FRB Governor Powell Discusses Expanding the Central Clearing of OTC Derivatives
Commentary by Steven Lofchie
At the Annual International Banking Conference, Board of Governors of the Federal Reserve System ("FRB") Governor Jerome Powell discussed the global initiative to expand central clearing of over-the-counter ("OTC") derivatives and how to ensure the successful operation of central clearing counterparties ("CCPs").
According to Governor Powell, roughly 20 percent of all credit derivatives and 45 percent of all interest rate derivatives are now centrally cleared. To accommodate the move toward central clearing, achieve risk reduction and avoid CCP failure, Governor Powell said, a number of issues with CCPs must be addressed by domestic and international regulators:
- Liquidity - Governor Powell explained that the adoption of the Principles for Financial Market Infrastructures around the world is driving improvements in CCP liquidity; however, he stated, CCPs and their supervisors must be vigilant to ensure that liquid resources are sufficient to withstand the kinds of liquidity shocks that would likely accompany a member's default. Additionally, he noted, it is crucial for liquidity scenario analysis to be a regular part of a CCP's stress-testing program.
- Transparency and Disclosure - Governor Powell stressed that CCPs must provide greater transparency to their clearing members and to the public. He stated that clearing members must understand fully their risk exposure to CCPs, meaning that CCPs must disclose stress-test results. Additionally, he said, CCPs should provide clearing members with appropriate information about the specifications and application of margin models and the sizing of default funds to cover losses.
- Stress Testing - Governor Powell called for domestic and international regulators to consider taking steps to strengthen credit and liquidity stress testing conducted by CCPs, stating that clearing members and regulators should have "a more systematic view of what stress tests are performed, at what frequency, with what assumptions and with what results." He also suggested that regulators work collaboratively and consider some sort of standardized approach to supervisory stress testing in order to ensure that the stress tests of different CCPs are comparable.
- "Skin in the Game" - Governor Powell mentioned that U.S. authorities should consider requiring that CCPs place significant amounts of their own loss-absorbing resources in front of a mutualized clearing fund, or other financial resources provided by clearing members, to create incentives for the owners of CCPs to consider new products and the modeling of risks carefully and conservatively.
Should a CCP fail, Governor Powell said, CCPs and regulators must develop clear and detailed recovery and resolution strategies that are designed to minimize the transmission of the CCP's distress to its clearing members and beyond. In order to ensure that CCPs do not themselves become too-big-to-fail entities, he explained, the industry needs transparent, actionable and effective plans for dealing with financial shocks that do not rely on an explicit or implicit role played by the government.
See: Governor Powell's Speech.
Commentary
Governor Powell's speech recognizes a number of the major risks of CCPs to the financial system. As he points out, the incentive system that might motivate CCPs to keep themselves safe is so uncertain that CCPs would still require "careful consideration," and a "number of [unidentified] factors would need to be considered in implementing [a skin-in-the-game] requirement" for the owners of CCPs. Although Governor Powell asserts that it is important for no institution to be too big to fail, it seems inconceivable that the government could actually allow a major clearinghouse to fail, given (i) the near-infinite notional value of contracts that must be run through the clearinghouse and (ii) the government's responsibility for forcing everyone to use the clearinghouse in the first place. To the list of financial problems that could befall a clearinghouse, we must add the possibility of operational failures.
As to liquidity risk, most troubling is the ability of a major CCP to survive by dragging down everyone else. That is, in times of extreme volatility and limited liquidity, a major CCP has the authority to demand unlimited cash margin from its participants, thereby draining liquidity from the economic system at the time when it is needed most. Global regulators appear to treat the idea that CCPs make the markets safer as axiomatic, but their assumptions are not well supported.