms. Ruffini's article reminds us that central clearing can be beneficial, but also can serve as "a source of fragility." See Ivana Ruffini and Robert Steigerwald, OTC Derivatives — A Primer on Market Infrastructure and Regulatory Policy, p. 81 (Nov. 25, 2014). For example, central clearing facilitates "multilateral netting," which is a real benefit, but, as Ms. Ruffini points out, "may not always be more efficient than bilateral netting." Ms. Ruffini then argues that a market structure based on mandatory central clearing eliminates neither counterparty nor systemic risk, and does not protect the customers of a defaulting FCM. Instead, as Ms. Ruffini and many other economists corroborate, it concentrates risk and in the process introduces new risks, such as triggering calls for additional collateral at the worst possible times during market stress.
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University of Houston Finance Professor Craig Pirrong argues that the 2015 Annual Report to Congress by the Office of Financial Research "misses the real problems" concerning the systemic risks of central clearing counterparties.
