OFR Releases Working Papers on Potential Risks of Central Clearing and OTC Derivative Transactions (with Lofchie Comment)

The Office of Financial Research ("OFR") released two working papers that present new approaches to evaluating the risks of a central clearing framework.

The first paper Systemic Risk: The Dynamics under Central Clearing, focuses on concentration risks to a central clearing counterparty ("CCP") posed by large clearing members. The model shows that, as banks hedge undesired risks by trading through the CCP, systemic risk can build up over time. According to the paper, larger clearing members crowd out smaller clearing members. This creates a concentration that increases the exposure of a CCP to the failure of its largest clearing members, increases the cost of capital, and reduces the effectiveness of hedging. The authors propose a self-funding concentration charge to clearing members as a policy response for regulators and market participants.

The second paper, Hidden Illiquidity with Multiple Central Counterparties, focuses on the challenges of managing systemic risks in markets cleared by multiple CCPs. The authors find that CCPs need to take into account overlapping CCP memberships in setting margin requirements. According to the paper, if a clearing member defaults at one CCP, it will fail at all CCPs of which it is a clearing member. The authors argue that addressing this problem requires some sharing of information between CCPs. According to the paper, a lack of coordination can lead to a "race to the bottom" in which the CCP with the most optimistic view of liquidation costs drives competitors out of the market.

Overall, the papers suggest the need for attention to concentration risks in central clearing to strengthen CCPs and to guard against threats to financial stability from disparities in clearing member size and their portfolio liquidation impacts.

Lofchie Comment: These two working papers provide additional punctures in the assertion that central clearing is the great solution to systemic risk. At what point does it become time for a re-evaluation of the "theories" behind central clearing under Dodd-Frank?

See: Systemic Risk: The Dynamics under Central Clearing by Agostino Capponi, W. Allen Cheng, and Sriram Rajan; Hidden Illiquidity with Multiple Central Counterparties by Paul Glasserman, Ciamac C. Moallemi, and Kai Yuan; OFR Press Release.